Berkshire Ruminations

Of Permanent Value - the Trilogy!

2010-04-06T19:22:00.001-07:00

Just thought I'd do my part to promote Andy Kilpatrick's latest magnum opus, the 2010 edition of Of Permanent Value: The Story of Warren Buffett: A trilogy. This three-volume, 2000 page, behemoth replaces the two-volume 2008 "cosmic edition" that weighed in at a mere 10 pounds and 1800 pages. I have no idea how physically big the trilogy will be, but I imagine he won't be sending out many review copies with shipping costs that high.

But the most exciting part is that the Warren Buffett Class at the University of Missouri has an entire chapter devoted to it. Of course, there are over a hundred chapters, but it is still pretty cool. Anyway, Mr. Kilpatrick is a terrific guy. I had a lot of fun corresponding with him about the class and his obsession with Buffett. I encourage everyone to try to acquire copy of the this "Buffett encyclopedia" even if it currently is listing for $70 on Amazon.

Berkshire History in the Making!

2009-11-03T07:04:00.000-08:00

I don’t maintain this blog much anymore, but that doesn’t mean I don’t follow Berkshire Hathaway. And I would be remiss not to comment on the news I awoke to this morning.

Today is likely the most historic day in the history of Berkshire. The company is making the largest single acquisition – by a huge margin – that it ever has by acquiring the 75% of Burlington Northern Santa Fe it doesn't already own. Additionally, BRK.B is getting split 50-for-1. No more $3000 shares. Is this the end of the BRK mystique?

Two years ago, while teaching the Warren Buffett class, Burlington Northern CEO Matt Rose visited our MBA program. It proved to be a perfect opportunity for the students to see the tires meeting the track. Berkshire had just made its first major investment in Burlington Northern, and Mr. Rose couldn’t have been happier about it. We were able to quiz him about Buffett’s interest in the company, the company’s growing returns on capital and its position in a changing U.S. economy. We found him to be very personable, optimistic and, at least ostensibly, very honest. I am not surprised whatsoever that Buffett befriended Mr. Rose.

But the most important lesson was a crucial one to the study of Buffett and Berkshire Hathaway. While BNSF was far from a typical Berkshire investment, it had enough of the characteristics Buffett looks for to make it appropriate for Berkshire’s portfolio. Railroads are interesting investments because, on the one hand, they are very capital-intensive and lack what Buffett calls “franchise value.” However, more than compensating for these shortcomings is the economic position of the company.

All railroads – and BNSF in particular given its reach – basically own the transportation rights of anyone wishing to ship goods, much like a toll bridge. Of course, Mr. Buffett famously identified “toll bridge” type businesses as desirable investments early in his career. After his investment in the Buffalo Evening News in 1977, Berkshire was sued by the News’ only competitor. The plaintiff claimed Buffett was trying to drive it out of business to give the News a monopoly in the market. This was probably true. During cross-examination, Buffett explained that newspapers are like “toll bridges” in that they are relatively free to raise advertising rates as much as possible because anyone wishing to advertise in town had nowhere else to turn. I can just imagine his legal counsel cringing as he explained this concept in what was undoubtedly his characteristic simple, matter-of-fact style.

Railroads are very similar. The tracks have been laid, and for the most part will not be expanded. BNSF owns the largest portion of these tracks. With oil and gas prices set to rise (I’m talking long-run here) the greater fuel efficiency of shipping via rail versus truck will become increasingly appealing. And when this shipping occurs via rail, shippers will have little choice over with whom to do business.

Moreover, for a hundred years railroads have been consolidating. Now there are only a few very large railroads left. This seems to have resulted in significant scale economies, because returns on capital are for the first time in many years convincingly and consistently in excess of the cost of capital. These companies are creating value.

A difficulty I have had in teaching the Warren Buffett philosophy over the years is that there are many different attributes that may make for a good stock investment. We can try to construct a checklist of things Mr. Buffett looks for – many people have tried over the years. But the reality is that each potential investment must be evaluated on its own merit, not necessarily its merit relative to some predetermined definition of quality.

Apparently a no-brainer. Who knew?

2009-08-12T08:59:00.000-07:00

I thought it was interesting that yesterday the Wall Street Journal reported that "economists are nearly unanimous that Ben Bernanke should be reappointed to another term" and that the majority also "say the recession is over." Who exactly are these economists, I wonder. Let's just hope they are better at predicting the economy than Bernanke himself!

100% Insanity

2009-08-06T11:27:00.000-07:00

To me, this is proof the mainstream media has absolutely no clue about economic reality.

CNN proudly boasts today that Cash For Clunkers program is “Real Stimulus,” claiming that “The boost to auto sales caused by the government trade-in program should lead to increased production from Detroit. That could have a big ripple effect.”

This whole Clunkers idea is rooted in the Keynesian logic that spending in and of itself stimulates economic growth. The logic goes that, because we built up our economy during good times and when times get rough various elements of the economy are suddenly underutilized, someone needs to fill the gap. Keynesians believe this gap should be filled by the government. What is ridiculous about this idea is that the government cannot produce any wealth, it can merely reallocate it. In order to fill this gap it must either tax its citizens or borrow. No new wealth is created through either process.

While Keynesian stimulus is clearly ridiculous, a lot of people believe it. So let’s say, just for the moment, that government spending is economically stimulative. All Cash For Clunkers will do is to pull demand forward a period or so. All those people who were driving vehicles that would need to be replaced in one or two years will replace them now. What happens in one or two years? Lower auto sales because fewer people are replacing their clunkers! This results in the same overcapacity a few years down the road that the stimulus was designed to fill today. The moral of this story is simple: the government can treat the symptoms, but it cannot cure the disease.

People can easily define their wealth on an individual level. I own a house, a car, furniture etc and all these things have value because they are useful. Therefore my wealth is defined as the cumulative value of all these useful things I own less the claims others have on them (read: debt). But when we expand this to the national level people seem to have trouble understanding.

American wealth is all the stuff we own, collectively, that has value. So when the government destroys things that have value, like cars worth less than $4500, this destroys wealth. The guy who sold his $2000 car to the government for $4500 may indeed by $2500 wealthier, but this wealth had to come from somewhere. (While the government can create money out of thin air, it cannot create wealth out of thin air.) In this case, because $2000 in wealth was actually destroyed, the full $4500 will come from everybody that doesn't sell their car to the government. The rest of the population doesn’t notice this personal wealth loss because it is either too small when spread throughout the economy or it hasn’t even happened yet and will eventually be borne by future generations.

This wealth destruction is particularly pronounced when the government doesn’t have the $4500 in its pocket that it needs to purchase the vehicle that it plans to destroy, because this means the purchase will have to be financed with borrowing. Because the national debt is already unmanageable, eventually this $4500 debt will be monetized by printing new money to repay it (a process that, incidentally, has already begun). This causes inflation, which lowers the wealth of everyone that owns dollars.

So I guess the only conclusion I can draw from this nonsense is that our elected leaders and the majority of our population continue to behave like children. Listen carefully: Americans already have too much debt. The last thing the government should be doing is encouraging them to take on even more, while simultaneously taking on more itself!

But alas, humans aren’t long-run thinking for the most part, so it shouldn’t be a surprise that the reaction to economic crisis is to lessen the pain in the short term at the expense of long term prosperity. And that, clearly, is why the Clunkers program has been praised by just about everyone that hasn’t really thought it through. Just as someone apparently has defined “stimulus” as government spending concentrated over a short period of time, they have defined “success” of the Clunkers program by the program’s ability to concentrate car sales in a short period of time. Congrats guys. You did it. I hope your grandchildren can forgive you.

Cash For Clunkers

2009-08-01T21:41:00.000-07:00

Here’s an idea for wealth creation that can’t fail:

Let’s encourage everybody with a particular asset that has value - namely a car worth less than $4500 - to sell it to the government so the government can then destroy it. The government will finance the purchase of this soon-to-be destroyed asset with money borrowed from foreign investors (since it doesn’t have any money of its own and seems unconcerned with the prospect of exponentially rising levels of debt). Then, after the asset is destroyed, the remnants of it will be shipped abroad in the form of scrap metal, so that foreign manufacturers can re-form this metal in to a new valuable asset that Americans will be more than eager to purchase with money they still don’t have.

Yeah, that should work.

Buffett was wrong about this one. (Unfortunately it is the most important one of all.)

2009-04-25T09:39:00.000-07:00

This is an issue that has become very important to me lately, and I hope readers will be patient and read through my thoughts. It is not a pleasant topic and most people would prefer to pretend the problem doesn’t exist. But it needs attention soon.

One evening last spring I took my wife to a local movie theater to see the premiere of the documentary I.O.U.S.A., the movie designed to increase awareness of the “inconvenient fiscal truth” that our nation faces. It was a great event, and was followed by a live Q&A with some of the stars, including Dave Walker and Warren Buffett.

Walker was the doomsayer, and expanded on the already strong case made by the movie that due to the national debt and other liabilities of the federal government, our children are destined to end up worse off than we are today. Buffett was the counterpoint, arguing that although it is a serious problem, America will be fine in the long run.

Buffett was wrong.

I wanted to believe the guy, my hero, the Oracle of Omaha. But the facts just didn’t support his Alfred E. Newman-esque stance. Here we are a year later, and things not only look bleaker than ever, it almost seems as if the sky has started its fall.

When Bush 43 took office in 2001, our nation had $5.6 trillion in outstanding debt. In the eight years since then, through a combination of tax cuts, wars and expensive Medicare supplements, the amount has mushroomed to nearly $11 trillion. Think about that: the balance of our national debt is climbing at an annual compound rate of 9%. And this doesn’t even include the unfunded liabilities of Medicare and Social Security, which will come due at ever increasing rates in the coming years and by most accounts dwarf our current $11 trillion in debt.

The Peter G. Peterson Foundation estimates that our “real” national debt, after accounting for all these unfunded liabilities that will presumably have to be financed by taking on additional debt, is now $56.4 trillion – four times our current GDP. Comfortably paying this off is simply an impossibility.

Now, in a misguided Keynesian approach to solving the financial crisis(which is not unrelated to the problem of government overspending in the first place), Obama and the others are spending a trillion dollars MORE of money WE DON’T HAVE. Of course, this is not a Democrat or a Republican issue. Democrats like to spend money, Republicans like to cut taxes. BOTH are equally dangerous. No one will want to do it, but what this country needs is higher taxes, lower spending and a higher personal savings rate. How the hell are we gonna pull that one off??

I don’t think we will. And that is why I think Buffett was wrong. Washington, now more than ever, lacks the political will to correct this problem. And that is why we are doomed. Sadly, what will eventually happen is the government will have to print enormous sums of new money, causing hyperinflation and prohibitively high interest rates. What it cannot do, ironically, is choose to simply default on its mountain of debt as the Russians did in the 90s. This is because the vast majority of our debt is actually owed to ourselves, via Social Security and Medicare entitlements. What a fricking trainwreck.

What I am saying is nothing new. People throw these kinds of numbers around all the time. At some level, this may even be counterproductive – people get desensitized to the enormity of problem. What we don’t hear enough about is what life will actually be like when this hits the fan some twenty years down the road. How will we be living when 75% of our GDP is committed to simply servicing our national debt? Where will jobs come from when reinvestment ceases because corporations are forced to forfeit their earnings to the government? How will the citizenship react the government is forced to confiscate nearly all the earnings of the public while simultaneously eliminating the programs upon which everyone has become so accustomed to relying? From a sociological perspective, this is terrifying. Chaos could ensue. Good thing the second amendment hasn’t been completely repealed.

Perhaps most frustrating to me is that the root of the problem seems to be something that is all but impossible to change. It is a societal attitude towards debt – the entitlement philosophy that WAY to many (though not all) Americans adhere to. I DESERVE that 52” plasma tv, because I work ten hours a day flipping burgers, and burger flipping is hard work. That kind of attitude will kill a society fiscally, because the truth is that simple hard work does not entitle you to anything more than someone else is willing to pay you for that work. If they don’t pay you enough, you need to find a way to become more economically productive so as to boost your wages so that you can afford that Cadillac Escalade only AFTER having saved for it.

It’s a chicken-or-egg situation to determine whether it is the government setting a bad example for individuals or if it’s an infiltration of the government by entitlement-minded individuals, but clearly both segments of our society have the same attitude towards debt. This MUST change.

I worry about my one-year old son, David, and what type of world he will face as an adult. For his birthday earlier this month, a good friend of mine gave him a $50 Series EE “Patriot” savings bond. I loved the message of savings and responsibility in such a gift, I only wondered if it would be in default when David goes to cash it in 2039. I tell you, I would do anything possible for my son but ensuring he lives in a prosperous economy seems beyond my control. That worries the hell out of me.

I am sure many folks will think I am wacko for this outlook, but I hope those that do take an honest look at the situation before concluding I am wrong. At a minimum we need to put ourselves on track to reverse the current trend.

*** Clarification, 28 Apr 2009***
In this post, I did not mean to imply that I think Buffett was wrong just because of what has happened over the past year. Buffett said last spring that "America will be fine in the long run" and by long-run I assume he means 30, 50 years. I just happen to disagree becuase as long as we continue this trend of enormous deficit spending ($1.7 trillion this year alone) we will not be fine in the long run.

A dual-class arbitrage in Berkshire stock?

2009-02-27T12:56:00.001-08:00

Hat tip to Ray for pointing this out to me. A few days ago BRK.B was trading at a level significantly lower than 1/30 of BRK.A. In fact the spread represented 7% of the value of BRK.B.

This was a decent arbitrage opportunity, as the two BRK classes have historically been pretty good about reverting to parity fairly quickly. Indeed, within two days the spread has already narrowed to less than 2% (as a % of BRK.B). Below is a chart of the difference over the last year.

It is interesting to see how the spread became more erratic as market volatility increased in the fall. Note that the spread rarely dips into the negative. This is by construction, since BRK.A is convertible in to BRK.B but not vice versa. This means that a mispricing favoring the B shares could immediately be corrected by arbitrageurs converting their A shares to B. But the opposite cannot be done, leaving the arbitrageur at the mercy of the market to correct the mispricing.

In the rare cases when the spread does bounce up to the 7% range, this makes for an opportunity for a quick profit for those vigilant enough and quick-fingered enough. The recent bounce lasted at least 24 hours from what I could tell, which is plenty of time to implement the trade.

A few other notes: BRK is a great stock to play the dual-class arbitrage with because it is so liquid and small investors should have no trouble finding A shares available for short. Of course, you need at least $78,000 in capital so I guess the really small investor is out of luck.

Moreover, the differential in voting rights between the A shares and B shares is inconsequential in the case of Berkshire since Buffett et al. control the voting power of the company anyhow. Thus we can expect the 1:30 ratio to hold irrespective of the differential voting rights of the two shares.

I suppose measuring the spread as a % of BRK.A would be more appropriate, because a true arbitrage strategy would short BRK.A and long BRK.B, holding until the difference was zero.

At what point does Berkshire get "stupid cheap"?

2009-02-20T10:35:00.000-08:00

I own a lot of Berkshire stock. I don’t like seeing it go down because I don’t have a lot of liquidity at the moment, otherwise I would welcome the buying opportunity. But this begs the question, is this indeed a buying opportunity ? Or is it the beginning of the demise of the greatest investment of all time?

With is decline today, Berkshire stock has just experienced its largest drawdown ever. From Jun 19, 1998 to Mar 10, 2000 (the same day the NASDAQ hit its high, by the way), BRK lost 48.9%. From December 7, 2007 to today, BRK has lost 49.33%. It is worth noting that its current low is 81% higher than its 2000 low, which equates to a 5.6% annual compounded rate of return (trough-to-trough). Not exactly Berkshire’s historical annual average.

In my opinion, Berkshire currently suffers from a tremendous lack of transparency. This may sound blasphemous, but it is not. Although Warren Buffett prides himself in holding simple, understandable businesses, Berkshire’s portfolio is anything but. The company has an insurance business that only Buffett fully understands, with mysterious macro bets that seem entirely inconsistent with the style of investing that got the company to where it is today.

Investors are rightfully very suspicious of all these derivatives, particularly since Buffett refuses to talk about them except in broad, vague terms. I’m not faulting him for this necessarily, since for many companies such refusal would be expected. But we expect Buffett to explain everything to his investors much more thoroughly than a typical CEO would. If he believes the annual report should provide investors with enough information to allow them to accurately value the company, as he has said in the past, then it might seem he is now failing in this regard.

In last year’ letter to shareholders he goes in to quite a bit of detail about what derivatives the company owns, but in the current market environment this information is stale and insufficient. For instance, he says,

We have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

This is clearly a much higher level of disclosure than many companies would provide. But it almost raises more questions than it answers. $4.7 billion? Has this happened? The third quarter 10Q provides no more detail, but does indicate that a) the company wasn’t substantially hurt by the derivatives up to that point and b) that it increased the size of its derivative portfolio. (I lump both the options and credit default swaps in to this category.) The real problem is that there is no telling what has happened since September 30.

Of course there are more obvious reasons for the Berkshire’s stock’s slide. Two of Berkshires three largest common stock holdings, Wells Fargo and American Express (Coca-Cola is the third) have each been clobbered by more than 70%, costing the company at least $11billion were we to mark them to market. Ouch. Kinda makes you wonder if he (along with just about everybody else) misjudged the threat of financial contagion on Berkshire’s investments in financials, or for that matter the ability of management at these (supposedly very strong companies) to resist it.

The annual report that is due out in the next few weeks will be very interesting. We have heard the “end of Berkshire” refrain before, not coincidentally at the same time as its last trough that I mention above. So on a superficial level one might be inclined to assume it’s another chicken-little situation. But this recession is different from the tech bubble burst and I’m not counting any chickens just yet anyway. There is just too much uncertainty this time around.

RBP Investing Update

2009-01-22T12:43:00.001-08:00

Back in June I mentioned on this blog that I had started working for a company called Transparent Value, which developed the Dow Jones RBP Indexes based on their proprietary methodology called "Required Business Performance," and that I had been writing a blog for them.

While I realize it may sound like I am just trying to sell the company, I seriously think anyone with an appreciation for value ought to give this methodology a look because it looks like the guys at Transparent Value really are on to something. This is evidenced by the performance of the indexes in 2008. If you had used their methodology to construct a long/short market neutral portfolio you would have beaten the market handily (and actually earned a positive return in 2008!). Granted we only have one year of performance history, but what a year it was to test an idea like this!

For an academic and value investor like me, their methodology is the perfect blend of empirics and fundamental value. Basically they take each company determine what assumptions one would have to make about it in order to make a DCF valuation yield whatever the current stock price is. Then based on historical performance the assign each company a probability that they will be able to deliver up to those assumptions. The indexes simply select stocks based on this probability.

I am always looking for empirically solid but economically logical investing strategies (in fact my other blog, Empirical Finance Research, is devoted to this idea alone) and RBP fits in perfectly. If any readers of this blog have questions about it, let me know because its sometimes hard to understand at first. But once you get the gist of it it's pretty rockin.

Fundamental Value Investors: Characteristics and Performance

2009-01-09T09:20:00.000-08:00

My good friend Wes Gray and I recently wrote an academic paper about value investors. Wes is a fellow coauthor mine over at the Empirical Finance Research blog. In our paper we analyze the investment recommendations on the website Value Investors Club, which in my opinion has some of the highest quality research accessible by the general public.

VIC started about nine years ago and today has more than 3000 very high quality research reports written and published by its members. Most, though not all, VIC members are professional money managers and membership in the club is limited and coveted. Wes and I wondered (from an academic point of view) if these people were actually able to beat the market given that, in an efficient market, we would expect them to not.

Our results indicate they do beat the market and can produce substantial alpha over one-year holding periods. They do best picking small cap stocks, but for horizons longer than one year they fail to beat the market. From this we conclude that there is more inefficiency in small caps and that the broader market recognizes these inefficiencies if you give it a year. This was an exciting finding for us since it logical and makes economic sense and also means we aren’t wasting our time reading VIC write-ups!

Anyway we posted the paper at SSRN yesterday and Guru Focus has already republished it themselves, although I am keeping an updated version on my personal webspace. We would love getting feedback on it as we are looking to improve it and prepare it for academic publication.

Doing the math on CEG (back of the envelope)

2008-12-18T09:55:00.000-08:00

I post this not as any type of authority, but just to figure it out for myself. Can anyone explain better than I have here why CEG stock fell yesterday?

This past summer MidAmerican Energy agreed to acquire all outstanding shares of Constellation Energy Group (CEG) at a price of $26.50 per share in cash, or $4.7 billion.

EDF came along a few weeks ago and offered to pay $4.5 billion to acquire half of CEG’s nuclear division.

In 2007, the nuclear division generated about 60% of CEG’s revenue. So, effectively, EDF was offering to pay approximately as much for 30% of CEG as MidAmerican was offering to pay for the entire company. EDF emphasized that this offer priced CEG stock at a minimum 100% premium to its market price.

Before the EDF offer, CEG stock languished at around $23.50, about a $3 discount to the MidAmerican’s cash offer price of $26.50. Upon the offer, CEG stock shot up to around $28, clearly because EDF’s offer was so superior.

Yesterday, both companies confirmed that MidAmerican was terminating its agreement to acquire CEG. As part of this termination, CEG was to pay MidAmerican a breakup fee of (approximately) $500 million plus shares equaling 10% of CEG’s equity. Upon the announcement of the termination and subsequent details of the breakup, CEG fell 12%, to less than $24/share.

If EDF is offering to pay $4.5 billion for 30% of the company, then the company as a whole should be worth $15 billion minus the breakup costs, assuming of course EDF is not overpaying. With 178 million shares outstanding, this would be about $84/share minus breakup costs.

At its current price, CEG has a market cap of $4.3 billion. In other words, it is about to sell part of one of its units for more than you could buy the entire company for today. Were you to buy CEG today you would (theoretically speaking) get all your money back upon the consummation of the EDF deal, leaving you with half of the nuclear unit and all the rest of CEG as gravy, but also with the obligation to pay MidAmerican $500 million in cash (about $3/share) as well as shares equal to 10% dilution of the stock (if we assume intrinsic value before dilution is 84 – $3 = $81 then this would be $8.10/share).

So what do we have? CEG should be worth $84 – $11.10 = $72.90? Is this right?

I think it may be, but that doesn’t make it a buy. Not in this market anyway. I mean, the stock soars when the EDF deal was proposed, then tanks when the deal was confirmed. This is just nutty.

The logical explanation for CEG’s fall yesterday is that investors simply will not buy anything in this environment that does not have an identifiable and imminent catalyst. There is value all over the place right now, so CEG is not alone with its unfairly low valuation. Because of this, and because the market is so nutty anyway, investors just don’t want to put up with owning the stock now that they know they won’t be getting their $26.50 cash payout.

These are amazing times. Ben Graham is smiling from the heavens I am sure.

Thoughts on a Big 3 "Bailout"

2008-12-15T12:12:00.000-08:00

With so much talk, debate and controversy over the idea of “bailing out” the Big 3 automakers, I find it amazing that so little of this discussion has been on the topic of bankruptcy. The media, congress and the Big 3 CEOs seem to accept as a foregone conclusion that a bankruptcy filing would be a bad thing. This is completely absurd and I would like to discuss why.

Businesses fail in this country (and across the globe in fact) all the time. Because of this, and because chaos might ensue among creditors otherwise, we have this nifty section of the U.S. Code called Title 11 entirely devoted to the idea of the federal court system dealing with failing businesses (or individuals) and aiding in equitable distribution. This is not new – the power to codify such a thing was written in our constitution. What is new is the idea that in some instances we ought to abandon this time-tested framework and instead let Congress directly and deliberately affect the outcome of financial distress for a limited and specific group of companies. Reminder: Congress is not in the business of running businesses. (We need to remind ourselves of this these days.)

I will, for the purposes of this essay, assume that it is in the best interest of the nation to see the Big 3 survive. However, I do think very strong arguments can be made that they ought to be competed out of existence. Nonetheless, let’s assume that the job losses that would result from an outright liquidation of the automakers would be permanently catastrophic to our economy.

Under this scenario the solution is simple: File Chapter 11 like every other company that runs in to difficulty. Many pundits seem to be equating bankruptcy with corporate death, which is just not the case. Chapter 11 primarily allows a firm to restructure its capital. In the end the company comes out of bankruptcy with less financial burden. Operational changes usually occur, but that is not the point. It is a financial maneuvering first and foremost. Filing Chapter 11 does not necessarily mean any factory-line autoworker need lose his job. However, one caveat: If your job is not needed, it may (and should) be put on the chopping block as part of the plan of reorganization. Perhaps this is reason for the UAW’s opposition to bankruptcy?

What Chapter 11 does usually mean is that the CEO will get fired. With very rare exception, the existing CEO gets canned between the time the bankruptcy petition is filed and the plan is confirmed (for empirical support of this contention see Hotchkiss (1995)). This, I think, is why we saw the three CEOs fly their corporate jets to Washington to beg for help. All of them are probably not long for their posts, save perhaps for Mr. Nardelli, who could probably make the strongest argument he is not to blame for his firm’s woes. Thus, the CEOs clearly would rather not go the Chapter 11 route. And so they go before Congress to testify in front of a group of politicians that desire to be seen as the saviors of the auto industry, and who know that the majority of the American public doesn’t really understand what bankruptcy is. It’s a win-win for the powers that be. Not so much for the millions of other stakeholders.

There are two reasonable arguments against a Chapter 11 filing for the Big 3. The first is the weakest, but also the one that has been cited the most by the ignorant media. People won’t buy cars from a bankrupt automaker. Sounds bogus to me, I mean people fly on bankrupt airlines every day. But maybe it is true if potential customers are legitimately worried about the soundness of their warranty. Perhaps. But there is a logical solution that does not include writing a $14 billion check: Have the government guarantee all Big 3 car warranties for a period of time sufficient to restore confidence in the companies. Maybe until confirmation of a Chapter 11 plan of reorganization when the company will have more firm footing?

The other argument against Chapter 11 is more legitimate. This is that, once in bankruptcy, the automakers won’t be able to find the necessary debtor-in-possession financing to keep them afloat through plan confirmation. One reason bankruptcy works as well as it does is that, once the petition is filed, all subsequent debts are given priority over pre-petition debts. This is called debtor-in-possession (DIP) financing. With the credit markets tightening, it is not unlikely that the Big 3 would find DIP financing scarce. No problem! The government can't wait to lend these companies money. Problem solved.

If the government is going to provide lending to the Big 3, it ought to be under the oversight of the bankruptcy court. Congress could tell them to go ahead and file, while assuring them that DIP financing will be available from the government if needed. It seems unnecessarily arbitrary to extend a loan to a troubled company outside of bankruptcy for no other reason than that they employ many people. By structuring government involvement within the framework of bankruptcy (through a government-backed DIP loan and/or guarantee of manufacturer warranties), at least the many other existing creditors will have a voice in the direction of the companies by allowing them to vote on the plan of reorganization.

I don’t like the term “bailout” because it implies that whatever problem exists will be fixed. Congress' proposed bailout promises a great deal of bailing, but not much hope for a bail-out. I mean seriously, blindly throwing money at businesses that are losing billions of dollars every year with no real guarantee that anything will change is an awfully foolish idea for anyone, but especially the government.

Merger Arbitrage Mania!

2008-11-06T09:22:00.000-08:00

I haven’t heard a lot of discussion about this, so I thought I would put my thoughts down on this blog, because to me the phenomenon is pretty obvious. There is some serious value out there right now, and for the last two months the market has been more inefficient than I have ever witnessed in my lifetime. Many stocks, especially small caps, are selling at valuations FAR below their intrinsic value, even after accounting for the possibility of severe and prolonged recession. I am convinced the reason for this is not fundamental, it is institutional.

Hedge funds make up a huge portion of the market and the vast majority of them are levered, many highly levered. By “hedge fund” mean simply the plain-vanilla, independent equity long/short type (not the arcane structured-product investing kind like Bear Stearns’ that got us in to this mess in the first place). By “highly levered” I mean anything from 400% gross exposure (this would be 200% long and 200% short) to infinity.

These are the types of investors that buy up small value stocks. Well, when liquidity dries up brokers have to boost margin requirements. Couple this with falling stock prices and the resulting margin calls and what you have is a situation where everyone is selling. This is basic stuff. But compounding the problem is even more selling as the result of investor redemptions. All hedge funds have different redemption periods, but my guess is that as the year closes we will see even more hedge fund selling as investors dissatisfied with this year’s performance cash out.

I still think it is this delevering phenomenon that explains much of the disparity between price and value that we are currently seeing in the market. But where it seems most obvious is in the merger arbitrage arena. This is where I am focusing currently because a) the value of the stock is much less ambiguous and b) the delevering effect is likely especially pronounced among stocks heavily invested by hedge funds who must leverage up substantially to take advantage of what are typically small discounts.

The first case-in-point is a long-time favorite company of mine, Anheuser-Busch (BUD). InBev settled with BUD back in July to purchase the company for cash of $70/share by calendar-year end. The stock hovered around $68, representing a reasonable merger arb discount, until the market blew up in September. At this point the stock, like all others in the market, fluctuated wildly and momentarily got as low as $56. This $14 discount implied a 25% raw return, or 240% annualized! Investors immediately assumed this was because the deal was in limbo because of the state of the European credit markets. But InBev soon issued a press release reiterating that the cash offer was still a go and still expected to close by the end of the year.

I was lucky enough to load up on BUD around $58. Since I don’t mind owning it as a standalone company (in fact I had for many years anyway), my rationale was simple since the expected value of the purchase was enormously positive. That is, there was a high probability of the deal going through, resulting in a large gain, and only a small probability of it not going through, which would result in only a small loss.

The second case-in-point is an even bigger no-brainer. Remember back in September when Berkshire Hathaway announced that MidAmerican Energy would acquire Constellation Energy (CEG) for $5 billion or $26.50 per share? Did you know the stock is currently trading at $23.50? This doesn’t make any sense, but yet the cigar butt is right there in front of us. With this deal, although not expected to close until sometime in Q2 of 2009, there is absolutely no danger of the acquirer failing to find financing. We are talking about Warren Buffett and his war chest!

I believe that the only reason these situations are occurring is because of the deleveraging effect. It certainly does not seem to be a function of risk so far as I can tell. Highly levered hedge funds MUST sell off their BUD or CEG stakes simply to meet higher margin requirements or investor redemptions. This leaves the individual investor with some great opportunities. But these types of opportunities are unlikely to ever be repeated, which is why I am placing large bets on them.

A couple of other merger arb plays to consider: HPC and MVCO

Ashland Inc.’s acquisition of Hercules Inc. (HPC) is a deal that has been approved by all shareholder constituencies and is expected to close next week. I don’t know much about these companies but I can find no indication anywhere that the deal is in trouble. If it is, someone please let me know. The shareholders will get $18.60 plus 0.093 shares of the acquiring company. With Ashland currently around $20, this puts the value of HPC around $20.50. HPC stock is currently at $18.

Meadow Valley Corporation (MVCO) agreed to be acquired back in July for $11.25/share and the deal is still expected to close by the end of the year. With the stock currently under $8, we are looking at a 26% return in two months.

Another intriguing thing about these merger arbitrages is that even if our return is small, the market in general does not look good in the near term anyway. We could play the safest mergers and still come out ahead, since the standard discount out there right now seems to be in excess of 10% annualized.

FD: I am long BUD, CEG, HPC and MVCO

Victory for Wooden Arrow Advocates

2008-10-02T08:43:00.000-07:00

It was a glorious evening yesterday when the U.S. Senate passed its version of H.R. 1424, the package of legislation representing Congress’ half-hearted attempt to stabilize the economy. It was glorious for all those of us who have striven so hard in our lives to ensure the proliferation of wooden arrows designed for use by children.

I was ecstatic to see that, upon passage of this legislation, wooden arrows (with shafts consisting of all wood and containing no laminations or artificial means of enhancing the spine of such shaft) will be exempt from excise tax. Importantly, this provision allows for wooden arrows with shafts measuring 5/16 of an inch or less! The heck with all those wooden arrow manufacturers who intend for their product to be suitable for use with a bow. Who needs ‘em? I am talking about arrows with natural spines. What a landmark victory in the history of wooden arrows!

In times of crisis, I am still able to rest assured that our elected officials are able to reach meaningful legislative consensus.

Thoughts on Anheuser Busch and InBev

2008-06-19T11:53:00.000-07:00

I have always had warm feelings towards Anheuser Busch. Growing up in the St. Louis area I couldn’t help it – afternoons at Grant’s Farm, countless Cardinal games at Busch Stadium and the occasional brewery tour. AB is all around you in that town. And it is a good kind of omnipresence. In spite of the differences and segregation with which the city constantly battles, everyone can be proud living in the home of the largest brewer in the world.

So with the proposed acquisition of AB by InBev, St. Louisans are in a complete tizzy. I was contacted by a reporter from St. Louis Post Dispatch on Tuesday wanting my opinion on what role Buffett might play in the deal, given Berkshire's 4.8% AB stake. I wish he had waited a few days to ask because I hadn’t given it much thought (thus missing out on another opportunity to get quoted) other than my initial gut reaction which was sadness that our town could lose yet another large corporate headquarters. But since then I have done a lot of thinking about the deal.

I own AB shares. In fact I bought at $48 them just before Berkshire’s stake was disclosed a few years ago. So it is great that we now have a nice 30% gain, but in the same way I had mixed feelings about the acquisition of Wrigley, I am uncertain of my opinion on this one. It is a great company generating enormous returns on equity - in no year since 1994 has it returned less than 25%. Unfortunately the company has found ways to destroy value just as quickly as it is created – book value per share has also remained flat over this time. But the company does have an extremely valuable brand that rivals the strength of Coke and this has kept price-to-book as well as PE’s pretty lofty. So perhaps, just maybe, InBev could come up with better places to deploy the shareholders’ capital. It wouldn’t seem it could do any worse.

But these are AB concerns, not InBev-AB concerns. And when considering what InBev can bring to the table I don’t see Warren Buffett resisting. His only objection might be the terms of the deal, which is currently all cash. Just as he did with the P&G acquisition of Gillette, he would be wise to negotiate a stock swap instead, deferring the taxes on his gains and also giving him continued exposure to this fantastic business. I am fairly sure he could care less about the extra $2.3 billion in cash that would end up on Berkshire’s balance sheet and would much rather have a few million shares of InBev, a good company in its own right, instead.

Nevertheless, rest assured that if Buffett backs this deal as he should, it will sour his popularity among the fools that know nothing else about him. But remember what they say about a fool and his money.

To see what type of irrationality St. Louis is currently dealing with consider the following as evidence.

Politicians are generally pretty stupid I think, at least when it comes to business and economics. Ordinarily this doesn’t bother me, but when they try to speak as an authority I can get pissed. An example is the genius that our state sent to Washington a few years back, Democratic Senator Claire McCaskill. Not surprisingly she came out screaming when the InBev deal was proposed. Check out the following from an article in the Post Dispatch (original here) on Wednesday:

McCaskill blasted the deal as one designed to give "premium profit for hedge fund investors." She said A-B is a strong company that has provided thousands of good middle-class American jobs. "This is not a company that's in stress." Addressing concerns about a foreign firm taking over an American icon, she added: "We do not have a 'For Sale' sign on our front lawn in America."

There is so much ignorance in that paragraph I really can’t even believe the paper printed it. Or maybe I can.

The first statement about hedge funds is just completely baseless - total political pandering. The largest shareholder of AB is Barclays, at a mere 5.1%, after that is Berkshire then the Busch family. Even if all of Barclays’ stake is held through hedge funds, I wonder where she thinks the remaining 94.9% of the premium profits are going. Clearly this woman thinks she is speaking to a very ignorant constituency whom she probably assumes a) is not invested in AB themselves and b) doesn’t even know what a hedge fund is.

While she is correct that “A-B is a strong company that has provided thousands of good middle-class American jobs,” this fact is not threatened by the takeover. If jobs are to be lost as a result of this deal they will be the upper-level management jobs, not the blue-collar factory jobs I am sure she is worried about. InBev has made no indication it plans to move stateside breweries overseas – nor would this seem to be a wise business decision.

McCaskill also seems to need a lesson in M&A. A company need not be “in stress” to be a takeover candidate. How dumb would InBev need to be to pay that “premium profit to hedge fund investors” if the company were in stress? AB’s strength is the very reason it is a target! Duh!

Finally, and most hilariously, McCaskill claims "We do not have a 'For Sale' sign on our front lawn in America." Oh really? I got news for you lady. That is exactly what we have on our front lawn. For decades now we have been shipping our dollars overseas, effectively selling off small pieces of the farm to finance our overspending. What do you expect other countries to do with all those greenbacks, stuff their pillows? As a result of this trade imbalance, of course, InBev’s euros are at an all time high against the dollar.

What I gather from all this is that, at least locally, there is too much sentimentality at play and far too little rational business deliberation. Further, people are dumb. And when you mix sentimentality with ignorance you are left with a lost opportunities.

Full Disclosure: I own shares of BUD, BRK.B and WWY. I have no position in InBev, KO or PG.

USA Today

2008-06-09T12:07:00.000-07:00

There was a good article recently in USA Today about Warren Buffett that quotes me, among others. http://www.usatoday.com/money/markets/2008-06-04-warren-buffett_N.htm

RBP Investing

2008-06-05T03:16:00.000-07:00

As some readers may know, I recently started writing a couple of new blogs. One is called RBP Investing. RBP stands for Required Business Performance and was developed by a company in New York called Transparent Value.

RBP is a proprietary stock analysis methodology that, although not something Warren Buffett himself would use, is completely consistent with all of his ideals. It looks at companys in reverse, by starting with the stock price and deducing what the market expects of the company, in terms of both revenue as well as actual product sold. From this, the investment question becomes something more like "Does the market valuation make sense?" or "Can this company actually deliver what the market expects?" They call this reverse discounted cash flow analysis.

This made perfect sense to me, being someone who believes DCF analysis is the only legitimate way to value a stock. The RBP method is a pretty ingenious way of looking at things and has the potential, I think, to become mainstream now that Dow Jones has started publishing the RBP Index Series. I encourage readers to check out out the blog at www.rbpinvesting.com.

Fox Business Network Buffett Special

2008-05-01T14:52:00.000-07:00

I received an email from a representative of Fox Business Network telling me about the special they are doing at the meeting this weekend. I agreed to publicize it for them, but have to wonder why Liz Claman didn't request an interview with me as part of the show. CNBC would have. :)

For Warren Buffett watchers…FOX Business Network is presenting a live special this Saturday night (5/3) at 7 pm EST after the billionaire investor’s annual shareholder meeting in Omaha, Nebraska.

FOX Business Network’s Liz Claman will anchor a live hour of news and analysis after the Berkshire Hathaway annual meeting, which draws about 30,000 attendees.

Look for an interview with Warren Buffet himself, as well as the first ever television interview of Buffett’s long-time stockbroker, John Freund of Citigroup.

Wrigley Deal and the Annual Meeting

2008-05-01T14:32:00.000-07:00

I have been hesitant to jump to many conclusions about the Wrigley deal because I think there are still a lot of unanswered questions about Berkshire's involvement in it. Hopefully many of the details will be explained this weekend at the annual meeting. I do have some initial thoughts, however.

Wrigley is a company I have owned for about two years now, and have done very well with it. I like bragging about investments like this because lately most of mine have been losers, not winners like Wrigley. My original purchase price was $46. At the time the company simply seemed undervalued. And anytime a family-run business with a huge moat and extremely consistent operating history sells at even slightly less than intrinsic value, I thought, it is a good time to get in. And that is exactly what I did. It was shortly after Wrigley had acquired the Kraft confectionary group. The market was worried Wrigley would have trouble integrating it into its existing business. Ultimately, these concerns proved unfounded.

So when I heard the company was being acquired at $80/share in cash, my reaction was mixed. I enjoyed the nice one-day pop, but as with many cash or taken-private transactions, this also means the party is over. I will not be able to own Wrigley and share in the company's success any longer. In that sense, I was not happy to hear of the acquisition.

But perhaps most striking is the way in which the media has described the deal as a joint venture by Mars and Berkshire. So far as I can tell, it is not. This is where the discussion this weekend should be informative. It sounds to me like Berkshire is supplying a mere $5 billion in debt capital. This is far from a Berkshire acquisition. Moreover, it is quite possible the $80 bid was way too high, and that Wrigley stock was more appropriately valued before the deal was announced, at $65. Berkshire, by supplying only debt, wouldn't necessarily balk at Mars offering an arm and a leg.

Nonetheless, it is always comforting when Warren Buffett is involved in a transaction in any way. And having decided a while back Wrigley was a good investment, I enjoy being proven correct, if that is the appropriate way to interpret this. There is now doubt that Wrigley is a Buffett-type investment. I just wonder if it really is a Buffett investment.

Another Hilarious Screen Capture

2008-04-28T11:31:00.000-07:00

Could someone tell me how this headline ended up on Google Finance?

To Whom it May Concern:

2008-04-16T18:19:00.000-07:00

This blog is not dead. I am just taking a break. Lots of personal stuff going on, including the recent birth of my first son. I had hoped to work out a combination of names such that his initials would be BRK, but in the end we named him David Andrew. (I checked, DAK is not a ticker that I am aware of.)

Anyway, don't give up on me. I will post again soon.

Buffett Videoconference at MU on Friday

2008-04-02T06:36:00.000-07:00

I thought I might help publicize the University of Missouri Trulaske College of Business' 2008 Forum on Emerging Issues & Trends in Real Estate. That is mouthful. What it means is that on Friday as part of a symposium on real estate that we have every year, Warren Buffett will be videoconferencing with us for an hour in the auditorium. He has asked for student questioners, but I don't know how strict that rule is. The symposium is free and open to the public, but registration is required. Here is a link.

A few thoughts on the Bear Stearns situation

2008-03-21T15:12:00.000-07:00

The first lesson that came to my mind when I heard about this debacle was straight from Buffett: Don’t buy what you can’t understand. Was Bear a simple and understandable business? Of course not. Their investments were so complex that it is not unlikely that no single individual at the firm understood them all. If this is true, then it is even less likely that ordinary investors understood them.

But the lesson for the Bear employees heavily invested in Bear stock should have already been learned. Remember Enron? Remember the sketchy (ultimately fraudulent) ways they seemed to be making money out of thin air? The Enron employee didn’t understand how the company was making money. If he had he would have known it was all a farce. But nonetheless many, many hardworking people put their faith in their employer’s stock and in many cases invested their entire retirement in it. Big mistake.

But it need not have even be an issue of understanding the company. From a pure diversification standpoint any employee is better off keeping his investments out of company stock since his human capital (read: income) is already 100% invested in the company. Instead, these folks have lost not only their jobs but also their savings.

I don’t mean to take the high road, nor do I mean to downplay the tragedy that this has caused families. Indeed, it is not even their fault. It is their employer’s fault for encouraging them to invest their retirement in company stock, since I assume most of them are not financially sophisticated enough to understand the diversification argument while an investment house like Bear certainly should be, and for creating the illusion that the company was strong enough to warrant their investment. It’s a rotten situation all around.

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Much has been made about Bear’s current stock price, which is 200% higher than the JP Morgan acquisition price. It could be that investors are betting that either the bid will get raised before the deal goes through (a highly unlikely notion in my opinion given the Fed’s involvement) or that they think the deal will be delayed long enough for the company to right itself so that it eventually survives as a standalone.

Even considering these possibilities, it remains somewhat puzzling. But I think the explanation is a bit more academic than it might seem at first glance. Specifically, this is a textbook example of behavioral finance. According to theory, there are two requirements for irrational investors to drive prices from intrinsic value and, consequently, for the market to inefficiently price securities. Those two things are a) psychological biases and b) limits to arbitrage. In this case I think both are met.

The probability that the bid will get raised or that Bear will actually survive is not zero. But I think it is low. How low exactly I am not sure, but it is certainly not high enough to justify a stock price three times that of the most likely outcome – that the JP Morgan deal goes through as planned. Rather, the stock price is three times that of the bid price because there are irrational investors betting on the aforementioned possibilities and there is no arbitrage opportunity for more level-headed investors who would otherwise correct this blatant mispricing. At least that is the way it seems to me. Has anyone been able to successfully place a large short sale on BSC shares within the last week? I tried and I couldn’t. The lack of shares available for short is a natural limit to arbitrage and, according to behavioral finance theory, opens the door for irrational investors to control prices.

The investors willing to pay $6 a share for Bear seem to me to be falling victim to the following psychological biases:

Overconfidence – These irrational investors are overconfident in their own assessment of the situation, so much so that they are willing to pay a price far in excess of what would seem logical. They are also likely overconfident in Bear’s ability to weather this storm. This is understandable since big storied companies like this typically don’t just vanish overnight. But that doesn’t mean that can’t.

Endowment Effect – The investors who already have an equity interest are valuing their shares at a price much higher than the $2 bid. This too is understandable. Most people are reluctant to sell a stock for next to nothing when it was worth $150 as recently as a year ago, even if a price of $2 seems reasonable given today’s information set.

Disposition Effect – If these investors give in to the current offer, they will feel a tremendous amount of regret. Regret for not selling at $50, regret for having ever invested in a company with subprime exposure. To mitigate this regret, they are willing to increase their stakes by buying more shares, all while convincing themselves that since they liked the stock at $60, they should really like it at $5.

These biases create the environment in which mispricing might occur and the inability to short sell creates the limit to arbitrage that allows it to persist. So behavioral finance should explain the bizarre mispricing we are witnessing. Unfortunately, inherent in a situation like this is the inability for the rational investor to take advantage of it. Said differently, the stock would never have become mispriced if it could be arbitraged, so clearly there is no way for us rational investors to arbitrage it now. What a bummer.

Empirical Finance Research Blog

2008-03-07T06:34:00.001-08:00

If you are interested in financial research you may want to check out a new project I am starting with a friend of mine who is a PhD student at the University of Chicago. It is called Empirical Finance Research:
http://empiricalfinanceresearch.blogspot.com/
Our goal is to review for the non-academics any literature that may be of practical use to the investor. There still isn't much on the blog yet but expect more in the coming weeks.

Bullish on TMA

2008-03-06T14:01:00.000-08:00

I captured the following screenshot from Yahoo Finance shortly after the market closed today:

This was kind of surprising to me given the performance of TMA stock:

Thoughts on the 2007 Chairman's Letter

2008-03-05T09:52:00.000-08:00

As usual, Mr. Buffett touches on both classic and contemporary issues in this year’s letter. Two stand out to me as worth quickly addressing.

The classic issue most interesting to me is his discussion of See’s Candies (see page 7). It lends support to an argument I made on this blog last spring that it is return on equity, or in some cases return on capital, that is the crucial ratio to the value investor. See’s exemplifies this perfectly, since it requires hardly any invested capital. As Mr. Buffett notes, See’s needs only $40 million to continue to operate, yet in 2007 the company earned pre-tax profits of $82 million. Since it was acquired in 1972, See’s has reinvested only $32 million to maintain its operational growth. The rest of its earnings, about $1 billion, has been deployed elsewhere. Earning huge returns on little capital investment is the definition of a good business. Yet investors rarely consider it.

Returns on capital are, in my opinion, horribly underrated by the investing public. Evidence of this can be found in the public’s fascination with companies like AT&T, GM or any airline. These are businesses that, while they may generate large earnings, do so only after investing large amounts of capital. Why not skip over these businesses whose hurdle is so high that only the most outstanding performance will yield the investor a decent return? That is what Berkshire has done over the years.

The contemporary issue that interests me is the one everyone has been talking about. Much has been and will be made of Berkshire’s derivative positions, but little was said in the letter about them. Personally I think Mr. Buffett is missing out on a see-I-told-you-so opportunity. It was in the 2002 letter that he, noting the role they played in LTCM’s implosion, warned derivatives were “financial weapons of mass destruction,” at which time he began to wind down the derivative business of the newly acquired General Re.

Since then I think he earned the right to boast a little about recognizing this fact but he did not in this year’s letter. For instance, this year he only mentions in passing the key aspect of Berkshire’s derivatives that set it apart from other companies drowning in credit-default swap failures and such. “In all cases we hold the money, which means that we have no counterparty risk,” he says. This is huge and deserves more attention. After all, it is the reckless and poorly capitalized bond insurers that have contributed the most to this mess.

The new bond insurance arm of Berkshire, Berkshire Hathaway Assurance Corp, was established in December which probably means the letter was already complete at that point. But I must assume the creation of BHAC had been planned for some time before that and thus it seems like a missed opportunity that Buffett doesn’t point out in the letter how well positioned Berkshire is to pick up where the MBIA’s and Ambac’s of the world failed. Especially with those companies’s refusal to grab Berkshire’s lifeline, I think responsible underwriting in this area will prove to be a big opportunity for Berkshire.

Warren Buffett Exposure

2008-02-27T08:35:00.000-08:00

It sure seems Mr. Buffett is more willing than ever to appear publicly. Next week he will be on CNBC discussing the new letter to shareholders. Here is a link to details on that:

http://www.cnbc.com/id/23359277

On March 14 (which is coincidentally my birthday) I will be accompanying 150 students from our college on the annual trip to Omaha. This is the largest group we have ever taken and, given the extraordinary events in the economy over the last year, should be one of most interesting question and answer sessions we have had. This year, I am coordinating the questions we will be asking ahead of time, to ensure we get the most information possible from this 90-minute session.

I post this in the hopes that the students participating in the trip watch the interviews next week so we don't unnecssarily duplicate questions from it. For that matter, do any other readers of this blog have any questions you would like us to ask Mr. Buffett? Please feel free to submit such questions via the comment feature on this blog.

Bill Belichick and Employee Stock Options

2008-02-05T16:32:00.000-08:00

Here is another sports-related post…

To me, the biggest justice of the Patriots’ losing of the Super Bowl was not that Tom Brady had snickered with overconfidence at Plaxico Burress’ ultimately accurate prediction or even that Bill Belichick had stormed off the field before the game was over, it was the fact that the Patriots are a team of admitted cheaters! Am I the only one to feel that “Spygate” taints the Patriot’s “perfect” regular season just a little? Admittedly, I am a Rams fan, and the possibility that the Patriot’s squeaking by the Rams in Super Bowl XXXVI was the result of cheating does kind of irk me. But the larger question should concern any sports fan: Why does it seem that professional athletes these days are always doing something crooked?

In baseball we have steroids, in the NFL we have spygate (and steroids too I guess although it hasn’t been as publicized as in baseball) and in basketball we have referees being bribed by mobsters. Doesn’t it seem a little ridiculous to be dealing with these issues in an arena as inane as sports? These are silly games played with bouncy balls for pete’s sake.

To me, this is just an outstanding illustration of the power of financial incentives. When there is money at stake, everyone’s attitude changes. It is no longer just a matter of pride, there are dollar bills waiting for these players should they perform well. What else, besides money, would entice anyone to go to such lengths to get a leg up, particularly given the risks? In the spygate scenario, the risk is getting caught and the humiliation and condemnation that comes along with it – call it “negative pride” perhaps. That is, Bill Belichick saw the expected financial return as being appropriately balanced against the enormous amount of disgrace that getting caught would cost.

Baseball is where this is most obvious. Not only is there a large amount of shame associated with being known as a doper (see Roger Clemens), using steroids will actually shorten the user’s life! Considering these risks taken collectively, clearly the expected return from the use of steroids must be huge. Of course, it is.

It is thus my contention that the rise in sports cheating, whether it be spying, doping or gambling, is the direct result of the huge amount of money that is now at stake – money that was not at stake during a more innocent era of professional sports. It is also my contention that the rise in cheating is not the result of some degradation of American society or a failure in the moral upbringing of our children. It is simply the result of humans acting the way they always have.

With the possible exception of certain biological incentives, there is no other incentive that humans, in general, find stronger than money. This is not inherently a bad thing, of course. Indeed, it is fundamental to the functioning of a capitalist society. But I do think that everyone ought to be cognizant of the overwhelming power of financial incentives.

In business the phenomenon is much more obvious, if for no other reason than that employees work for money. But parallels between sports cheating and business cheating are numerous. And if we have seen humans in the locker room take unbelievably large risks in pursuit of money, it shouldn’t surprise anyone to see them do outrageous things in the board room.

Enter Jeff Skilling. Having read several accounts of the accounting maneuvers undertaken at Enron, it is hard to believe any of them really thought they could get away with it. I think of this whenever I hear of some idiot trapped in a check kiting scheme. It is unavoidable that he will get caught, yet the lure of the dollar is so strong he tries anyway. Would it be outrageous for me to suggest that it was the rise in the use of stock options as executive compensation that, for the first time, created a financial incentive strong enough to coerce managers to cheat as overtly as those at Enron?

That would likely be a controversial assertion. After all, options are supposed to align the incentives of managers and shareholders. I believe, however, that it is possible to align the incentives of managers with shareholders even while maintaining the incentive to cheat. This is due to the rise of short-term or day trading. When the shareholders of a company are constantly changing, the long-term prospects of the company cease to be of central concern. The day trader doesn’t care if the company ultimately goes bust (as Enron did) because he isn’t maintaining his position for any amount of time. Likewise, Jeff Skilling might not have cared since he planned to dispose of his options long before the day of reckoning.

The corporate governance literature has provided empirical evidence of the problems with option compensation including a) the fact that options reward luck (Oyer (2003)) and b) that the recipients of the options value them at far less than their true cost to the company and therefore demand far more than they would otherwise demand in cash (Hall and Murphy (2003)). But I have yet to hear anyone assert that using options as compensation shifts the time horizon of the relevant parties and is thus detrimental over the very long term to the company as a whole.

I think this is part Warren Buffett’s objection to the use of options. While some Berkshire subsidiaries use them, Mr. Buffett generally has not been a proponent. He was very vocal about the need to expense their issuance, and is adamant that they do the holders the unjust favor or rewarding handsomely for sub-par returns on capital. He has also argued that options don’t expose the holders to any downside risk, since they are typically issued at the money and without any intrinsic value.

The natural alternative to an option compensation program is a targeted stock ownership program. In such a plan the manager is required to own a certain amount of company stock. So long as he stays employed with the company he will continue to be exposed to both the upside and the downside of the performance of the stock. It also stretches his time horizon as far as possible and, if the shares are simply granted to the manager, there is no ambiguity as to their cost. The stock will rise in value at a rate commensurate with the company’s return on capital. Academic literature has been very supportive of these types of programs – see Core and Larcker (2002) – but not necessarily ownership as a mechanism to align interests in general. I think it would be very interesting to investigate this shrinking-of-time-horizon phenomenon.

Now THIS is cool.

2008-02-01T14:31:00.000-08:00

Have you heard about this? Cleveland Indians minor league pitching prospect Randy Newsom is securitizing himself by selling off 4% of any future major league earnings he may realize. For $20 you can buy one share which entitles you (the shareholder) to 0.0016% of his big league earnings. By doing this, Newsom will raise $50,000 in capital. He has even established a company to facilitate future transactions - his own "investment bank" if you will.

The best discussion I have read about this is from Steven Levitt of Freakonomics fame. Professor Levitt conjectures that, assuming Newsom is risk neutral (a big “if” by the way), this price implies Newsom believes his future earnings will equal less than $1.25 million. I just wonder what is going on; if Newsom is simply in need of cash now or if he doesn't think he has a shot at the big leagues anyway. After all, there is enormous information asymmetry between Newsom, effectively the owner-manager, and the shareholder, so I assume we are adapting an extremely high expected return to our valuation. Alternatively, maybe he is most interested in the business and is using his own "stock" to help launch it, also a good way to hedge the possibility of never making the bigs.

I know that if I were a minor leaguer and could accurately assess my own probability of major league success, this scheme would have enormous appeal. Just think about the earnings differential between minor league and big league baseball. I mean, to a 25-year old who has spent his career playing minor league ball $50k is quite a bit of money, but to a millionaire superstar, the 4% of his million dollar salary is comparatively insignificant.

Finally, a post about the economy.

2008-01-30T15:00:00.000-08:00

I don’t claim to be a macroeconomist, so take what I have to say with a grain of salt. And I am certainly not a market prognosticator, so please don’t interpret what I say as a prediction for the direction of the stock market. But the more I hear about the state of the U.S. economy, quite frankly, the less confident I can be that it will flourish in the near (5-10 year) term. Let me detail several stylized facts that, taken collectively, lead me to this conclusion.

#1. The dollar continues to weaken.

#2. At this time last year the yield curve was flat, portending recession.

#3. Housing price run-ups have historically preceded recession. Need evidence? Check out this new NBER report.

#4. The nation is addicted to debt, both at the individual and governmental levels. The federal government’s chronic deficit spending has, in effect, caused us to sell of a great portion of the wealth to which we as Americans once had claim simply to finance our overspending. This appears to be driven only by political pressures and not by any level-headed economic analysis. As individuals we have an insatiable desire to consume, making even the wealthy prone to borrowing. This high leverage leaves us in a precarious position, as it eliminates any buffer against the inevitable downturns of the economic cycle.

#5. The subprime meltdown was caused by greed, on both the lender and borrower sides of the transactions. The widespread securitization of mortgages meant mortgage brokers, underwriters and even guarantors had little concern for traditional loan-approval criteria (like income!). This is because they were completely severed from the mortgage after the transaction giving them an incentive to make the deal happen at any cost. Thus, with no ultimate culpability, the consequences of defaults and resulting CDO failures will be shared among all players in the financial markets.

#6. The Fed cannot solve this problem with rate cuts. It can solve liquidity problems with monetary policy, but the problems this time around stem from outright insolvency. In fact, short-term stimulus initiatives – including Fed rate cuts – will only encourage further debt-financed spending. So while the issue of liquidity may be resolved in the short term, we have not gained any ground since presumably we would experience even more insolvency. Thus, we have cut off our nose to spite our face.

#7. Psychological factors (while relatively unimportant in the long term) will weigh heavily in the short term. The advent and popularity of mortgage backed securities creates an environment of uncertainty, as judging the credit quality of the underlying mortgage becomes close to impossible. This breeds contagion.

#8. Interest rates, in general, have no where to go but up. Especially with the recent cuts we are at very low historical rates. The long bull market that began in the mid-80s and is now coming to a conclusion coincided with an enormous fall in rates. This juiced the returns on equities in an economy that, while growing, was not keeping up with the growth of its equities. This is because as rates fall, the discount rate used in cash flow valuation falls, giving us higher present values. This corresponds to higher stock prices and helped pushed earnings multiples far beyond where they have historically resided.

When I consider all of these things collectively I can’t come up with any convincing argument that we won’t end up in recession. What is more, there is a decent amount of evidence that what happens will be even worse than recession, a prolonged economic downturn.

The financial markets, and in particular the credit markets, have changed tremendously in recent years. Americans more and more feel no moral obligation to repay their debts. Bankruptcy has lost its stigma, and with enormous worldwide lenders making loans, there is little personal or social pressure to behave responsibly financially. This trend has the potential to completely uproot our existing financial system. That disruption is reason enough to expect the worse.

I don’t mean to sound like a complete doomsayer, because I do think that this country will continue to thrive in the end. And I will continue to invest in American stocks. I just think we are in for some unpleasant surprises in the near future. So why not take the good with the bad? This upheaval will undoubtedly produce some bargains when investors panic. Maybe we will even have the chance to pick up some Berkshire on the cheap.

The Agony of Defeat

2008-01-16T06:09:00.000-08:00

This is one of those times when I just don’t know what to say. Perhaps it’s my relative inexperience, perhaps its just human nature. But the market is tanking, I am losing money and I can’t help but second guess my past decisions. It is important not to make emotional decisions, but to tell you the truth it is hard to tell if the decisions I am making even are emotional. By that I mean, it’s tough to know whether I am rationally changing my own perceptions, or whether I am allowing the pundits that pervade the news sources from which I get my information to sway my opinion.

I know not to let fear or greed influence my decisions, but how do I know if they are? I know to let the market be a tool, not a guide, but it is hard to rely solely on my own interpretation of available information. After all, how arrogant must I be to assume I am right while everyone else in the market is wrong? Bottom line: this is the type of environment when investing is most aggravating.

Of course the biggest losses have come from the financials. Those are the easiest to brush off too, since it was much more of a macroeconomic phenomenon than a company-specific one effecting these losses. It is the individual picks that cause the most distress.

For me, the one individual stock for which this frustration is most pronounced is Sears Holdings. I’m not really sure what to think about this investment anymore and at times I struggle with the question of whether my original purchase of the stock was an emotional one, or one based on a rational consideration of the facts. The question is justified. Ever since Business Week asked in November 2004 if Eddie Lampert was “the next Warren Buffett,” folks started jumping on the SHLD bandwagon. Maybe that was reason enough for me to stay away. But I didn’t. I jumped right alongside them. Now, it seems, they are all jumping off that bandwagon. Why? Let’s talk about that.

A year ago, the theory was that Lampert would use Sears as a vehicle by which to invest in other businesses (a la Warren Buffett and Berkshire). Folks debated this issue, but the theory that Lampert saw the company as merely a turnaround lost out to the competing theory from the bulls who had more faith in Lampert’s investment prowess. As such, the story went, whether or not the retail business really grew (Lampert claimed he wanted it to nonetheless) was not of top concern, since the plan was to merely use the cash flow from Sears’ current operations to make better investments outside the company.

But now, it seems, the retail business is so bad that it isn’t even generating that cash flow! So Lampert is left with no cash to invest, at precisely the time when the market might be creating the best bargains. Remember, this is a company directly competing with Wal-Mart, not an enviable position in which to be for anyone.

In addition, everyone thought Sears’ real estate assets were a hedge against the performance of the company’s retail operations. Ha. What does the market for commercial real estate look like these days?

The plan appeared to be working because Lampert did, to his credit, do a great job cutting costs and boosting profitability. So even as sales lagged income rose. But the benefit of cost cutting is limited by the company’s sales. Don’t get me wrong, Eddie Lampert is certainly one of the most successful hedge fund managers in recent years and obviously a very bright and astute businessman. I love the way his shareholders’ letters are written and the obvious parallels we can draw between them and Berkshire’s. But that doesn’t change the fact that he must begin by making sure the utterly lousy retail business he is burdened with doesn’t completely fail.

Part of me feels foolish for even writing about this. It has been written about to death. And 99% of that writing is motivated purely by the hope that Business Week was right. Nobody knows at this point if the company will survive long enough to turn in to a new Berkshire. But we hope it will.

Note the word “hope.” This is an emotion. And if I bought SHLD “hoping” that it would become something huge then I was greedy, because there was not a whole lot of evidence indicating it would be. There reasonable speculation, but no solid evidence that would afford the margin of safety that I should have demanded. There was a lot that could have gone wrong that I should have considered, but I didn’t because I let the dollar signs blind me. Ah, hindsight.

I think the lesson from all of this is the following; Emotional discipline is the number one most important factor affecting investment performance. Warren Buffett has been successful because he has that emotional discipline. I think he would have passed on Sears Holdings, even as great a guy as Eddie Lampert is. But just as it is so difficult to change one’s personality, if we don’t already have emotional discipline we can’t expect to obtain it easily. And this might just make some type of structured investment philosophy that disallows the influence of emotion preferable.

Expectations Investing

2007-12-31T10:54:00.000-08:00

After the interview I recently gave CNBC, as I typically do, I began rethinking the sound bites of mine the show’s producers included and how I could have better said what I did. One quote of mine that was included in the show but I really don’t think came out right is the following:

“It is an appreciation for all things that make a good business, not just the financials. Warren Buffett has been the best at allowing us to understand what makes up a good business.”

Here is what I meant, said far more eloquently:

Warren Buffett has a unique ability to assess a business holistically, or on an integrated functions basis. This allows him to recognize attributes and/or assets that may have been overlooked by Wall Street, where analysts are often more concerned with short-term trends or earnings announcements than with underlying business economics.

My point is that a stock represents a share of ownership in a business, not merely a security that trades on a large national market. Thus, there are many things that happen outside of the stock market that affect the stock’s value. Some people ought to be saying right now, “Well duh.” -- I never said this was rocket science.

I recently read a fantastic book describing an investment strategy that embraces this attitude while preserving a structured and disciplined approach to stockpicking. It would be perfect for the investor not confident enough in his own intuition about the future of individual companies to focus on only a few businesses, perhaps for the “know-nothing” investor that Mr. Buffett has referred to.

The book is called Expectations Investing and was written several years ago by two academics, Alfred Rappaport and Michael Mauboussin, and published by Harvard Business School Press. I should point out that I was not asked to review this book by anyone nor do I have any interest in the book’s success. I just bring it up because I liked it.

The book begins by making the assumption that outguessing the market is too difficult. A better method by which to make decisions uses the information provided by the market to infer expectations and then judges the reasonableness of those expectations. I think of it as a bottom-up-bottom-up approach. Not only are we analyzing the company on a fundamental basis first, but we are actually using the current price of the stock to read the market’s expectations for how those fundamentals will change.

For instance, a few months ago I blogged that although I do not know if Google is overvalued or undervalued, an investor in the company ought to be aware of what its current stock price implies. Namely, that at $700/share, the expectations of the market implied by this price are that Google will eventually become the largest company in our economy. I don’t know if that will happen or not, but that is what will need to happen lest Google’s stock will underperform.

The book describes how “value drivers” and “value factors” work to affect shareholder value. While, for example, sales growth will drive shareholder value, it is the value factors such as volume and pricing that affect sales growth. So by starting with the stock price and working backwards we can infer what the market seems to expect to happen to volume and pricing. At this point we can ask ourselves if these expectations seem reasonable and also if we should expect the market’s expectations to ever change. With a good holistic perspective of the business like that which makes Buffett so successful, we should be able to answer this question easily.

The book also makes the case that a discounted future free cash flow model is the only legitimate way to measure shareholder value. Frankly, I don’t see how anyone can argue with them on this point, but clearly many people cling to short-term metrics such as PE ratios even though such metrics incorporate only information about one period’s performance. Only future free cash flow directly affects changes shareholder value since it is this cash flow that represents the return on the shareholder’s capital investment. Of course, plenty of things indirectly affect shareholder value and these are the things about which we are trying to infer information when we employ the expectations investing methodology.

Alas, we have taken an alternative approach to answering the same question. Instead of deciding on an intrinsic value to which we will compare the current price, we infer from the current price what the market’s expectations must be in order for the current price not to exceed the intrinsic value of the business. Taking this backwards approach strikes me as much more judicious application discounted cash flow valuation because it allows us to focus on what we do know for certain (the market price) rather than what we don’t necessarily know (the intrinsic value of the business).

Although he probably has never thought of it in quite these terms, I am fairly confident this is the same type of intellectual exercise Warren Buffett engages in when making an investment decision. Nonetheless, this commonsense type of analysis does not happen very often in the market. Perhaps investors are just creatures of habit.

FD: No position in GOOG

Thoughts on Index Investing

2007-12-26T08:45:00.000-08:00

There are two general ways to play the equities game. You can try to pick individual stocks yourself in the hopes of someday replicating the success of Warren Buffett, or you can leave such aspirations to the more ambitious folks in our society and simply try to earn an average return. As I have argued before, although I do believe it is possible to beat the market consistently as Warren Buffett has done, this does not mean that just anyone can hope to do so. It takes a unique person. Of course, where does that leave the rest of us?

Mr. Buffett has said that the ordinary investor is better off investing in a passively managed index fund than an actively managed mutual fund. While the proponents and salesmen of index funds or fund families that try to capture the benefits of index funds love to use this quotation for their own self-serving benefit, it is hard to disagree with Mr. Buffett. He calls such ordinary investors “know-nothing investors,” although he doesn’t mean it as an insult. He just means that if you don't know what you are doing, it is safest to simply accept your mediocrity and guarantee yourself average returns. This begs the question, though, what is “average? “

This argument is also consistent with the efficient market theorist’s investment strategy. Since we can't expect to beat the market anyway, why not simply arrange to earn the relatively high returns equities offer us while minimizing fees through passive management? Note the underlying assumption behind all of this, that "the market" is best proxied by a value-weighted index, and this is where we get in to trouble. What is “the market?” Professor Richard Roll’s famous critique of the Capital Asset Pricing Model has stumped theorists for nearly thirty years now. He contended that we will never be able to truly quantify risk because the true “market” portfolio is unobservable – it includes all assets that contribute to wealth, everything from stocks to baseball cards to human capital.

So let me ask two simple questions. Why are market-value weighted indexes such as the Nasdaq Composite or S&P 500 the most generally accepted benchmarks by which to compare investment results? Is there any particular reason for such value-weighting other than convention?

Some fund companies have made a big business out of creating alternative indexes that try to outperform or by taking the components of existing indexes and weighting them equally, and yet others weight them according to the Fama-French Three Factor Model. Yet we continue to measure performance relative to value-weighted benchmarks. Perhaps, since as individual investors we likely never have sufficient wealth to affect the value of one stock purely through our individual trades, we should have no limit to how to we (passively) allocate our wealth. Hence, by benchmarking ourselves to the S&P 500 we are actually overstating our relative performance.

Exchange traded funds, ETFs, are very much in vogue at the moment. The original ETFs were broad-market index funds such as the SPDRs, which mimic the performance of the S&P 500, and appealed to two types of investors. The first type is the delusional folks that think they can actually predict the direction of the market. We can thank those geniuses, I suppose, for providing liquidity to the second type of investor who uses the SPDRs for true investment purposes.

But by purchasing shares of SPDRs or any other broad-market index fund, investors are inadvertently investing most heavily in those companies that are most likely to be overvalued. This is the crux of my argument. Since the S&P 500 is a value-weighted index, the value of one share of a SPDR will be dominated by the largest companies and those that have most recently appreciated. So while you may rest assured that your share does in fact represent the collective performance of five hundred different companies, why should you prefer that, among those five hundred companies, you are weighted towards the ones that are quite possibly the most overvalued?

For illustration, consider the three largest components of the S&P 500; ExxonMobil, GE and Microsoft. This trio is clearly not surprising - these companies are the three biggest in the economy. But what makes me think that these three companies deserve the largest portion of my money? Do I really want $5.88 of the $146.00 I pay for my SPDR to be allocated to ExxonMobil? Moreover, the mere fact ExxonMobil is so large (as measured by market value) may be because investors are paying too much for it.

These are philosophical questions. The index fund advocate will argue that investing in the largest companies is the point. That is, because ExxonMobil is so dominant in the economy, so too should it be dominate in my index fund. But to me this seems unnecessarily limiting, since both larger companies and those to have recently appreciated are likely to underperform their counterparts - provided we believe the evidence provided by Fama and French (1988, 1992) of long-term mean reversion in stock prices and the outperformance of small firms. (I do.)

As I have a habit of doing, I have raised some questions without suggesting any real answers. I will leave that up to anyone wishing to comment.

New CNBC show - Warren Buffett: The Billionaire Next Door Going Global

2007-11-29T08:35:00.000-08:00

CNBC is airing a new show about Warren Buffett in which I may appear tomorrow, November 30 at 8:00pm central time. Here is a link to CNBC's listing for it.

Several weeks ago, a crew from CNBC visited our college and my class while preparing a new documentary about Warren Buffett. As you may know, the network also visited last year and featured the Buffett class as part of the original show, Warren Buffett: The Billionaire Next Door. Last year before the show aired I warned that there was no guarantee they would even use the footage of our class, and of course they actually devoted an entire five-minute segment to it. Nonetheless I will again issue the same warning. I don't really know what direction they are taking the show this year so I don't know for certain that I will appear, but it will be worth watching regardless.

***** UPDATE, 12/1/07 4:00pm *****
In case you missed it, looks like the show will re-air for the first time tomorrow, Sunday Dec. 2 at 10:00pm central. But I expect many more reruns in the near future too.

***** UPDATE, 12/4/07 6:00pm *****
Here are some more show times as listed on cnbc.com:
Wednesday, December 12th, 8:00pm and 11:00pm central time
Sunday, December 16th, 10:00pm central

What makes Warren Buffett successful?

2007-11-26T12:45:00.000-08:00

I was asked this question during a job interview I had some six years ago with a St. Louis-based brokerage firm. I bombed it. And it has haunted me ever since. How could I fail to articulate a coherent response to such a simple question? Well, it’s complicated, so allow me to explain.

First of all, if the success of Warren Buffett were easily understood and replicable, clearly there would be many more wildly successful investors in the world, but of course there are not. While I concede that this observation comes dangerously close to efficient market theorist’s six-sigma explanation of Mr. Buffett’s success – that with so many coin-flipping investors you are bound to have an outlier like Buffett simply by chance – I do not think it is a null hypothesis that can easily be rejected. The truth is there are very few investors even in the same ballpark as Buffett. But why? Is it just chance?

Kind of. Mr. Buffett has explained it by acknowledging that he is “wired” in such a way that makes him very adept at capital allocation. This might be a disconcerting notion to some as it implies that you either have it or you don’t.

But what is “it” anyway? To me, it is a combination of an array of characteristics, some very learnable, some less so. The learnable ones are characteristics every CFA charterholder probably has. These are things like strong analytical skills as well as simply a good knowledge of the financial markets. That is not especially hard to replicate. Moreover, with tens of thousands of CFAs in the world you would expect a few more Buffetts were this all it takes.

It is the less-learnable characteristics that set Buffett apart and this is where watching Warren Buffett the person may help the most. People who have spent time with Mr. Buffett notice two things. For starters, he reads – constantly. Sometimes he can spend his entire day reading, and it’s not just for pleasure. He reads because he is hungry for information that will make him a more successful businessman. Very few people have the drive Warren Buffett has.

Easy enough right? You are probably thinking, “Well if all I have to do to become a billionaire is read all the time then sign me up for the value investor’s book club.” Not so fast. A lot of people read a lot. The difference is Buffett’s memory. Not only does he read but he remembers everything he reads. Folks familiar with the man know how tremendous his memory is. Very few people have the memory Warren Buffett has.

The most important less-learnable characteristic Buffett possesses, though, is very uncommon. It is emotional discipline. By this I mean the ability to resist the natural human instincts of fear, greed, pride, regret and all the other irrational biases to which people are inherently inclined to succumb. I have been trying myself to master these biases for years and, let me tell you, it is tough. Even once an investor is cognizant of these biases he may find it extremely difficult to control them. I can’t let myself buy because stocks are going up (greed) or sell because they are going down (fear). I have to base my decisions entirely on an unbiased assessment of the underlying business. This is far easier said than done.

Several years ago the WSJ ran a story about entitled “Lessons From the Brain-Damaged Investor.” The article discussed studies in the field of “neuroeconomics,” a sub-field of the more general category of behavioral economics. Some of these studies suggest that brain chemistry itself can explain irrational financial decision making and that individuals with damage to the part of the brain responsible for controlling emotion actually make better financial decisions. A sample of brain damaged individuals more appropriately weighed risk and payoffs in a simple gambling game than a control group consisting of individuals with similar IQ but no brain damage.

No, I am not suggesting Warren Buffett has brain damage. Rather, I think he has an innate acuity to controlling emotions that most people do not. Perhaps some people have as much control over their emotions, but the number is probably small. Further, it is unlikely that such a person also has the intelligence, knowledge, ambition, memory and patience of Warren Buffett. Said differently, all the characteristics necessary to construct a master investor may exist independently in many different people, but the probability of them all existing in the same person is very low. Warren Buffett happens to be the only one to date.

Consider some of the other personal qualities that have contributed to Mr. Buffett’s success. He is very personable and pleasant. That certainly hasn’t encumbered his road to riches, as it took the personal relationships he had with the original investors in the Buffett Partnership for Mr. Buffett to get started. He is also very good at reading people, whatever you think “reading” them might involve. Just look at how many successful investments were in part due to his ability to assess the integrity of the business’s management.

So there you have it. Warren Buffett’s success is indeed the result of luck. But it is not the coin-flipping kind of luck that academics would like to believe. Rather, he is simply lucky to be endowed with all the requisite qualities that make for investment success. This begs the question, then, is it worthwhile to study what has made Mr. Buffett successful? Can we even hope to acquire the skills driving his success? Without hesitation, I would answer in the affirmative. Even if we cannot hope to ever be as wealthy or respected, any effort to be will make us both better investors and better businesspeople. Warren Buffett is the pinnacle of investing perfection. While we may never get to his level ourselves, we can still benefit from trying.

BCS Title, here we come.

2007-11-25T16:46:00.000-08:00

Yeah, I realize this is a financial blog, but this is just too exciting for me to neglect to mention. The Missouri Tigers beat the #2 Kansas Jayhawks last night and for the first time since 1960 are the #1 football team in the nation. Words cannot express how huge this is. Nobody saw it coming.

Now, I have been a Tiger fan all my life, but like many others had avowed that Mizzou would forever put up a second-rate D1 football team. The border war last night changes everything. We are now on the main stage with the likes of LSU, Ohio State and USC. A win over Oklahoma next week puts Mizzou in the national championship. Could somebody please pinch me?

And rumor has it that the Heisman-contender that conducted last night's orchestra, Mr. Chase Daniel, is a finance major. Maybe he will take my course next semester...

This is huge for the sports fan in me, but I think its also good for the university in general. A big time football program gives the school a national presence and makes it easier to recruit quality faculty. In my field, we sometimes categorize finance programs based on the university's athletic conference affiliation - it gives the program an identity even if the relation between quality football teams and quality finance faculty is, well, dubious at best. At least this is the way it seems to me in my short career as an academic thus far.

Anyway, I am just so frickin proud to be living in this town of Columbia and attending the University of Missouri - I just had to say something. Sorry bout that. I'll get back to ruminating about Berkshire Hathway soon.

Borrow now, while you're still young.

2007-11-05T10:06:00.000-08:00

Sometimes the cleverest ideas are the ones that initially seem the most preposterous. Such was the case with a paper I recently heard presented by Yale Law Professor Ian Ayers, coauthored with Yale Business School professor Barry Nalebuff.

These authors contend that the typical young person should invest 200% of his net worth in stocks. That is, buy everything on 50% margin. This is because far too little is invested in stocks by individuals when those individuals are young, resulting in very poor diversification across time. What? You’ve never heard of inter-temporal diversification? Well the intuition behind it is obvious once you mull over it for a while. For me it was one of those “yeah-I-never-thought-about-like-that” moments. We all accept that exposure to only certain asset classes is risky, but what about the differential exposure to stocks that I have in 2007 (when I am young and less wealthy) and 2040 (when I am older and, of course, wealthier)?

Ever heard of the traditional wisdom by which you subtract your age from 110 and then invest that percentage of your wealth in stocks? Well as Warren Buffett might say, traditional wisdom is often long on tradition and short on wisdom. In this case, there is no theory behind the advice at all. It is just made up. Sure, it’s convenient for the investment adviser who needs to create the impression he is following some sort of strategy, and is a great marketing tool for the life cycle mutual funds that actually practice the principle. But why should we believe this is correct?

Ayers and Nalebuff argue that this rule is too conservative and actually provide theoretical support for their notion through a simulation of the strategy. Investors should leverage up significantly in their early years and then reduce their leverage over time. This gives them equivalent exposure to the stock market when they are young and when they are old and this diversification reduces the overall risk to their savings.

If you are like me, you can understand the intuition but nonetheless have some gut-level objection to the idea. The authors are prepared for this and address the issue directly.

There is definitely an aversion to borrowing to invest in our culture. Individuals have no problem borrowing to purchase a home, car or education. But borrowing to invest is taboo. Is this justified? Most folks will point to the ’29 market crash, when margin calls perpetuated an unstoppable slide. While this point is valid, the type of margin borrowing that occurred at that time was done for the purposes of speculating in the short-term. What these authors are suggesting is far different, with a time horizon for the borrowed funds several decades in length.

Margin calls are usually thought of as portfolio-destroying, but in this simulation the authors show that margin calls actually have no meaningful effect, since they assume that performance of the market after a margin call is as likely to be positive as it is negative. So sometimes a margin call will result in forgone profits, sometimes forgone losses.

And what about those high margin interest rates? Well in real terms they are still considerably lower than even conservative estimates of the equity premium, so the young investor still stands to benefit. But in fact margin rates should be much lower anyway. A loan secured by highly liquid assets with positive expected returns over which the custodian has power to liquidate at a moments notice is far from risky to the lender. Nonetheless margin rates are often double that of mortgage rates or student loan rates. That they persist at levels so high may, in fact, be further evidence of the cultural objection to margin investing. The perceived risk is far higher than the actual risk.

I hope I have accurately portrayed these scholars’ proposal. It is fascinating to me, both because I am a victim of the natural margin-aversion that many others are, but also because it suggests that aggressive investing, when done responsibly, can reduce risk.

Whether or not new ideas such as this prove to be wise, I think it’s always good practice to question the traditional wisdom. For instance, Warren Buffett’s assessment of diversification, and how lower diversification can actually reduce risk by increasing the deliberation made over any single investment, has always seemed a counterintuitive proposition. But there is certainly truth to it. Likewise, the idea of borrowing when young is counterintuitive and there may indeed be truth to it as well.

Google: Reality Check

2007-10-23T10:30:00.000-07:00

I would like to start by making the following disclaimer so all the rabid Google bulls won’t start threatening my family:

Google is one of the greatest growth stories in corporate history. There is absolutely no doubt about that. It’s a great company and has effected tremendous change in its industry.

With that settled let's talk about valuation. Google now trades at $665 a share (up another $15 this morning). That puts its market cap at $207 billion. Now what other companies have comparable market cap? Here is a short list: Citigroup, Wal-Mart, Johnson & Johnson, Microsoft, and AT&T. That is some pretty impressive company – consider how long it took each of those companies to reach a market cap of that level. It took Google only nine years.

In the last four quarters, Google has earned $3.9 billion, putting its trailing PE somewhere around 53. That multiple sure seems high, particularly considering that the aforementioned companies typically earn that much in a single quarter. But Google is a growth company, right?

Well its growth certainly has been impressive, but it is important to consider the limits of such growth. Google earned a mere $7 million in 2001, and had only earned $400 million around the time of its IPO in 2004. Although this exponentially growing income is really unprecedented it is a huge mistake to assume it can continue. Here is a fun calculation that demonstrates my point. If we derive the implicit rate of growth since 2001 from the ratio of $3.4billion to $7million, then compound our $3.4 billion at that rate for ten years we have:

$3.4billion*{1+[($3.4billion / $7million)^(1/6)]}^10 = more wealth than exists on earth or even will for several centuries

Since evidently investors are not crazy enough to price the company at a level that implies it will take over the universe, I believe we can assume they agree the growth must slow. This begs the question, though, how much money will Google be earning ten years from now and how much will the company’s growth slow between now and then?

It is not necessarily my contention that Google is overvalued, but only that investors in the stock at these levels, if they think it is not overvalued, must realize what they are conjecturing as to the company’s growth. That is, for $665 per share and a PE of 53 to be a reasonable price, I figure Google must continue to grow its free cash flow somewhere between 35% and 40% for at least the next seven years. This is a tall task, but given their history maybe it is possible. The problem, though, is that companies already this large have a hard time achieving that kind of growth. In fact I am fairly certain no company this size ever has grown that fast. But I will leave this open for anyone to prove me wrong.

Let us think about what the current implicit future growth rate suggests about the dominance of this company in our economy. Within ten years, Google will be earning as much or more than over half of the Dow 30 components. Google will indeed be the biggest and most dominant American company. That may happen. It may not. But if it doesn’t, then Google is too expensive at this level. Said differently, there is simply no margin of safety.

Also consider the company’s rate of investment. This company has total assets of over $23 billion, a good chunk of which is cash. Further, it was revealed last week that Google just hired 2100 new employees – an investment that, although not appearing on the balance sheet, is indeed real. The company’s returns on capital have been remarkable in the past – it maintains a ROE of over 20% - but with so much more of this capital to work with it will take tremendous returns on that capital (at a level consistent with the earnings growth mentioned previously) to create value. Where such capital can be deployed in the virtual world in which Google operates is not readily apparent to me.

Look, I use Google everyday just like everyone else. The services are amazing and far superior to the existing alternatives. But I do remember a time not long ago when we said the same thing about Yahoo. Or Amazon. Can we really even bet that Google will maintain its current dominance of internet services, let alone the dominance of commerce in general? I guess the short answer is yes. But it’s a long shot, IMHO.

FD: No position in GOOG.

Kent Brockman, reporting live...

2007-10-02T09:14:00.000-07:00

I have to admit this is not the best market for a long-term value investor like me. This is a trader’s market. Nevermind the enormous volatility the market has experienced in the last six months or so, there seems to be a good deal of outright craziness in investor behavior. I pay attention most closely to Berkshire Hathaway news of course, so perhaps my perception is biased. But can anyone tell me why stock prices are reacting to pure media speculation?

Who are these people that started the rumor last month that Berkshire was going to buy Countrywide? More importantly, who were the people that took the reports of it seriously? There is absolutely no factual basis whatsoever, yet Countrywide stock shot up in reaction. Given the necessary access to the talking heads everyone seems to so blindly believe, I suppose I could have thrown that idea out there and potentially profited nicely myself.

Then, a few weeks later, they said the same thing about Bear Stearns. Again, not a shred of evidence, yet the stock shoots up. Did we not learn our lesson the first time? The rumor du jour is now Capital One for anyone interested, this one spurred by Jim Cramer. Again, folks, please give me some hard facts before manipulating stock prices like this.

Perhaps it’s the market wishfully looking for some direction in the uncertain (in fact, confused) credit markets. What better sign that things won’t get so bad after all than Warren Buffett taking a large stake in an institution heavily affected? That is what investors would like to see. Unfortunately it probably won’t happen. The lending industry is facing some very serious problems and nobody knows how it will all play out.

I certainly am not qualified to predict the direction of the economy. But I can say there is a nonzero probability that we will end up in some sort of recession. In the meantime, all this uncertainty creates an environment in which the sanguine rumor can flourish. A friend of mine and outstanding blogger, Chad Brand of the Peridot Capitalist, recently commented very poignantly on the credence given to the financial media and the problems it creates.

I think it is important to remember that those publishing or reporting in the financial media are journalists first, and economists or businessmen second. Just as we crave sensational stories in the popular media like OJ, Paris Hilton etc, we crave feel-good stories in the financial media. And those media, wanting to feed our craving, oblige.

Come to think of it, I once read somewhere that you can’t believe everything you read…

FD: Long Berkshire, no other position

Wall Street Journal Ranks Missouri #28

2007-09-17T11:30:00.000-07:00

There is no shortage of MBA rankings out there. US News, Business Week, Forbes. The list goes on forever. So take this for what it is worth, The Wall Street Journal is certainly one of the most respected publications in business journalism. Section “R” (I guess that stands for “recruiter”) of today’s Journal ranks MBA programs according to recruiters’ responses to questions about past and future recruitment at each school. The national ranking lists twenty of the usual suspects, i.e. Dartmouth, Berkeley, Chicago, Harvard etc. The Regional Ranking, however, ranks schools that “draw many of their recruiters from their local regions.” This one is a little more surprising.

Coming in at #28 on that list is none other than the University of Missouri - Columbia, with its Crosby MBA Program. This is a huge jump for us and several things about the list stand out to me.

First, consider the geography of the other schools on the list. Nearly all are near or in much bigger markets. We here in Columbia are a good hour and a half from the closest big cities and even those cities don’t really offer the type of opportunities on the coasts or in Chicago or Texas. A school with comparable geography that comes to mind is Iowa, which came just shy at #31. Also interestingly low is my former employer, Washington University in St. Louis, at #46. From what I understand, most of the recruiters that come to our school also seek WashU grads.

Second, we are third among Big 12 schools, behind Texas (how do you compete with them?) and Texas A&M. Further, we are ahead of five of the Big 10 schools. This indicates to me that as far as public midwestern business schools go, this one is right at the top.

Third, we are first among schools making the list for the first time. That’s right. Didn’t even scratch the top 50 last year. I won’t claim credit for anything, but I certainly don’t think it hurt this school’s image to have a nationally televised – and relentlessly re-televised – CNBC documentary singing our praises. I am, of course, referring to Warren Buffett: The Billionaire Next Door that featured me and the class I teach here at Missouri.

I think I can offer a unique perspective on the situation, as both an alumnus and a teacher of the Crosby MBA Program. So here goes, all biases aside, my advertisement for the school.
This is a fantastic way to get a degree, people. We have a beautiful five year old building that generally awes our visitors. We have financial aid out the wazoo for MBA students, meaning that a good portion of them (of which I was part) don’t pay a dime out of pocket. Compare that cost to the one of the WashU MBA I mentioned earlier. We are in a great community, the quintessential college town with big gameday festivities in the fall and cultural activities year-round.

But most importantly, the curriculum in the MBA program, more and more, is useful! This really can’t be said about some programs I don’t think. We train students to graduate with the skills that impress employers. This is hard to explain in a soundbite, but it is absolutely true. Besides Buffett, we have a large investment fund managed by MBA students, courses in security analysis and financial statment analysis, and an entire real estate institute.

I am really excited to be a part of this rise to prominence. Anyone considering an MBA please feel free to drop me a line. I’d love to give you the low-down.

Argh!

2007-09-06T14:43:00.000-07:00

So I get this email that says “When are you going to post on your blog again?” Well my answer is, eventually. Right now I am in the midst of studying for my comprehensive exam in October, taking two courses in econometrics and teaching Buffett, all while managing several portfolios and trying not to get distracted by the Cardinals last-ditch playoff run. So, to anyone about to give up on following my blog, rest assured that I will resume a little more frequent posting pace shortly, but for the time being I am too busy pulling my hair out...

YTD, Berkshire now outperforming

2007-08-16T07:38:00.000-07:00

Just a quick note.

Although it took a total collapse on the S&P 500's part, Berkshire is now ahead for the year. Amazing how an index of 500 companies can show so much more volatility than a single well-operating business that has outperformed over the long-run anyhow. And so I ask rhetorically, what does this say about Berkshire shareholders?

Thoughts on a Chaotic Market

2007-08-10T08:19:00.000-07:00

Today I choose to write about something that I don’t know.

I cannot, nor can anyone, predict what this turbulent market will do in the short term. The nonsense that is going on in the lending industry may turn in to a complete catastrophe, or it may blow over and we will be able to return to our normal everyday investing lives. Nobody knows. That much I do know.

It has been an unusually wild and unpleasant ride recently and this will undoubtedly cause some to panic. I am not among those. I have a portfolio of very strong companies that, barring any widespread contagion of historic proportions, are completely removed from the subprime lending market. Nonetheless, as all the worrywarts are reminding us, the problem could spread to other areas of the economy, credit could dry up and I may indeed suffer severe losses as a result. But I have no business selling my stakes in such strong businesses merely on this speculation.

However there is one specific and valuable lesson I have gleaned from this mess: Judging the strength of a financial institution is extremely difficult, if not impossible, for an individual to do well. In fact, many analysts and institutions probably face the same difficulty. Moreover, before I invest in any business, I must understand it. And if you can’t understand it, you shouldn’t be investing in it. I suggest that the investors who have gotten burned the most did not understand their businesses well enough. They couldn't have.

How was I to know the vulnerability of New Century Financial’s loan portfolio to a sudden adjustment of ARMs? I wasn’t. How could I have known that American Home Mortgage would suddenly announce it was liquidating? I couldn’t. Anyone who did know was on the inside. Consequently, everyone on the outside – not just the little guys but big institutions as well – got slammed in one brutal press release.

The truth is that banks, mortgage REITs, and even insurance companies have very opaque financials. Unless I am the loan officer that sees the credit report and 1040 of the nice couple that walked in to my office wanting to buy a house, how am I to know, realistically, the likelihood that they will default? I claim that I really cannot. Nor can I really gauge the underwriting discipline of an insurer with the information available to me. Sure, banks have standards and algorithms on which they base lending decisions. And the holding companies have historical default rates and CAMELS ratings to report to their regulators, but how well does this convey to the investor how strong the loan portfolio really is? I claim that it doesn’t do it very well.

And so, as I see it, the investor is left with three options. We can rely on management reports and judge the company on the basis of those reports. Taking this approach devastated the AHM investor, and I guess that is the one piece of wisdom to take away from this fiasco. Or, the investor could invest in only huge banks, i.e. Citigroup, JP Morgan etc., whose mere size all but guarantees adequate diversification.

Alternatively, we can take the faith approach. Investing in a bank with well-respected and responsible management, say perhaps Wells Fargo, would have left the WFC investor unscathed. If I really trust these folks to do what is best for the company in the long-term, then I needn’t worry quite so much.

I realize this is a simplification of the issue, since all such financial institutions are inescapably intertwined and they all rely on each other for liquidity, but the choice among these approaches could mean the difference between complete disaster and only moderate losses. And judging management is no easy task itself. So I guess I haven’t really provided any sort of solution to this fiasco, but that’s because I don’t have one. Just a few thoughts for consideration.

FD: I have no position in any company mentioned in this post.

Alt Berkshires: Some Choices in Funds

2007-07-30T09:32:00.000-07:00

Well it turns out US News & World Report is stealing my thunder. I promised a few weeks ago to devote a few posts to “alt-Berkshires” and will continue today anyhow, but it turns out this is exactly the topic one of the cover articles in the current issue of that magazine. Surprisingly, some of the alts that seem most obvious to me are not mentioned, so I will mention them.

Case # 1 - Weitz Funds
This is the only of the fund companies I will discuss in which I have invested. Wally Weitz and co-manager Brad Hinton run a total of only eight funds. There is an income fund and a money market fund, but the rest of the funds are very similar to each other and essentially aim to mimic a conglomerate like Berkshire Hathaway. And the managers make no secret of the similarities between themselves and Buffett. Weitz lives and operates out of Omaha and projects the down-home, midwestern aw-shucks kind of air. I like that – but I also like his investments.

Not surprisingly, Berkshire Hathaway the number one holding in three of the four marquee funds. Other top holdings include the Washington Post, Wal-Mart and AIG, all of which have clear Buffett ties. Omaha-based TD Ameritrade is held by most of the funds, as is USG – the housing sector-plagued but undervalued bankruptcy play that Berkshire currently owns 18% of. Unfortunately, Countrywide Financial also makes up a good sized chunk of the portfolios. Although Countrywide has been a good investment for the family over the last fifteen years, it will obviously weigh negatively in the near term.

The Weitz Funds family of funds has consistently beaten the S&P 500 over the past twenty years. According to the company, the Value, Partners Value and Partners III funds have earned annual returns of 13.5%, 13.6% and 14.2% respectively versus an S&P gain of 10.7%. The returns have not been as strong recently, including over the time I have owned the funds (about four years). Two of the three funds mentioned above lag the market over the past five years.

The fees are exceptionally reasonable, as one might expect for an alt-Berkshire. There is no load, of course, and the funds charge between 1.1% and 1.3% of assets per year.

Case #2 – Tilson Mutual Funds
Probably better known than Weitz Funds, but only because Whitney Tilson is a well known author in addition to fund manager. He co-authored Poor Charlie’s Almanack, the best book available about Charlie Munger and writes for several national periodicals.

The company is brand new and has a short track record, but what it has is very impressive. Mr. Tilson formed the company in 2005 after developing a reputation as an astute value investor in private equity and has beaten the market handily since. In fact, during this past year’s bull market the flagship Focus Fund has nearly doubled the already steep growth of the market. But because it is still young and unproven, it is probably better to focus on the funds’ philosophy than their performance.

Mr. Tilson has only two funds – the Tilson Focus Fund and an income fund known as the Tilson Dividend Fund. Berkshire Hathaway represents a remarkable 14% of the Focus Fund. When they say “focus" they mean it. It has some overlapping holdings too, including USG. The annual report features a section outlining the company’s investment philosophy that might as well just quote Berkshire’s Owners Manual; eating their own cooking, demanding a margin of safety, and holding cash in the absence of good opportunities. These are principles a value investor should look for. It also demonstrates an emphasis on long-term performance, even though the funds’ performance in the short term has been stellar.

Tilson Fund’s fee structure is a little disappointing, though. In addition to a 2% back-end load the Focus Fund also charges more than 2.4% per year.

There are some other alt-Berkshires that aren’t available to the average joe, but are probably worth mention nonetheless.

Sequoia Fund
Bill Ruane, a former classmate of Buffett’s and Graham disciple, formed this company in 1970. In fact, when the original Buffett Partnership was dissolved, Buffett referred his clients to Ruane. The success of the fund is undeniable, but since 1982 has been closed to new investors. This has made its growth far less constrained and thus much more impressive than, say, Fidelity Magellan, which got so big it simply couldn’t get much bigger.

Pabrai Funds
Mohnish Pabrai seems to have come out of nowhere to become one of the more prominent value investors today. Perhaps it was the highly acclaimed book he released earlier this year, The Dhandho Investor, or more recently his winning bid of $650,100 to have lunch with Warren Buffett. Whatever it is, this guy seems like someone worth following. But Pabrai does not sell mutual funds, so the small investor probably won’t be able to share in his investment success. That doesn’t mean one shouldn’t follow Mr. Pabrai, though, who appears to have a strong interest in sharing his knowledge, in much the same way Mr. Buffett does.

FD: Long Weitz Value, Weitz Hickory, Berkshire Hathaway, USG. No position in any other security mentioned.

Alt-Berkshires

2007-07-18T09:34:00.000-07:00

If there is one cliché that I hear value investors (including me) use more than any other it has got to be “Company XYZ is the next Berkshire Hathaway” or maybe “XYZ is a miniature Berkshire Hathaway.” Everyone wants to buy the undiscovered, pseudo-Berkshire (for obvious reasons) but it is easy to toss such a description around without a real consideration for what makes Berkshire Berkshire. I have decided I will devote a few posts to investment opportunities that I see as legitimate substitutes for BRK. In many cases, these investments might even outperform Berkshire, as they aren’t limited by Berkshire’s enormous capital base. Something to think about if your dream is living the life of Otis Booth.

#1 Wesco Financial Corporation

To me this should clearly be first investment discussed as it is actually part of Berkshire Hathaway – it is 80.1% owned by BRK. Charlie Munger’s company is easy to forget about with its much larger and more famous parent. In fact, ask the typical investor who Charlie Munger is and he or she will probably reply “vice-chairman of Berkshire Hathaway,” rather than “CEO of Wesco Financial.” But this greater obscurity might also make Wesco a more attractive alternative, particularly with its share price off 18% of its all-time high earlier this year. This is not to say, however, that there aren’t several very important differences between it and its parent, though.

For one thing, unlike Berkshire which is very well diversified, there are really only two operationally disparate parts to Wesco, the insurance businesses and CORT Business Services. The company also owns Precision Steel, a small steel company, as well as a small real estate company called MS Property. But, in 2006 for example, the insurance businesses and CORT together supplied 98% of Wesco’s earnings.

CORT is a furniture leasing company, which rents to both businesses and individuals. Its primary operations involve supplying businesses with furniture, while, through its relocation services, it supplies individuals working for those businesses. This makes for effective cross-selling.

When it was purchased in 2000 for $326 million it was earning about $30 million per year. It would appear that not much has changed – in 2006 it brought in merely $27 million. Of course times have changed dramatically since 2000 and in retrospect 2000 may have been just the wrong time to make a major acquisition (that is, at an economic peak, before a major terrorist attack and war). Soon after the acquisition income fell off dramatically, even in to negative territory, but in recent years the company has been on the rebound. Mr. Munger is “cautiously optimistic” that things will improve soon but the truth is CORT really has not done much for Wesco to date. The good news is that we can certainly rest assured that the company is being led by competent and trustworthy management, but will that be enough to turn things around? And you could probably make a weak macro prognostication about how with home sales being down more folks will dwell in apartments and need to furnish them temporarily etc, etc, but I really think that is merely speculation.

However, CORT does have one great competitive advantage – the Berkshire name. And the company appears to be attempting to leverage that by advertising that it is “A Berkshire Hathaway Company.” This could be more valuable than you might think. CORT’s core customer base is a collection of Fortune 500 companies, a constituency with which the Berkshire name carries a great deal of credibility.

Wesco’s insurance businesses have done very well lately and this is really Wesco’s flagship anyway. Like other Berkshire insurance subsidiaries, those of Wesco earn both an underwriting and investment profit and have for many years. There are two parts to this business, reinsurance through Wes-FIC and bankers insurance through Kansas Bankers Surety. Wes-FIC is effectively part of Berkshire’s wholly owned subsidiary National Indemnity, which runs its operations and the float generated by the company is forwarded on to Berkshire and hence managed by Mr. Buffett himself. So through Wes-FIC the Wesco shareholder is indeed getting Berkshire Hathaway management even though the profits of Wes-FIC belong to Wesco shareholders.

Reinsurance can get confusing with so many parties involved. For instance, National Indemnity provides reinsurance to XYZ Insurance Corp and then “cedes” part of the reinsurance to Wes-FIC. But through its association with Berkshire, Wes-FIC enjoys outstanding capital strength that many other insurers could only dream of. In 2006, Wesco’s statutory surplus – the amount of reserves held by the company in excess of that required by the various state statutes – was $2.3 billion.

Now let’s consider the company’s balance sheet. At yearend, Wesco had about $2.37 billion in cash and marketable securities, a “problem” not unlike that of Berkshire. Munger bemoans that so much cash and nowhere to put it spells poor prospects for future returns on capital, which may be true. But it also enables the insurance operations to expand (as discussed above) and helps us value the company more confidently. All that cash is worth about $317 per share while Wesco stock trades at $394. So, assuming the insurance operations merely break even on an underwriting basis, we can effectively purchase Wesco’s other operations (CORT) for $77 per share – that puts CORT at 21 times operating profit. This is a huge “if” though. The reinsurance operations share the risk of megacatastrophes – those on the scale of 9/11 or Katrina. A large megacatastrophe could be catastrophic, so to speak, to the company. Of course the underwriting discipline of National Indemnity and Berkshire is very highly regarded so not knowing the specifics of the company’s contracts we ought to rest somewhat easy that Wesco’s exposure is acceptably limited.

The history of Wesco is very interesting and even landed Buffett and Munger in front of an incredulous SEC that couldn’t understand why they were willing to pay a premium to the existing management. Although I won’t get in to it, I encourage anyone curious to read through Roger Lowenstein’s account of the acquisition in Buffett: The Making of an American Capitalist. Without a doubt the best book written about Mr. Buffett to date.

There is much more that can be said about this company but for the sake of brevity I will end it here.

FD: Long Berkshire Hathaway, no other postition in any security mentioned.

The Chipotle Mispricing Persists

2007-06-22T11:09:00.000-07:00

The stocks of Chipotle Mexican Grill are both down today on an analyst downgrade, which is fine. The company’s price has certainly been bid up. What continues to amaze me, though, is the lack of attention to the very obvious mispricing that exists between the company’s class A and class B shares. For one thing, oftentimes the B shares aren’t even mentioned, or reports will just make reference to “shares of Chipotle,” as if they are all the same. Something very interesting has been going on here but no one seems to care.

When Chipotle was spun off of McDonalds last year in an IPO, it had only one class of publicly traded stock. McDonalds retained a majority interest in Chipotle, though, calling the shares it owned B shares and assigning ten times the voting power to them. Then, when McDonald’s sold its remaining interest in October (perhaps because it saw CMG as overvalued?) the B shares came to market.

The shares have the same economic value. That is, the B shares are identical to the A shares except for the fact that they have more voting rights. So, if anything, the B shares should trade at a small premium to the A shares. But they don’t. They have persistently traded at a 7% discount to the A shares. This is an example of investor irrationality. I read about it in various places after the phenomenon began, but it took a call to the company itself before I believed it.

Anomalies like this drive academicians nuts. How can this happen? Why aren’t arbitrageurs eliminating this discrepancy? The literature on behavioral finance contends that such anomalies can persist when there are “limits to arbitrage.” This explains why shares of 3Com traded at a discount to shares of Palm, which it owned, my favorite Wall Street anomaly of all time. Know-something investors couldn’t get their hands on shares of the overvalued stock to short, so it kept getting pushed up.

But I don’t think this can explain the persistent mispricing in this case. Both classes of stock trade several hundred thousand shares per day, and I personally have been able to buy both classes – the A’s before the B’s were around, then was able to easily sell the A’s and buy the B’s. So there is no liquidity concern here, and even if there were, I would expect the A shares to be discounted as there are slightly fewer of them outstanding (and thus they are less liquid).

So can this discrepancy be arbitraged? The short answer is yes, but it has not been profitable yet. Since the phenomenon continues to persist, those who shorted the A shares and bought the Bs have not yet realized any gain. And if it takes long enough to correct the mispricing, they may never realize a gain. I found it difficult to get historical price data for CMG.B because, again, everyone is focused on the A shares. It isn’t available on Yahoo, Google or even Ameritrade’s resources. I finally found a source for both classes on the Chipotle IR website, although I had to search for each day’s price independently. I then, painstakingly, charted the profit from an arbitrage of them by manually entering them into excel. And here it is, in all its glory:

I assume that I initiated the arbitrage trade on January 10, since this was around the time that I personally learned of the mispricing, by buying Class B shares at $52.40 and shorting Class A shares at $56.21 . The cost basis is the cost of the shares I bought, $52.40, so to date the arbitrage would have produced a gain of $2.00/$52.40, or 3.8%. If we assume the cost of shorting is 9% APR, or 4.5% over the six months we were short, then the interest on the short would completely wipe out the gain on the long. And this ignores the time value of money, the return on the market and, perhaps more importantly, the fact that a long position in either class of stock would have produced a great gain.

The analyst report that came out today also makes reference to the large short interest in CMG in the explanation of its downgrade. Couldn’t this simply be because of investors trying to arbitrage the difference?

PS - What do you suppose SocialPicks will say about this one?

FD: I have no position in any stock mentioned in this post.

Andy Kern does not make "picks"

2007-06-21T10:53:00.000-07:00

As the name of this blog should indicate, my goal is not to make stock picks but rather to muse about current events in the stock market and the field of finance generally. Nonetheless, a website called SocialPicks has taken it upon themselves to label my thoughts as either a "buy" or "sell" recommendation. This is not what I do, so I take exception to what this site is suggesting. I never asked to be covered by this group, nor have they responded to my requests that they stop. Further, they tally my "picks" and track and rate my performance! Ugh.

What is more, they are completely ignoring even the general sentiment of my posts. For instance, earlier this year I wrote a post about my thoughts on the Home Depot situation, which was really just a reflection on what is good and what is bad corporate governance. Somehow, for some reason, the website decided to label this an Andy Kern "buy." Or, last month I titled a post "Sell GGG - They recalled their baby toys." This was supposed to be funny because GGG doesn't make baby toys, rather Google Finance had confused the company with a different one of a similar name. Well, SocialPicks didn't get the joke (or more likely, just didn't read the text of the post) and labled this an Andy Kern "sell." All these errors cause the "Andy Kern tracker" to have a very low rating.

I am posting this in the hopes that someone out that can provide me with contact information for the owners of this website. I have sent repeated emails and gotten no response, but I know of no other way of contacting these people. I would like a mailing address or phone number so I can have my attorney write a friendly letter explaining that they ought to stop such defamation. So far as I can tell, this is outright libel.

All that I have been able to find so far is the name of two of the operators, Weiting Liu and Jason Fang. If anyone has any other information I would appreciate the help.

Value Plays Rebuttal - Part 2

2007-06-08T10:37:00.000-07:00

Now on to the question at hand. Is Berkshire better off without Warren Buffett? Todd seems to be asserting that holding cash of $40 billion alone is grounds for Mr. Buffett’s removal from office. Is Todd suggesting that Mr. Buffett is not efficiently allocating his capital and thus should leave the company? Perhaps, but if that is the case then I suggest he rethink Mr. Buffett’s track record, you know the most impressive capital allocation track record ever.

It is a theme I hear often repeated: Buffett did well in the past, but won’t do well in the future. This is true in one regard. Berkshire is now a big fish. It will certainly not perform as well as it has in the past because its “universe of potential investments,” as Mr. Buffett puts it, is much smaller now. There aren’t a lot of $40 billion dream companies available for sale at the moment, nor will there ever be. Does this mean Buffett should lower his standards? Certainly not. What many people argue, though, is that it means Berkshire should pay a nice $26,000 per share dividend. (That’s $40 billion divided by 1.54 million Class A equivalent shares.) I am not terribly opposed to that idea, but here are some reasons why it might be worthwhile to let him continue to hold this cash.

The company’s cash horde has been around its current level since yearend 2003. In that time, the per-share book value of Berkshire has increased 68%, compared to a return of 73% for the S&P 500. However, also in that time Berkshire stock has only increased by about 30%. Perhaps the market is deterred because it is uncomfortable, as is Todd, with the company’s huge stash of cash. I would suggest that if the company can essentially match the performance of the market while maintaining such a large cash balance, then the operations in which it is engaging must be doing exceptionally well.

So what good does sitting on $40 billion in cash do? Well sooner or later there will come an opportunity that will quiet everyone down about this. Berkshire spent $10 billion on acquisitions in 2006 and Mr. Buffett hinted at the possibility of a huge acquisition sometime soon. But since the company had operating cash flows of about the same amount as the costs of its acquisitions, the cash balance didn’t change. Mr. Buffett also hinted at a possible but unlikely acquisition at last years meeting. (He said it was in the neighborhood of $15 billion – some people speculated it was Omaha-based ConAgra.) But I think what we can infer from this is that he his actively seeking ways to put the $40 billion to use. Unfortunately, bargains are hard to come by in this market, as I am sure any value investor these days is aware.

But what a mistake it would be if the company paid out all that cash only to miss an opportunity that would be highly profitable. If the cash is paid to shareholders, they will be forced to pay income tax immediately and may or may not be able to invest it at a rate of return greater than what Berkshire would otherwise earn. Remember, Berkshire, despite its cash, is still not underperforming. So at the worst, that $40 billion is earning its shareholders the same return as the S&P 500.

But when that big acquisition opportunity does come, Berkshire will be ready. I have faith that Mr. Buffett is confident enough that it will happen sooner rather than later, and that is why he is willing to wait with so much cash. I also think that over the course of his career he has proven himself to be a responsible custodian of shareholders’ wealth. If he wants to sit on $40 billion in cash, I trust that he sees the likelihood of being able to invest it sometime soon as sufficiently great to justify doing so. And lets not forget that Mr. Buffett himself is the largest shareholder of Berkshire Hathaway, and would get billions from a large dividend like that.

If you don’t trust Warren Buffett to make the best decisions for the company, then I suggest not purchasing the stock. But I think you are making a big mistake. I know Warren Buffett. I have had lunch with Warren Buffett. I know and trust close friends of Warren Buffett’s and can assert confidently that all the good things you hear about Warren Buffett’s character are absolutely true. There aren’t many people I know with such upstanding principles. The fact that he is the most successful investor ever shouldn’t be reason for anyone to doubt his integrity, but many people do anyway. I don’t. And I will continue to own Berkshire Hathaway.

FD: I own shares of Berkshire Hathaway.

Value Plays Rebuttal - Part 1

2007-06-08T10:33:00.000-07:00

Todd Sullivan over at Value Plays suggested that I rebut the argument he made that Berkshire Hathaway is better off without Warren Buffett. His post, which I suggest you read first, contends that Berkshire sits on too much cash, and has sat on it for too long. Thus, Mr. Buffett should step down and allow someone else to run Berkshire’s investments. The post elicited a plethora of anonymous Todd-you-are-an-idiot comments, some of them fair, some of them not. I don’t think my faith in Mr. Buffett is quite as blind as these anonymous readers, nor am I afraid to attribute my comments to myself. So here I go, an unbiased and - what is the opposite of anonymity? Nymity? Anoanonymity? Whatever it is, that is how I am presenting the following comments.

Berkshire Hathaway is unquestionably better off with Warren Buffett. I would even go so far as to say that most American businesses would be better off with Warren Buffett. He is the greatest businessman and business leader in history.

However, contrary to popular belief, many of the stocks that Berkshire buys are not necessarily Warren Buffett picks. Mr. Buffett is much more focused on the acquisition of entire businesses. The minority interests Berkshire takes in companies such as Wal-Mart, Johnson & Johnson and US Bank (and losers such as Pier 1 Imports and H&R Block), although listed on Berkshire’s consolidated statements, are most likely investments made by Lou Simpson of GEICO. Whereas other Berkshire subsidiaries send earned capital directly to the parent company, GEICO invests its own cash. Mr. Simpson has been so successful at investing GEICO’s float that historically he has been suggested to be a heir to the throne. (If only he weren’t so old.)

In his posting, Mr. Sullivan commits several errors of fact. Let me address two of them:

Tood states that “[Buffett’s] recent purchase of 10% of Burlington Northern and 15% stake in USG marked the first time this century he has taken a meaningful stake in any company.” And also that “Berkshire's investment portfolio today resembles a mutual fund with small positions in over 30 companies that are bought and sold regularly.” Neither of these statements is true and it seems Todd has forgotten that Berkshire also owns 73 businesses either outright or has a stake large enough to allow for complete consolidation on Berkshire’s financials.

To put things in perspective, Berkshire’s stake in Burlington Northern is currently worth about $3.3 billion, according to its April 2007 beneficial ownership filing. And even the now close to 40% stake in USG is worth less than $2 billion. This is relatively small compared to the acquisition of Iscar Metalworking in 2005 for $5 billion, or Berkshire’s 85% stake in Mid-American Energy, which purchased PacificCorp for $5.1 billion in 2006. The company has made several other acquisitions of comparable size, such as Shaw Industries in 2001 for $2.1 billion or Clayton Homes in 2003 for $1.7 billion. To suggest that Berkshire has not made meaningful acquisitions this century is simply not accurate.

Nor is accurate to characterize Berkshire’s investment portfolio as resembling a mutual fund of 30 companies. It is true that Berkshire has “investments” – or minority interests – in about 30 stocks, but the total market value of these stocks is only about $60 billion. For a company with balance sheet totals of $250 billion it should be clear that the company is much more than a portfolio of 30 stocks. People in the press and on blogs like to talk about the public equities Berkshire owns because they are still available for purchase to the public. Wanting to chase Berkshire’s success, these are the investments they focus on. But in reality, the company’s common stock investments represent only a small portion of the company.

Berkshire Hathaway is a conglomerate of 73 subsidiary businesses, which also happens to own a portfolio of 30 stocks.

FD: I own shares of Berkshire Hathaway.

A Valuation Rumination

2007-05-29T12:42:00.000-07:00

Some folks consider themselves value investors if they tend to buy stocks with a low P/E. I think this is superficial, but it highlights what may be a pervasive oversight that all types of investors make: We often forget what stock is and why anyone would be willing to pay money to own it. In the lines that follow, at the risk of ultimately just playing with words, I will try to articulate my opinion of where value comes from and thus what constitutes value investing. At least in the Graham-Dodd sense of the term.

Companies operate to make money. No business would exist, except in some alternate bizzaro (or maybe socialist) world, if that wasn’t its goal. Hence, earnings are important. But they are not all that is important. Further, earnings themselves do not represent value. Rather, they are the source of value. Graham and Dodd cared about earnings only to the extent that they increased the firm’s value and the firm’s value, to Graham and Dodd, came directly from the balance sheet. By adopting their definition of value, return on equity, not earnings alone, is the most important metric of value creation.

Graham and Dodd focused on purchasing companies that traded at a discount to book value. That is, they preferred stocks whose market cap was less than the book value of that firm’s equity. This was logical since they saw the stock as representing a claim – a residual claim, mind you – on the company’s net assets. If the company were to liquidate today, the stock ought to be worth today whatever would end up being paid to the shareholders. Sell the assets, pay off the debt, what ever is left over (net assets) is what the company is “worth.” If we can get it for less than that, we are getting a bargain. So the only real consideration in this simple scenario would be any discrepancy between the actual market value of the assets and the value at which they are booked on the balance sheet.

Think about this concept for a moment. If you knew a company was going to instantaneously liquidate at 3:00 pm this afternoon, how much would you pay for it at 11:00 am this morning? Answer: net asset value per share.

But what if the company doesn’t liquidate today? What if, instead, it liquidates in twenty years? What if it never liquidates? The principles of valuation ought to be the same, Graham and Dodd would suggest, but the calculations get tremendously more difficult. Again, the company is worth the value of its net assets, but now we don’t know what that value will be in the future. Additionally, because of the time value of money, we must discount that unknown value back to the present at some other, also unknown, discount rate. Oh yeah, and the number of periods we are discounting that unknown value at an unknown discount rate is also unknown.

Maybe by now it is clear that, despite the uncertainty, at least we know that what really drives the value of a stock is the claim that the stockholder has on the company’s assets. If not, consider the valuation of a bond, which also represent a claim on the company’s assets. Bonds are simpler to value, though, because there is far less uncertainty as to what the owner will be paid. At maturity, bonds are “liquidated” just as our stock was in the above hypothetical. The value (price) of the bond is simply the discounted value of all those payments.

Earnings are important because they boost the stockholder’s claim on the firm’s assets. This results from retained earnings. As the company books profits, those profits are retained on the balance sheet, boosting asset value without a corresponding increase in liabilities. So shareholders’ equity (book value) increases. We measure this rate of increase by the return on equity. The problem is that we don’t know how much the company will earn so we don’t know how much book value will increase. Note that the payment of dividends is only a minor complication – instead of value being retained by the company for eventual, indefinite payment to the shareholder, it is paid out immediately. Either way, it ends up in the shareholder’s pocket.

But not all earnings are created equal, and this is probably the important part of my musing. Not all earnings boost book value. If net income cannot be retained or paid to shareholders as a dividend, then it can’t increase book value of equity. And there are simply too many ways that net income can be manipulated (willfully or not) so that it does not accurately reflect the value added to the balance sheet. Additionally, that unknown discount rate that I alluded to earlier ought to be based the firm’s cost of equity. If this cost of equity is high, then a firm can actually be destroying value even as its net income grows.

First of all, it is logical to discount future net income at the firm’s cost of equity, rather than its weighted average cost of capital (WACC), because the net income number is already net of the cost of debt. I see a lot of students who have been taught capital budgeting (a similar-but-different exercise) try to discount such numbers at the WACC. Cost of equity is a somewhat abstract concept and is often difficult to calculate. At the very least, though, we can say that it is some modest amount higher than the interest rate the company pays on its senior debt, since equity is much riskier to its owner than is debt.

If we assume that we are discounting that future income at the cost of equity, then the firm must boost its book value at a rate greater than this cost of equity if it is to create value. That is, it must earn a return on its equity that is higher than its cost of equity. Otherwise, even though we have future positive net income to add it to our current book value, after discounting to reflect its cost it is worth zero or less.

Graham and Dodd’s notion of value has several other implications. One is that a profitable company should not sell for less than the market value of its net assets. If it does, it is a bargain. But the market does some quirky things and occasionally this happens. It happened frequently when information gathering was as difficult as it was in Graham and Dodd’s era, but probably happens far less often today. Graham and Dodd idealized a bargain in what they called a “net net stock,” one that sold for less than the value of its net working capital. These were tremendous bargains that are all but nonexistent in today’s market.

I guess the bottom line is that ROE, not P/E is the most important ratio in stock analysis. A value investor, though, realizes its importance because he realizes where the value of a stock comes from.

Berkshire Ruminations now has an RSS feed

2007-05-23T06:04:00.000-07:00

I finally tried to figure out what exactly an RSS feed is. I feel dumb for not knowing about this system earlier, but because I didn't know I simply never bothered to look into it. Although I still don't really understand how it all works, I believe I have one now, its on the sidebar at the bottom. Enjoy.

Sell GGG - They recalled their baby toys!

2007-05-21T09:59:00.000-07:00

On this blog, just as a matter of principle, I have tried to avoid simply republishing previously published news bites or other bloggers’ postings. But this one was just too outrageous to pass up. It was brought to my attention on the Google Finance message boards by Dr. Bob Kiser. Dr. Kiser pointed out that Google Finance listed news of the Graco Children’s Products Inc. recall of its Soft Block Tower Toys alongside the Graco Inc. stock quote. The funny thing is that these two companies, although they share a similar name, have absolutely nothing else to do with one another.

Graco Inc. (GGG), the fluid-handling systems manufacturer, is a company I have been following for several months now. This no-debt company has averaged an ROE of over 40% for ten years and spends little in the way of capital expenditures. I wonder if periodic bad news from the other Graco sometimes has an adverse impact on the stock of this Graco when rash investors confuse the two…

Such a postulation is not as ridiculous as it may seem at first glance. Last year, when Jim Cramer mania was at its peek and a mere Mad Money endorsement was all it took to move a stock by five or ten percent, several stocks that were confused with the actual recommendations traded in concert.

This phenomenon is nothing new and has generally been attributed to the presence of ignorant “noise traders,” those that don’t do their homework before making a trade. The Harvard Business School dissertation of Michael S. Rashes, later excerpted in the Journal of Finance, documents the similar trading patterns of two securities with similar ticker symbols that are otherwise unrelated. In the late 1990s, MCI Communications traded on the Nasdaq under the ticker symbol MCIC. The ticker symbol MCI was an NYSE ticker reserved for a closed-end fund called Massmutual Corporate Investors. Clearly, these two securities have no relationship beyond their ticker symbols, yet Rashes shows an extraordinary amount of comovement between them.

During the period of the study, MCI Communications was in frequent merger negotiations with a number of different firms. (Of course, eventually it was acquired by Worldcom.) This gives Rashes many big news days to examine the corresponding behavior of Massmutual. He finds that on days of good news for MCI Communications, volume for Massmutual increased as well. Further, through regression analysis, he finds that the returns for Massmutual are actually a statistically significant explanation for the contemporaneous returns of MCI Communications, even though the returns of other telecom companies, such as AT&T, are not. Rashes estimates that as many as 1% of the trades in MCI during 1996 and 1997 were erroneous MCIC trades.

Graco Children’s products is not publicly traded – it is owned by Rubbermaid (NWL) – so ticker symbol confusion couldn’t cause the type of blatant mispricing mentioned above. But it nonetheless would seem feasible that there are individuals, even perhaps overwhelmed portfolio managers, reckless enough to sell GGG shares short upon hearing about the Soft Block Tower Toys recall. If this is the case, maybe we should watch Graco Children’s as part of our monitoring of Graco Inc.

FD: I own shares of GGG, but have no position in any other security mentioned in this post.

Paying for Growth: The Value Investor's Quandary

2007-05-03T10:16:00.000-07:00

This is the story of two great growth stocks, one that I bought, one that I should have bought and both of which just released blowout earnings of (coincidentally) 38 cents a share.

The one that I bought is Green Mountain Coffee Roasters (GMCR), one of my all-time favorite companies (see “The Best Investment I ever made”). The one that I should have bought is Chipotle Mexican Grill (CMG), one of my all-time favorite restaurants.

GMCR reported fantastic numbers this morning for its second quarter. Net income doubled over the year ago quarter on sales growth of about 77%. Analysts had expected EPS of $0.34, and GMCR came in with $0.38. This represents an ROE of 13.4%. The stock shot up 10% this morning. As I have written about before, this company has some of the most level-headed and seemingly honest folks running it of any company with which I am familiar. After a decade of watching the company grow at a fast, but not ridiculous, rate I am now witnessing a true explosion of value.

There are at least two factors at work here. The first is that GMCR has created itself a niche that is protected by intellectual property rights. This gives it a wide moat that competitors, even those as strong as Starbucks, will have trouble penetrating. I am referring to their development and acquisition of the patented Keurig K-Cup brewing system. A K-Cup is plastic container, about the size of a shot-glass, that is filled with Green Mountain Coffee and sealed on the top with foil. When used with the (also patented) Keurig brewers, the cup is pierced and the coffee is brewed in the cup, producing one serving of perfectly brewed coffee. This has proven extremely popular in office settings, where the dreaded “coffee-burn” phenomenon has hindered the appeal of coffee pots for years.

The second factor is the company’s new relationship with McDonald’s. McDonald’s launched its “Premium Roast Coffee” campaign last summer with great success, immediately challenging Starbucks on taste and convenience. The coffee is usually branded under the McDonald’s name, but in a select number of stores in the northeast McDonald’s actually sells Green Mountain’s Newman’s Own Organic Coffees as such. Not only does this position Green Mountain to potentially supply the largest restaurant chain in the world, it also gives the coffee exposure to a constituency it otherwise wouldn’t.

The market seemingly has high hopes, as the stock has traded at very lofty multiples for several years now. This can be difficult for the value investor to accept. GMCR must grow at its current clip to justify its valuation, and that simply introduces a great deal of risk in to the investment. Should I, as a value investor, really take a position in a company that trades at PEs upwards of 50? Usually I won’t. In fact, this is exactly the reason I failed to dive in to the stock of my favorite lunch destination, Chipotle Mexican Grill.

At this university, I think most people would agree that Chipotle is unequivocally the most popular place to eat on or around campus. Every day a long line stretches around and towards (sometimes out) the door – both at lunch and dinner time. Friends of mine eat there every day. I even recall an article in the student newspaper entitled something like “I love Chipotle.” The food is delicious and the customers are loyal. I know this because when a similar Mexican food competitor opened next door, hardly anyone switched. The lines at Chipotle remained just as long as they had ever been.

So when I heard McDonald’s was selling its interest in Chipotle, I was immediately interested. For several months I watched for updates at chipotleipo.com, but was disappointed when the IPO was announced. The stock would go public at about 30 times earnings. For a company posting a return on that new equity balance of only 10.5%, this seemed to be too dangerous. High multiples like this make the cost of equity very high, and force comparably high returns if value is to be created.

Nevertheless, I have watched from the sidelines as the stock nearly doubled. It doesn’t take much research to figure out that the reason is that the company continues to expand and grow at rates higher that even Wall Street’s lofty expectations. Compounding the stock’s growth is the treasured “multiple expansion,” the market’s reaction to its realization that growth may be even better than it thought. Whereas the P/E of 30 sounded high to me a year ago, CMG now trades at a ttm P/E of over 50! The forward P/E may look more reasonable, but is still high at about 44.

So am I just hardened by the tech-bubble crash when high-multiple stocks suddenly fell to more normal levels, or should I really be considering these high-growth, but correspondingly high-priced, stocks? It is a test of discipline. CMG is very expensive, but it also is a very strong company. Thus, I need to convince myself that it is creating value despite its lofty price. I cannot convince myself of that, since the returns that it is earning are simply not high enough to offset the high cost of equity capital implied by the current stock price.

FD: I own shares of GMCR, but have no position in CMG or MCD.

Mario Gabelli and Value Investing

2007-04-26T08:59:00.000-07:00

I recently got a chance to meet Mario Gabelli, chat with him briefly and attend a lecture he gave to our business school. It was another exciting opportunity for me that I owe to my status as a student at a school with a very generous benefactor, Mr. Harvey Eisen, who routinely helps bring the classroom to the real world.

Some folks might be more familiar with his company, Gamco Investors (GBL), than with Mario Gabelli himself, so let me review why I think he is one of the most important investors to study.

As far as the hall of value investing fame goes, I would say Warren Buffett and Charlie Munger top the list, but Mario Gabelli is not far behind. Like Warren Buffett, Mr. Gabelli is a graduate of Columbia Business School. So naturally he is a strong proponent of the value investing style formalized by Benjamin Graham and David Dodd in the 1930s. He is still active at the school, lectures occasionally and consults with the current value investing professors.

Mr. Gabelli’s innovation is the concept of Private Market Value (PMV). The underlying idea of PMV is that a public company is worth the amount that a private investor would be willing to pay for the company in its entirety were it not public. This is a somewhat more concrete modification of the concept of intrinsic value, for which Graham and Buffett both had more ambiguous definitions.

For instance, Mr. Buffett defines intrinsic value as the present value of all cash that can be taken out of the business over its remaining life. Of course, calculating this can be frustratingly difficult as it relies on important assumptions of future earnings, capital expenditures and various other unknowns. Conversely, PMV can be estimated a little more accurately by garnering an awareness of the private market for businesses. This strategy worked well for Mr. Gabelli as his firm was getting off the ground in the early 1980s, just as the leveraged buyout phenomenon was peaking and public firms were indeed being taken private with some regularity.

But Mr. Gabelli does not settle for only companies that are likely takeover candidates, as this would severely limit his universe of potential investments, especially in a less LBO-friendly environment. Thus, he also looks for a “catalyst” – something that can cause a public firm’s hidden PMV to be unlocked without the need for a buyout. Such things may include a new management or regulatory change.

While Mr. Gabelli rightfully gets the credit for popularizing this idea, one can see the strategy at play in the investments of many investors, including Warren Buffett. Take for example Berkshire’s investment in Coca-Cola in the mid-80s. Mr. Buffett saw an enormously strong brand that had been muted. But there was also a catalyst in the form of new CEO Roberto Goizueta who took over the company with a new strategy. More recent examples might include Berkshire’s investment in Mid-American Energy and PacificCorp, which came immediately after the repeal of the Public Utility Holding Company Act.

So what is value investing these days anyway? I get asked that from time to time, but it can be difficult to answer. The simple answer is that it is a catch-all term to characterize a variety of investing styles, all of which make the supposition that the market oftentimes gets prices wrong. Perhaps it is best to describe modern value investing by what it is not.

Value investors give no credence to charts, moving averages or any technical indicators. This is because, under the assumption that stock prices might be wrong, then so too can the charts. But it is also because value investors focus on fundamentals, whether those fundamentals include financial ratios, market shares or brand value. Note that such fundamentals are not necessarily easily measured or even identified.

Value investors do not worry about trends, and generally avoid “hot” stocks. Buying a stock on momentum and hoping that momentum is sustained is simply too risky. This does not imply that a value investor cannot buy a hot stock, but only that it being hot is not the reason for the value investor’s purchase.

However, value investors always distinguish between value and price. Far too many investors assume price and value are synonymous. They are not. Price is what you pay, value is what you get.

In the end, value investing boils down to the purchase of stocks for less than they are worth. What they are worth boils down to some estimation of value based on factors unrelated to the market or its pricing of the stock. Thus, the value investor does his best to ignore the market entirely until he decides what he feels is the right value of the stock – just as he would be forced to do were the company private – and then makes a decision by comparing this value to the price.

FD: I own shares of Berkshire Hathaway, but have no position in any other company mentioned in this post.

Beware the Sell-Side Analysts

2007-04-22T10:49:00.000-07:00

I thought I would publish some auxiliary results to an empirical study I have been working on, as they might be of direct interest to investors like me. I was able to get a large amount of data on analyst forecasts and corresponding corporate earnings announcements from a Thompson Financial database called the Institutional Brokers Estimates System.

The database contains data on the earnings announced each quarter by a company and the mean estimate for that quarter’s earnings among all analysts that follow the stock. I got all the data available dating back to 1984 and found the average difference between the forecast and the actual earnings. I call this “forecast error.” The bottom line is that analysts consistently overestimate earnings. This indicates that there are probably more earnings disappointments than there are surprises, or that disappointments are sometimes so large that they skew the results. The average forecast error is consistently positive, after accounting for nearly 250,000 quarterly earnings announcements over this time. In fact, in only two years, 2002 and 2003, was the error negative, indicating that analysts on average underestimated earnings in those years.

So how can we interpret these results? I hesitate to draw too many inferences as doing so might be seen as hasty by my academic colleagues. So I will leave that up to the reader. But it is not particularly surprising to me that stock analysts hired by brokerages or investment banks looking to make stock transactions happen would be overly bullish about a firm’s prospects. Or, alternatively, perhaps these analysts aren’t doing much thinking themselves and are instead merely following the guidance of the company, whose incentives are also obviously biased towards bullishness.

Regardless of the interpretation, this unambiguously suggests taking the pervasive “strong buy” recommendation with a grain of salt. But of course, we already knew that.

Debt-financed Dividends Part III

2007-03-28T19:55:00.000-07:00

Well I guess the folks at the Wall Street Journal got wind of my recent blog postings, because on Tuesday there appeared a story on page C1 about exactly this issue. Incidentally, it pointed out that in addition to the companies I have mentioned, Domino’s Pizza (DPZ) also recently announced a “dividend recap.” I feel somewhat better about my confusion now, because even this article didn’t profess any really decent argument in favor of these transactions.

Let us review when levering a company makes sense and why. Debt is good because it allows firms to do more with the same amount of equity capital. However, the argument has also been made that debt can be better than equity since it provides a tax shield (through the deductibility of interest payments) that equity does not. But unlike equity financing, debt must be reliably serviced through regular interest payments, else the firm will find itself in bankruptcy. So to rely too heavily on debt generally puts the firm in a very precarious situation, which consequently hurts the firm’s credit rating and raises its cost of debt. Theory therefore suggests that, at some point, management should find an elusive “optimal” capital structure, since debt has both benefits and drawbacks.

Hopefully the paragraph above illustrates that the benefit of debt is in the capital that it raises. A dividend-recap raises no capital, it merely alters the debt-to-equity ratio (same assets, more debt -> less equity). The stock will be worth less because of the lower total equity, but the shareholder will also have the dividend in his pocket. So in a world of no taxes, this would have no effect on value (this follows from Modigliani and Miller 1958). As a value investor, value is my main criterion, not earnings, share price appreciation or any combination of the two.

But in a world of taxes, two things happen; a) the company gets a tax savings from the service of its debt over years to come and b) the individual must pay personal income taxes on the dividend now which could otherwise be deferred indefinitely. Unfortunately, so long as the corporate tax rate is the same as the personal tax rate, the cost of b) will always be larger than the cost of a) because of the time value of money.

So it seems the proponents of dividend recaps are relying on the higher returns to shareholders that the new capital structure will generate to sell the idea. By “returns to shareholders” I presume they mean return on equity, and to look at return on equity in isolation is meaningless, since it can easily be manipulated by simply boosting the level of debt. What an investor should be concerned about is return on invested capital, and as we have seen the amount of total capital does not change. However, as I mentioned in Part II, the cost of this capital may fall. In fact, it must fall if management is not making a value-destroying decision.

Thus, the primary indicator of whether the dividend-recap creates value is whether the time value of money consequence mentioned above outweighs a reduction to the firm’s annual cost of capital. I surmise that this difference is minimal anyway, suggesting that the whole thing is a really just a wash.

So why undertake it? Well Scotts Miracle-Gro (SMG) recently paid a fully debt-financed special dividend of $8. But guess who got cut the biggest check. CEO and Chairman Jim Hagedorn, who owns 21 million shares and 31% of the company, ended up receiving $168 million from this transaction. Or how about Health Management Associates (HMA) which paid a $10 special dividend on March 2, representing nearly half of the firm’s market cap. Chairman William Schoen owns 13.5 million shares and 6% of his company and got an easy $135 million paycheck. Don’t misunderstand, though. I have no objection to these people’s wealth and proportional sharing in corporate distributions. But given the financial meaninglessness of the transaction, I cannot help but be a little skeptical.

By conducting the dividend recap, these individuals were able to get a huge payday while not receiving any “compensation” from the company. Similarly, they were not forced to sacrifice any controlling interest they may have had as they would if they had simply sold shares. Finally, they were able to diversify their wealth some without triggering an insider sales filing, which may be seen as a negative signal by the market, lowering the value of their remaining shares. So there are plenty of positives for these insiders that are not applicable to the ordinary individual shareholder.

FD: I have no position in any company mentioned in this post.

Debt-financed Dividends Part II

2007-03-26T08:59:00.000-07:00

After combing through a collection of press releases, conference calls and other materials, I concluded that the most worrisome aspect of the so-called "dividend re-cap" phenomenon is the tremendous managerial spin and occasionally deception that it demonstrates. Invariably, management ends up bragging about their company’s ability to pay these abnormally large dividends. Perhaps, since cash is king, the complacent investor ought to be impressed that the company has the resources necessary to carry out such a transaction. And the whole thing can be spun as a recapitalization, which, although accurate, really just glamorizes an otherwise unnecessary transaction.

The truth is that probably most any big company could obtain the debt financing needed pay a large special dividend if it so chose. The question, then, is why would it make this decision.

On March 2, Dean Foods (DF) announced a special dividend of $15 per share payable on April 2 and funded entirely by a senior, partially secured, credit facility. The stock currently trades at $48. The corresponding conference call and press release were titled “Dean Foods Announces Plan to Return Approximately $2.0 Billion to Shareholders.” I might argue that no cash is actually being “returned” to shareholders, since the capital the shareholders contributed is still tied up in the company’s assets. Rather, the company is merely transferring money from its lenders to its equity holders.

Management repeatedly refers to the set of transactions as a recapitalization. There is certainly nothing wrong with a recapitalization if the company believes that it needs to restructure its balance sheet. In fact, oftentimes a restructuring would benefit the firm. For instance, if its cost of equity capital is tremendously higher than its cost of debt, then adding more debt to reduce the cost of equity might be worthwhile. Typically a firm will achieve such an objective by issuing debt (or any type of borrowing) and repurchasing stock, and if stock is more costly than debt then it will have reduced its cost of capital. Interestingly, at the same time it announced its special dividend, Dean Foods also announced it was discontinuing its share repurchase program.

Could it be that the firm is reluctant to repurchase its shares because it believes they are overvalued?

Although Chairman Gregg Engles makes passing reference to a desire to reduce the cost of capital in the conference call, he does not elaborate. Maybe this is because the transaction does not actually achieve a lower cost of capital. It may reduce the firm’s average cost of capital by increasing the debt-to-equity ratio, but the overall dollar cost will not improve. This is because that special dividend is itself a cost of equity and is being paid for with debt, which has its own cost. Of course, the same could be said for borrowing to repurchase shares. But if the impact of the new debt on the firm's current credit rating is significant enough, it could easily negate the benefit from any savings from reducing the level of equity capital.

But the rest of the management’s comments aren’t consistent with those of a firm desiring more leverage. When pressed about the impact the new leverage will have on earnings, Engles tells a Bear Stearns analyst that the company should be “back at our current leverage level… by the end of ’09.” A transaction that alters the balance sheet for only two years doesn’t sound like something designed to generate a “more appropriate capital structure.” If it is a temporary exploitation of cheap debt, then why do the company representatives neglect to discuss the actual terms of the borrowing, which would evidence the relative benefits of the transaction? And why do company representatives fail to discuss what impact the transaction will have on the company’s existing cost of debt?

In the Q&A portion of the conference call, the sell-side analysts were certainly not reluctant to congratulate the company on the transaction. But although the deal is extraordinary, it doesn’t seem to really produce any particular benefit to the company or any of its stakeholders, at least none that the call participants ever discuss.

And there is one group of stakeholders, though, that should be the most upset about these transactions, even on a strictly financial level: the bondholders. Ordinarily when a company takes on new debt it uses that cash to boost its productivity. Hopefully, the cash gets used to expand operations or invest in a new line of business. So even subordinate claimants like bondholders ought not get too upset since that new money should be working to ultimately increase income, and debt coverage accordingly. But with these transactions, the money that comes in immediately goes out producing no operational benefit to the company.

Additionally, the new debt is secured and senior, presumably subordinating other claims to the financing of the one-time dividend. This ought to have damaging consequences to the ratings on its corporate debentures, and should outrage bondholders. For instance, CFO Jack Callahan agrees that the expected level of debt paydown will match free cash flow over that time. This is probably why, the day after the announcement, Standard & Poors downgraded the company’s debt citing a “weaker financial profile” and sending its 7% bonds down 3.875 cents. Why then, doesn't the company simply use its next two years' free cash cash flow to fund a new, higher quarterly dividend and avoid higher debt burden?

I guess my conclusion from this part of my musing is that, any way you interpret it, the debt-financed special dividend is not a good signal for a potential investment in the company’s stock or bonds.

FD: I have no position in any company mentioned in this post.

Debt-financed Dividends Part I

2007-03-23T09:48:00.000-07:00

About two years ago I tuned in to CNBC to see Ameritrade CEO Joe Moglia boasting about the company’s recently announced acquisition with TD Waterhouse. He seemed especially proud of one-time special dividend of $6 per share to be paid to Ameritrade shareholders prior to the merger. What struck me as odd, however, was that he also explained that about two-thirds of this dividend would be financed not with cash currently on hand, but through new debt financing the company had obtained.

I thought about this, questioning my own understanding of capital structure, but couldn’t convince myself that such an event actually benefited Ameritrade shareholders. Isn’t the company essentially forcing shareholders to take on a loan they never asked for and, at the same time, forcing an income tax payment that could otherwise be deferred (and at a long-term capital gains tax rate) to be made this year? About a year after that, Joe Moglia visited our college and I had the opportunity to speak with him one-on-one.

I can say unhesitatingly that Mr. Moglia is an outstanding and motivational leader. The story of his life is rather famous in business now, and I was not dissuaded of the characterization and reputation that follows him. He really seems like a great guy. Nonetheless I couldn’t get past the seemingly irrational dividend payment the company had made. And so I asked him, “What was the rationale behind borrowing to pay a dividend?” His response, peppered with reminders of how beneficial the merger would be, was that the special dividend was a reward to the Ameritrade shareholders that had stuck with the company throughout the difficult times following the tech bubble.

I was unconvinced. Naturally the stock price immediately dropped by $6 upon the dividend payment, and the balance sheet was left much more levered. So although the shareholders were “rewarded” with a check for $6, their stock was also worth just as much less. Not my kind of reward. Surely there is a reasonable explanation for this. When I pressed further, Mr. Moglia explained that the company had an excellent credit rating and sufficient cash flow to pay off all the debt within a few years.

Still, though, the plan had several blatant drawbacks. Through interest expense it reduces the company's future net income and the repayment of the principal will dramatically reduce future free cash flow. This limits the amount of capital available to be reinvested and used to expand the business. Where would such capital thus need to come from? Well either from borrowing more, resulting in mitigated net reduction of the debt, or from issuing more equity, which would dilute the current shareholders’ proportional ownership.

Dividends have become more popular and investor demand for them has increased over the past few years as the simple result of their new tax status. Long-term capital gains were once taxed at a rate of 20%, which was usually always less than the marginal tax rate investors would pay on their dividends. So there was a clear disadvantage to dividends.

With both long-term capital gains tax rates and dividend tax rates now both at 15%, there is more parity and the new relative attractiveness of dividends has made them more common. But that doesn’t excuse their overuse. Dividends still face the disadvantage of forcing a tax payment sooner rather than later.

Of course all this is old news now, but I have been thinking about the issue lately because there have been three similar special dividends announced that have caught my eye. As with the case of Ameritrade, the justification for them seems to me to be dubious. The announcements come from Health Management Associates (HMA), Scotts Miracle-Gro (SMG) and Dean Foods (DF). I will look at each of those in Parts II and III.

FD: I have no position in any company mentioned in this post.

Thoughts On the Home Depot Situation

2007-03-09T12:34:00.000-08:00

It was one year ago that Business Week suggestively declared, in its cover story no less, that Home Depot was “thriving under CEO Bob Nardelli’s military-style rule.” Under Nardelli, the story explains, HD began recruiting military veterans and focused on “conquering customers” just as the military works to conquer the enemy. Nevermind that such a strategy seemed somewhat dangerous even at the time (the story documents a “culture of fear” as described by anonymous former executives), with the benefit of hindsight we now know that it was simply the wrong choice.

We should have known better. We knew that Nardelli, who took over the firm as the first non-founder CEO in December 2000, oversaw a HD share price that went precisely nowhere, from $42/share in 2000 to $42/share 2006. But we also knew from the 2006 proxy statement that Nardelli earned a total of $12 million in cash compensation from the company – that is, excluding option and restricted stock grants, which were sizable. But $7 million of this compensation was in the form of a bonus. A bonus for what, you may ask. Well, admittedly, earnings and revenues did grow nicely over this time but come on, what is the CEO’s job really?

The proxy gets yet more suspect the further you read. The company even admits that Nardelli’s “annual bonus shall be not less than $3,000,000.” So is it a bonus or is it salary? You tell me. Regardless, it later came to light that Nardelli’s total compensation in 2005 was worth somewhere around $38 million, and nearly $250 million over his five-year tenure through December 2005. To me, notwithstanding that I am merely an outsider with no management experience of my own, this just looks categorically egregious.

If the pay of the CEO wasn’t enough to make one question the direction of the company, then surely the CEO’s outright contempt towards shareholders should have been. At the shareholders meeting last May, which lasted all of 30 minutes and which the entire board of directors (save for Nardelli, the Chairman) boycotted, Nardelli refused to take shareholder questions. I am not even a Home Depot shareholder, and this made me livid. But it also caused me to avoid HD stock like the plague.

I am glad I did avoid it, because $250 million in severance for someone who effectively failed at his job is just a slap in the face.

The Business Week story concluded by citing a survey that suggested the anti-touchy-feely, threatening demeanor that Nardelli uses to manage may surface in the interaction store employees have with customers. Today I read articles like the one on MSN from earlier this week that seem to echo my own personal feelings about the company – that by mistreating employees the customer experience has suffered, and Home Depot is no longer a pleasant place to visit. With an alternative like Lowes, I feel, there is really no reason to shop at or to invest in Home Depot.

Hopefully, after Nardelli’s January ouster, things may be able to change. But how quickly a new CEO can change the culture of a 350,000-person firm remains to be seen. I hope, for the sake of the corporate financial system, that the Bob Nardelli type of behavior continues to outrage investors.

FD: I have no position in any firm mentioned in this post.

Can Buffett-wisdom calm the market?

2007-03-01T09:02:00.000-08:00

The Berkshire annual report will be released this afternoon at 3:00 central. This is unusual as in the past it has been released over the weekend. Since we are in the midst of a very turbulent market it seems the report's release couldn't have come at a better time. By the way, I don't intend for this blog to serve as a news source, but thought some folks might like some good news like this on a day like today.

Graco, Inc.

2007-02-19T09:56:00.000-08:00

I love big companies that no one has heard of. Graco (GGG) strikes me as this type of company. It is similar to two other of my favorites, Leggett and Platt in its pervasiveness yet general anonymity, and also to Walgreen in its steady, long history of earnings growth. But the kicker in this case is that the stock may be cheap.

The company makes equipment used in fluid handling. This means such things as paint sprayers, newsprint ink transfer systems and the tool that injects Hershey’s kisses with caramel. Management boasts that Graco equipment is used on products all around us. For instance, CEO David Roberts points out that anyone who has had their home professionally painted likely had Graco products used. Anything that needs to be "glued, sealed, painted, or finished" will probably involve the use of a Graco product.

When I request an investor packet from a company’s investor relations department, I always consider it a good sign when included with the materials is a ten or fifteen-year summary of the company’s financials. It is usually only the companies with long, impressive histories of growth that will voluntarily provide such information. This is just what happened recently when I sent off for Graco’s materials.

Generally manufacturing firms like this are relatively less appealing as they ordinarily require high levels of capital investment. The machinery and equipment used to make its products are usually expensive. Fortunately, Graco is strong enough to easily finance its capital expenditures internally, and even end up with cash left over for expansion and distribution to shareholders. This translates in to a balance sheet with no debt yet a return on equity that has averaged well over 40% over the last ten years. With no debt, its return on invested capital is not much less, and since a mere 15%-30% of this return is spent in the form of capital expenditures, this company is clearly creating value a rapid rate. But then again it has been for many years.

What attracts me to the company today is that it looks beaten down. The 1-year chart below shows just when this happened, in mid-July of last year. This coincides with the company's acquisition of Lubriquip, Inc. from IDEX Corp (IEX). Unfortunately the terms of the Lubriquip acqusition were not released so it is difficult to assess if the company overpaid. The stock price reaction seems to indicate that at least a sizable fraction of investors think so.

What we do know about Lubriquip is the following. Its 2005 sales were approximately $30 million. It is less profitable than the rest of Graco, as the company, in its 2006 8-K, directly attributes a 0.3% drop in operating margin to the Lubriquip acquisition. There were no other major acquisitions in 2006 yet the goodwill account increased by about $15 million, and most importantly "acquisitions of businesses, net of cash acquired" amounted to $30.6 million. Also coincidental is Graco's $25 million credit agreement with US Bank, announced the day before the acquisition. Given all this information, I surmise that Graco probably paid about $30-$35 million for Lubriquip.

So, was this too much? Well IDEX tends to trade at less than 0.5 times revenue, while Graco (with its superior profitability) trades at near 4 times revenue. Regardless, the acquisition is not all that significant to a $3 billion company. Nonetheless Graco lost over $605 million in market value around the time of the acqusition. So unless the market sees the acquistion as indicative of poor managerial decision making that might ultimately cause the firm to flounder, I can only assume that this was a terrific overreaction. The stock fell from $46 to $37 in July but has only regained about half of the loss since.

It will be very interesting to read the 2006 Annual Report and see what the company has to say. There is plenty more analysis to be done on this company, but so far things are looking good from my perspective.

I welcome any comments or insight.

FD: I own shares of LEG, WAG and GGG, but have no position in IEX.

What market efficiency is, and what it isn't.

2007-02-08T08:42:00.000-08:00

As an academic-in-training as well as an advocate of a value-investing philosophy, I am in quite a peculiar and awkward position. This probably comes as no surprise to those familiar with the teachings of scholarly work in the field, the disdain Warren Buffett has shown towards those teachings, or both. But as I have learned more about ideas such as market efficiency, you will be happy to know, my allegiance to the Graham/Buffett credo has not been diminished.

The most controversial academic theory is something called Efficient Market Theory (EMT). Academics love it, real-world practitioners hate it. Why? Well, it makes life much easier researchers who can rely on the assumption that market prices are the best guess we have of true value because it means we can apply all sorts of other tests to stock prices that we otherwise couldn’t. But EMT also suggests that the real-world practitioners add no value – that a monkey throwing darts can do as good a job as they can at picking stocks. Hence the conflict. (Do you think Mr. Buffett appreciates being compared to a monkey?)

So first, I would like to clear up the most common misperception of all. Market efficiency is NOT the notion that every stock price is correct, as I often hear both students and the business press suggest. That is far too simplistic. Market efficiency is the idea that, on average, stock prices are correct and that, for any particular stock, we don’t know if it is overpriced or underpriced. The difference between these two ideas is enormous. The theory also holds that we cannot systematically choose stocks that will perform differently than the market. To me this is the crucial caveat, as it leaves open the possibility that we can unsystematically identify firms with characteristics that we feel will lead to successful investment. Alas, science has met art.

Whenever we try to value (or price) a stock, such a valuation comes with some degree of imprecision. Statisticians will call this imprecision error or residual. By definition, the sum of these errors will be zero, so we will never know whether the error with regard to a particular stock is positive or negative. Take for instance the all-but-debunked Capital Asset Pricing Model. This model suggests that a stock’s price is a function of a multiple, based on the stock’s past volatility, of the market’s “risk premium.” Everything else not explained by this multiple ends up in the error term. Since CAPM has been shown to provide little real ability to price stocks, new factors such as size and book-to-market have been added to the equation that reduce that error term.

In many cases this has made such pricing models more effective, but the obvious limitation of such models that they rely on measurable and easily accessible information. I remain of the opinion that there are times when stock prices clearly are overpriced or underpriced due to factors, like irrational exuberance, that cannot be quantified. Obvious example: the tech bubble, when the S&P 500 Composite Index temporarily sustained a P/E of over 44. Unprofitable companies like JDS Uniphase sold for $250 a share. The academic literature has struggled to make sense of this phenomenon since it happened, and thus the emergence of behavioral finance as a respected area of study coincided with this struggle. But I believe we can, in some situations, say with greater than 50% confidence that a stock price will rise at a rate greater than that of the market. Not because the book-to-market ratio or some measure of momentum dictates so, but becuase we see a firm with qualitatively positive attributes trading for less than it "should," whatever "should" means. (Passing this theory off on the financial scientists of the world is likely a futile effort that I will not make.)

Now, having said all this, let me warn everyone that to write off “market efficiency” in such a general sense is a huge mistake. Unfortunately I think many individuals unfamiliar with what exactly the term means, make blanket statements like “The market is not efficient.” As a favorite professor of mine has explained, the market should be assumed efficient until proven inefficient. Sometimes it will be inefficient, but more often than not it does a pretty good job of pricing stocks. And that is why we must be both careful and vigilant. One of my personal triumphs of late is my purchase of Coach (COH) shares early last summer at $26. The stock of this fast-growing company had fallen sharply for no real reason other than a general pessimism towards retail apparel. At $48 today, I have a nice 80% gain. (I’m not bragging, I swear!) But because the market is often very efficient, these opportunities will continue to be rare, so when we see them we must act. As Warren Buffett has advised, “Make large bets on high-probability events.”

FD: I own shares of COH, but have no position in any other stock mentioned in this post.

Airlines taking flight? Not exactly.

2007-01-17T17:14:00.000-08:00

Yahoo! Finance posted a surprisingly bullish USA Today story this morning on the heels of American Airline's (AMR) announcement that it had turned a profit for the first time in quite some time. It even cited an industry analyst who expects industry profits to total $5 billion this year! Now before we dump our BRK shares to buy AMR stock, lets calm down, take a deep breath and think about this situation.

Face it. Airlines are losers and will never make a decent investment of any kind. Even the stock of the strongest airline, Southwest (LUV), is now a mediocre investment at best. Although it has been a great investment over its lifetime, it has substantially underperformed the market over the last five years and, with the other airlines now trying to mimic LUV's low-cost model, it seems certain that its competitive advantage will begin to deteriorate. More on that later.

A quick overview of any airline's balance sheet immediately reveals the biggest problems they face. First of all, each airline employs an enormous amount of capital relative to its income. This makes for lousy returns and destroys value. Take American for example. This company has about $23 billion dollars invested in it, after allowing for the negative retained earnings account that has resulted from years of losses. Now, American is barely profitable, but for now let's make the very generous assumption that it is able to scrape together EBIT equal to the net income of most profitable airline, Southwest's $500 million. This would make its ROIC a paltry 2.2%. Meanwhile, the company is certainly paying no less than 7% on its $14 billion in long-term borrowing, making their annual cost of debt at least a billion dollars, far more than the assumed $500 million in income. This means that even ignoring the cost of equity, and even assuming the company is far more profitable than it really is, it would still be destroying value at a rate of more than $500 million per year.

But forget about all that cost of capital talk, before this most recent period the company wasn't even turning a profit. The reason for this is much simpler. The costs exceed the revenue. I will even go so far as to say that this is unavoidable for airlines. You see, as much as the companies would like to differentiate themselves, the typical airline passenger makes his purchase decision based exclusively on price. This makes an airline ticket merely a commodity and eliminates nearly all the pricing flexibility the airline has. Thus, the revenue of the company is out of the company's control. Meanwhile, the company's costs are just as uncontrollable and generally fixed, as they consist overwhelmingly of either a) depreciation of those expensive airplanes which must be maintained and eventually replaced or b) fuel costs. What we are left with is a company that can't control its revenues or its costs. No wonder these businesses never make any money.

Now, to make matters even worse, consider the fact that these airlines habitually file bankruptcy. The airline industry is one of the few in which firms are generally able to enter and emerge from Chapter 11 time after time. There was a great WSJ article a while back (called “Red Eyes: For Airlines a Shakeout Runs Into Heavy Turbulence,” Sep 19 2005, A1) that suggested the following: Airlines will continue to lose money and operate inefficiently as long as the bankruptcy process allows them to survive despite their inefficient operations. That is, the Darwinian nature of a capitalist system ought to weed out the weakest firms and allow only the fittest (the most efficient) to survive. But the U.S. bankruptcy system prevents this from happening by allowing firms to habitually rely on it for survival. An interesting assertion, but the article gave no supporting evidence so I can’t really assess its validity.

Regardless, an investor who purchases an airline stock must be prepared to deal with a high risk of bankruptcy, in which case he could lose 100%. Add this risk to a commodity business with huge fixed costs and a gigantic capital base and I just don’t see where the value will come from.

There is a reason there is no airline ETF...

FD: I have no position in any company mentioned in this post.

GMCR Followup

2007-01-14T16:07:00.000-08:00

Howard Linzon from Wallstrip commented on my Green Mountain Coffee Roasters post last month that a Wallstrip episode on the company may be forthcoming. The Wallstrip folks have put together a great video summary of the company that I encourage everyone to check out.

Sears Holdings - Part 2

2006-12-27T10:11:00.000-08:00

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

The Best Investment I've Ever Made and Lessons Learned

2006-12-20T12:33:00.000-08:00

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.

USG, asbestos and Berkshire

2006-12-01T09:57:00.000-08:00

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.

The real reason for lemon laws.

2006-11-27T14:09:00.000-08:00

On a day when the market is tanking, here is an economic observation to get our minds off the shrinking value of our stocks. While shopping for a new car, I noticed a Toyota Avalon with only 1000 miles that was selling for about $5000 less than a comparable new one would cost. That got me thinking. Why do cars depreciate so quickly, anyhow? Well here is my explanation, as it pertains to so-called "lemon laws."

When economist George Akerlof introduced the “Market for Lemons” in 1970 he revolutionized economists’ understanding of uncertainty. A lemon is a product of poor quality that is sold among other good quality products. But to the buyer, whether or not a product is a lemon is not apparent. Akerlof showed that these types of products can come to dominate the market and can even cause the entire market to collapse.

This is because uncertainty can result in “adverse selection” and that the bad drive out the good. This is extremely important to economic theory as it implies that informational problems can cause, at the least, only bad products to be sold and, at the most, the collapse of the entire market.

Because buyers of, for instance, used cars are uncertain about the car’s true quality, they are only willing to pay less than the expected true value of the car. The owner/seller of the car has information the buyer does not, namely, whether or not the car is a lemon. But since the buyer cannot tell the difference between a good car and a bad car, the buyer must offer the same price to sellers of both types. Realizing that the buyer will offer less than the true value of a good car to account for the uncertainty of the transaction, owners of good cars will not be willing to offer them for sale. Only owners of bad cars (lemons) will. Hence, the bad have driven out the good.

Another good example of the market for lemons occurs in the market for health insurance. Substantial informational asymmetry exists between an individual and his health insurer, as the individual clearly has an advantage when it comes to assessing his own health. Generally, riskier policyholders must pay higher prices. But as the price of an insurance policy rises, only higher risk individuals will choose to insure themselves. Thus, an element of adverse selection will have manifested itself. Insurers, because of their informational disadvantage, will raise premium rates to account for the increased risk of insuring very sick people. And as this price rises, only more and more risky people will choose to purchase the policy. Again, the bad have driven out the good.

This phenomenon has obvious and important governmental policy implications. For one, government programs such as Medicare may be necessary to prevent the bad from driving out the good in markets such as health insurance for the elderly, particularly given the life-or-death nature of health care.

For another, perhaps we need "lemon laws" to overcome these problems. So although lemon laws purportedly exist to protect consumers, such laws really just guarantee the stability of the market. Since government cannot overcome the information asymmetries in some markets, it instead guarantees that the buyer will be compensated should his purchase prove to be a lemon. As a result, the buyer is willing to pay much closer to the true value of a good product, and the market can be sustained. The seller is still permitted to sell lemons, but has little incentive to prefer lemons, as he may be forced to buy back the product if it proves to be a lemon.

Sears Holdings - Part 1

2006-11-16T13:29:00.000-08:00

I was excited to see that shares of Sears Holdings (SHLD) were down yesterday on lower same-store sales in the third quarter. This is a beautiful reaction to one of my favorite companies, as any pullback tempts me to plow more money in to it. The company is still seen as a retailer and, as such, retail analysts insist on evaluating it based on their favorite metric, same-store sales. But SHLD is much more than that now and, moreover, sales don’t put money in your pocket. Earnings do. And the company’s operating earnings were actually up, by more than 58%, after adding back in a large restructuring charge reflected in last year’s Q3 earnings.

To put is simply, although the stores’ sales may not be rising, their profitability is. This is due to two things: higher gross margins (from 27.4% in Q3 2005 to 28.3% in Q3 2006) and reduced expenses as a percentage of sales (from 24.4% to 23.7%). In English, this means that Chairman Eddie Lampert, et al have stopped selling unprofitable products, focusing on high margin products, and have also cut out a lot of costs.

But don’t fool yourself in to thinking that the retail operations of this company are of complete concern. SHLD has started engaging in many other investment activities unrelated to Sears and Kmart. In fact, these “investment activities” contributed a third of its Q3 earnings. The company attributes this to the investment of its “surplus cash,” of which it held about $2 billion of at the close of the quarter. Sound familiar? To some this sounds a lot like a certain New England textile operation that floundered in the late 1960s.

Eddie Lampert’s ESL Investment Management currently owns 41% of SHLD. But to many people, including me, it is clear that Lampert intends to turn SHLD in to something similar to Berkshire Hathaway. That is, Kmart and Sears may hang around for a while and produce decent cash flow, but the growth of the company will come from its other investments.

I owe a great deal to my friend Chad at the Peridot Capitalist for turning me on to this stock about a year ago. He has a ton of great insights in to the company as well.

FD: I own shares of Sears Holdings.

CNBC Buffett Special

2006-11-16T10:57:00.000-08:00

On Monday evening, November 20, at 7:00 central time, CNBC will be airing "Warren Buffett: The Billionaire Next Door." As part of the special, there should be a segment about the Warren Buffett Class at MU. A few weeks ago a crew from the network visited our college and interviewed several people, including me. I would have been excited about any hour-long Warren Buffett special, but to be included it in myself is a real thrill. I suppose there is no guarantee they will use the footage of my interview, but it should be a worthwhile watch regardless.

**UPDATE**
The show will be re-run throughout the weekend:
Thursday, November 23 7:00 am and 5:00 pm EST
Friday, November 24 3:00 pm and 11:00 pm EST
Sunday, November 26 10:00 pm EST

Some background on bankruptcy

2006-10-25T15:11:00.000-07:00

Recently I have been interested in companies emerging from Chapter 11 bankruptcy. My interest was piqued not only because of a little scholarly research I have been doing in the area, but also because of the tremendous opportunities for value investors that sometimes exist. Two excellent cases-in-point are Fruit of the Loom and K-mart, the former being bought by Berkshire Hathaway out of bankruptcy and the latter by Eddie Lampert.

These investments have been successful because they were purchased for very little and, because of the nature of the Chapter 11 system, with recently cleansed balance sheets. Having said that, investing in such companies takes much more knowledge and awareness than does a typical investment. This is why they are so risky.

Now, I give credit where credit is due, and credit for bringing the following stock pick to my attention is solely due to my friend Ryan Avola. His pick was US Gypsum, or USG. This company has recently emerged from Chapter 11 with Berkshire Hathaway holding 18% of the equity. Before I get in to this company in particular, I will provide a little background on the system, as I see it.

Bankruptcy is always an undesirable circumstance for both creditors and debtors. But the legal system designed to deal with debtor default and insolvency that exists in the United States seeks to minimize the economic harm caused. The corporate bankruptcy system is predicated the notion that, if creditors work together, they stand to benefit more than if they each attempted to collect from a debtor individually. That is, the system assumes that orderly collection among creditors is better and more efficient in the long run than the alternative, which is often collecting nothing at all.

When a company files Chapter 7 bankruptcy, it is safe to say all hope is lost. Chapter 7 liquidation is usually an acknowledgement that any future earning ability of the company is dubious. But when a firm enters Chapter 11 bankruptcy – a reorganization analogous to Chapter 13 for individuals – it usually has a decent business, else it couldn’t convince a bankruptcy judge or its creditors to approve the reorganization.

Title 11 of the United States Code is explicit in its explanation of the way bankruptcy shall be administered. In Chapter 5 it details “priorities.” Each class of claimant is to be paid in full, in the order of priority that the code specifies, before any claimant in a subordinate class is paid. Claimants in a class which cannot be paid in full are then paid on a pro-rata basis. Equity holders, it should be noted, are last on the priority list since they are the residual claiminants - this is just the way corporations work. This seems simple enough, but the code also empowers the bankruptcy judge with extremely broad power, more than any other federal judge the court system, to make exceptions as he sees prudent. This creates what is commonly referred to in the academic literature as “absolute priority rule,” or “APR,” violation.

Lawrence Weiss, in a 1990 Journal of Financial Economics paper documents the widespread nature of APR violation. In a sample of 37 firms to file between 1979 and 1986, Weiss finds that the rule was violated in 29 cases. This is in direct contradiction of statute and underscores the huge power the bankruptcy judge can exercise. This means that equityholders, who are in principle the residual claimants of the business, may in fact be repaid before some debtholders. This can cause all sorts of problems. For one thing, these debtholders will demand higher rates of interest, which changes the firm’s cost of capital. Thus, there is a hidden, “indirect,” cost to bankruptcy.

As unfair as this may seem, as a practical matter, absolute priority rule violation may be a necessity. This is because projections about the firm’s Chapter 11 in-bankruptcy performance must be made to ascertain how far down on the priority list repayment will trickle. Equityholders have an incentive to make overly optimistic projections, since that will increase the likelihood that repayment trickles down to them. But all claimants must approve the plan for reorganization. Hence, there is a large potential for conflict in bankruptcy proceedings. The only way to resolve this conflict is to empower the judge with final authority.

All this APR violation quite frequently creates opportunities for individual investors. Sometimes, things go as they should. Worldcom, for example, is a firm whose equityholders got squat. In many of these instances the debtholders are repaid with shares of stock in the newly emerged firm, and the old shares are cancelled. When they are, buying corporate debt is a logical way to get ahold of the new stock. When they are not, investors need to consider the causes for the bankruptcy and the firm's prospects with the reorganization behind it. In some cases, as appears to be the case with USG, the stock may not get cancelled and could indeed look like a great investment.

Wal-Mart's assault on CVS and Walgreen

2006-10-19T09:56:00.000-07:00

Since I haven't blogged in a while, here is a quick note on Wal-Mart's highly (ridiculously over-?) publicized new generic drug promotion which today it announced would be rolled out nationwide earlier than expected.

It certainly isn't good news for Walgreen, but I am not so sure it is all that bad either. A Bear Stearns analyst estimated that this new promotion could cost Walgreen as much as 7 cents per share per year in lost income. I cannot begin to speculate on the accuracy of this estimate, but nonetheless this represents only about 4% of Walgreen's trailing twelve months' earnings of $1.74. But Walgreen's stock has fallen over 15% since Wal-Mart made its announcement. So this could be a legitimate buying opportunity.

I also recommend checking out the press release Walgreen posted today on its website. Biases can be hard to disentangle in any press release, but the company does seem to be of the opinion that this is much more of a publicity move for Wal-Mart than it is a tactic of competition. (Wal-Mart has been criticized historically for its lack of attention to health care.)

Here it is:
http://news.walgreens.com/article_display.cfm?article_id=1732

A look at ebay - Part 2

2006-09-10T13:59:00.000-07:00

Ebay simply has one of the best business models imaginable. They have no inventory, yet they sell billions of dollars worth of merchandise every year. You can think of the company as a broker for just about every type of consumer good there is. A broker that takes a hefty 15% commission on each transaction. And because of the networking effect I discussed in Part 1, they are the broker that people around the world go to when they want to buy and sell stuff. There is no real limit, as I see it, to how much stuff they are capable of selling, so I do not think it is completely unreasonable to assume the company can continue to grow at some pretty remarkable rates.

What do I mean by remarkable rates of growth? Well, in 2005, 2004 and 2003, net income grew by 39%, 77% and 76% respectively. Revenue growth was comparable, at 39%, 51% and 78%. These numbers are phenomenal. All the while, profit margins have remained strong. Since 2000, the company seems to have focused on this. It made an important, and very wise, acquisition when it bought Paypal in 2002. In contrast to other acquisitions the company has made (to be discussed momentarily), Paypal not only yielded natural synergies with the flagship website, but was also a great, profitable company in its own right. Net margins got a nice boost from this acquisition, jumping from around 10% in 2001 to the current level of around 23%.

Despite the amazing growth in sales and income, ROE and ROIC have not budged, staying around 12% since 2000. Ebay has never paid a dividend, and rarely has assumed debt, so much of this invariability is due to the company’s retained earnings balance which has mushroomed along with earnings. But another big part of this phenomenon is the company’s continued issuance of new equity, whether it be the result of option exercise or SEOs. Indeed, the company’s paid in capital account has risen faster than retained earnings in every one of the last five years. So although the company is indeed growing by just about every measure, it has never become more productive. But 12% is not awful either, so as long as earnings keep going up, I suppose this is a pretty good indicator.

In general I would say that Ebay’s fundamentals seem consistent with the franchise value and competitive analysis I wrote about in Part 1. But one huge exception to the strength of Ebay’s franchise results from the acquisition the company made in 2005 of Skype Technologies, S.A. Skype is a voice-over-internet protocol provider, similar to its chief competitor, Vonage. After first hearing about this acquisition, I had a suspicion that it was a bad move.

As I have shown, Ebay has enormous brand value. But Skype operates in an industry where brand value does not go nearly as far. While the company is indeed a leader, I see no compelling reason to believe it must continue to be. The industry has very low barriers to entry, its technology is fast-changing and could potentially be supplanted by a superior technology in the future. More importantly, though, it provides a commodity-like service. Purchasers of VoIP, especially as the industry matures and new entrants enter the market, base their purchase decision in large part on price. This is a recipe for low returns, and something the individual investor should simply avoid were it a stand-alone company.

I find it telling that throughout Ebay’s 2005 annual report, management makes reference to all of the great operational ways Skype will help Ebay’s traditional operations, although management avoids ever using the word “synergies,” but fails to ever brag about what Skype will contribute to the company’s bottom line, profit margins or ROE. So let us take a closer look at what happened last fall.

Skype was purchased in October 2005 for about $2.6 billion (that is not a typo – that is billion with a “b.”) of which an amazing $2.3 billion was booked as goodwill. The remaining $300 million accounted for Skype’s tangible assets. Does a price-to-book ratio of 8.6 sound high to you? It did to me, so I did a little more investigation to put this number in to context.

For starters, the $2.6 billion is an understatement of the true cost, as Ebay also assumed obligations to pay nearly $1.3 billion in incentives to Skype executives should they meet certain targets. That is a lot of money, since at the time of the acquisition, Skype had never turned a profit. It is estimated, though, that Skype brought in $60 million in revenue 2005. (After the acquisition, of course, Skype’s revenues were consolidated with Ebay’s so it is difficult to tell exactly how much the company sold. But it wasn’t much.) That $60 million in earnings puts the purchase price at a beefy price-to-sales multiple of 65.

More importantly, though $2.6 or $3.9 billion is simply a lot of money for Ebay, which had balance sheet totals at the end of FY2004 of only $8 billion. So in essence, Ebay, the company with the dreamy business model and an iron-clad-alligator-infested moat, is wagering nearly half of its net worth on the future of Skype, which I believe to be very uncertain. This is downright foolishness in my opinion.

As always, any and all comments are welcome.

MIZZOU alumni magazine reaction

2006-09-09T13:13:00.000-07:00

In the recently published Fall 2006 issue of MIZZOU, the University of Missouri's alumni magazine, there appeared an article about my class, and to some extent, about me. The article was written by Catherine Pernot, and is similar to the article that she wrote for the Columbia Missourian earlier this year.

I anticipated some type of reaction, but beyond phone calls and emails from old friends, the reaction to the article was muted. The editor of the magazine did pass along a letter written to her by an alumnus of the journalism school. I repsonded to the letter only for my own benefit and for this blog, so as far as I can tell, the Reader will never see it. Below, find my summary of the Reader's letter, and then my reaction to it.

Reader writes (paraphrased by me):

Students of MU are ill-served by FIN 8001, the Warren Buffett Class. The material in the course contradicts our best understanding of the markets and even what Mr. Buffett suggests. Mr. Buffett suggests investing in index funds, therefore supporting the efficiency of the markets. I am dismayed that students enjoy "abandoning the academic ideas of efficient markets" and that the author of the article says "Markets are not efficient, financial diversity is for dummies..." Mr. Buffett's recommendation of index funds for individual investors shows that he thinks diversification is better than concentrating on a small number of stocks. Finally, I hope MU's medical school is not as dumb as the business school is to "abandon the academic ideas."

And My Response:

I can appreciate Reader’s reaction, as the article did indeed have a fairly antagonistic tone. And as he is an employee of an “academically-based” investment firm, I can understand his reluctance to embrace the benefits of our course. However, I think his understanding of the course is too superficial to knowledgably rebut it. I would submit the following to him in response.

Our course indeed acknowledges the merits of Efficient Market Theory (EMT), but also its shortcomings. I think Reader misinterprets the word “abandon” in the student quote to which he refers, “It was great to have a class on investing that more or less abandoned the academic ideas of efficient markets....” The course does not disregard EMT, but rather ignores it in favor of alternative explanations for business valuations. Such an approach is crucial to teaching the fundamentals of finding enterprise value – a skill that is highly transferable to a variety of areas in finance and financial services. That is, if EMT held, and firms trade at their intrinsic value, who would concern himself with determining what that intrinsic value is? Instead of dismay, I would hope Reader feels comfort that MU students are working to gain a skill set that many students at other universities graduate without.

I feel the following quote from Mr. Buffett’s 1988 letter to shareholders is very consistent with the perspective of FIN 8001.

"Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day."

Warren Buffett does indeed encourage individual investors to invest through index mutual funds, but not because of the efficiency of the market as this Reader asserts. Rather, he sees diversification as an effective way for an individual, relatively ignorant about business and its valuation, to take part in the economic productivity of business. Diversification is protection against ignorance, he maintains, but those who are not ignorant have no need to diversify. When an individual does diversify, index funds are the best way to do this because they minimize costs that commonly eat away at actively-managed fund returns.

Perhaps the following quote from Mr. Buffett's 1993 Annual Report will help Reader understand Buffett's position as well as the author’s commentary that “financial diversity is for dummies.”

“Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.

“On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”

I would also submit that mutual funds’ general failure to outperform the market is not a result of fear and greed, but rather the often excessive fee structures that they employ. Reader, being a beneficiary of such a fee structure, though, would likely rather ignore this factor.

The academic process is founded in curiosity and is only advanced through a constant questioning of accepted doctrine. If ever there were a place in business education to introduce an alternative explanation, I believe efficient market theory is it given the long history of anomalies and critiques that have been documented and published since Eugene Fama’s original paper in 1970. The recent literature clearly supports this attitude, in my opinion.

I am disappointed that Reader focuses on the course’s “dismissal” of semi-strong form EMT but only makes passing reference to the ideas derived from a different academic theory, behavioral finance, which is discussed in the course and mentioned in the article. It is for this reason that I find his analogy to the medical school “abandoning the academic ideas” not only scurrilous, but unfounded.

Finally, as an academic myself, I wholeheartedly appreciate Reader's objection. However, I think both his perspective on academic finance and on this course is too narrow.

A look at ebay - Part 1

2006-08-22T16:54:00.000-07:00

I have always wanted to buy ebay, but it had always looked too expensive. That has changed recently. Although I haven’t yet, I may finally take the plunge, particularly if the price gets any lower.

The impetus behind this posting is the WSJ article that ran yesterday – on page C1 “Ebay Merchants Seek Management Change.” The article echoes, and more importantly, confirms, what I see as the general sentiment that currently exists regarding this company. Revenue and profit growth has slowed. I can’t say that comes as a big surprise. I mean, the company has been growing at rates in excess of 50%. Obviously that is not sustainable.

The article contends that ebay merchants are upset with declining sales and that, thus, management change is needed. To support this contention, it cites only anecdotal evidence. In particular it references a videogame merchant upset with the duration of his ebay listings. (The videogame industry is in a transitional period right now, so it seems to me this individual’s concern is completely bogus.)

But even if merchants are generally disillusioned with the site, should investors worry? Lets consider the way the business works. The backbone of the ebay shopping system is the feedback rating. Before buying anything on ebay, a buyer can check the feedback the seller has received from previous buyers. The better this feedback is, the more confident the buyer can be in the seller’s product.

I have been an ebay member and seller since 1999. In that time, I have amassed a feedback rating of nearly 300, something of which I am somewhat proud. (For anyone who is interested, you can see my feedback here.) And herein lies the value driver of ebay’s business model. It is something that is quite obvious to me as a member, but which I rarely hear discussed in analyses of the company.

By building this nearly unblemished feedback record, I am very reluctant to consider business with one of ebay’s competitors. After all, the feedback profile is a representation of my ebay reputation, and having no reputation outside ebay makes it more difficult to sell outside ebay. This is the networking effect at its strongest – an example that should be studied in every MBA marketing class.

Being active in the ebay forums, I am also aware that other sellers feel the same way. Many have tried unsuccessfully to sell used items on amazon.com, but have difficulty establishing credibility. Also from regularly checking these forums I know that sellers love to whine and complain, so the WSJ article yesterday really comes as no surprise to me. Nonetheless, I am confident that, absent a really disgusting abuse of sellers by ebay management, ebay sellers will stay right where they are. They have options, after all, but no competitor has been able to even launch an arrow at ebay’s moat.

The long term economic prospects of this company are simply outstanding. If the fundamentals and the price are equally appealing, this company is a great investment. This has been Part I. Next I will take a look at these other facets of the business.

Simple, understandable buinesses and the circle of competence

2006-08-15T08:29:00.000-07:00

Mr. Buffett advises investing in simple and understandable businesses. But in my experience, the concept of a business being “simple and understandable” is, ironically, one of the most misunderstood. Perhaps it is the simplicity of this advice that causes the confusion, because far too many people fail to take the time to consider what exactly this means.

I have heard students make assertions like “Sprint provides phone services that we all use and therefore is simple and understandable.” The problem is that these individuals are confusing familiarity with simplicity. Just because you know what the product or service is and how the customer uses it does not mean you can confidently project how the business will fare in the future. That is, you cannot make an accurate assessment of the company’s economic outlook. Projecting this is the essence of business simplicity and understandableness, in my opinion.

Mr. Buffett describes a simple and understandable business in his 1996 letter to shareholders as one that is “unlikely to experience major change” and that you can be “virtually certain to possess enormous competitive strength then or twenty years from now.”

A company like Sprint just doesn’t meet those criteria. Although I use a Sprint phone myself, I have no idea what the company’s economic prospects look like. I know that they have a large network, but have no idea why it is so large or if it will remain large given the various competitive pressures. And beyond the letters GSM and CDMA, I have no idea the strength of the company’s technological advantage. Without an understanding of these, I can have no confidence in my assessment the economic prospects of the company.

Mr. Buffett has also explained that a simple and understandable business is one within your “circle of competence.” It isn’t how big that circle is, though, it is how well you have defined its perimeter.

In the late 1990s, of course, Berkshire was criticized and even mocked for failing to invest in technology firms. From the 1999 letter to shareholders: “If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.”

I have also heard students suggest that a company like Movie Gallery is simple and understandable. At least for me, even a company like this (keep in mind it is also very familiar) is not at all simple and understandable. First I might try to determine how likely is it that this company can maintain its current operations without major change. But then, I will have to decide how confident I am that I even know how likely this is. With a company like this, there are simply too many potential threats (video-on-demand, internet rental companies, internet video etc) for me to say that I understand the business’ economics.

To sum up, a simple and understandable business is one that is within your circle of competence. It will be in your circle of competence if you fully understand the underlying economics of it. Before you let someone convince you that a well-known company is simple and understandable, I think you should review Mr. Buffett’s guidance. To invest in something you do not understand can have disastrous consequences.

Quit whining about gas prices and buy oil!

2006-07-28T07:00:00.000-07:00

The following is not a Buffettesque stock pick. It is also not a political statement, as politics is something I choose to stay as far removed from as possible to the extent they don’t affect my pocketbook. Rather, this is what I feel to be a shrewd financial strategy, at least for anyone so obsessed with oil prices that paying $3.00 for a gallon of gas can cause nausea. I fall in to that category, but only because I am cheap. At a later date perhaps I will analyze the behavioral biases to which I am succumbing by behaving in this way…

ExxonMobil reported earnings yesterday of $10.36 billion in the second quarter. Surely this will get the ignorant public and federal lawmakers (whose job it is to appease this ignorant public) upset. And to some extent it upsets me too, but it isn’t that magnitude of the company’s earnings that is outrageous, it is the company’s earnings relative to the capital with which they are working. At the beginning of the quarter, the company had about $216 billion in total assets – of which only $6 billion was paid for with long-term borrowing – and $112 billion in equity. This means that a fairly unlevered company was earning an annualized return on equity of nearly 37% and an annualized ROA of 19%. The PE is now about 10. Numbers like this generally spell good investment.

There is more to it than this though. For instance, the company will be spending substantially more on exploration and capital expenditures this year. They had better, since they got yelled at by Congress after they made $10 billion in Q4 of 2005. (Note, though, that nothing came of these hearings, indicating that it was done merely for political show.) If you are going to make so much money, the argument went, you should at least spend it looking for oil at home. Well they have, and if they do indeed increase the supply of oil this should help gas prices, making me happy.

What I am trying to suggest is that a purchase of XOM may not be such a bad idea. Not as an investment, but as a hedge. This hedge will make the important assumption that oil company profits and gas prices are strongly correlated, but this assumption is supported by past data.

My gas-guzzling SUV often provides me no more than 15 miles of in-town driving per gallon of gas. Living in a small community with a short drive to work, this translates in to about $40 at the gas pump every two weeks. $40 X 26 = $1040 per year. Now assume that XOM will go up 20% in the next year and the market will go up 5%. If I buy 100 shares of XOM for $6600 and earn 20% I will have $990 more in one year than I would have had I invested in the market. So even if gas prices nearly double, I have locked in the current price of around $3/gallon.

Now assume that gas prices actually decline to around $2.50. XOM now earns me only 3%, but the market still returns 5%. In this case I will have earned $230 less by purchasing XOM than I could have otherwise, but my annual cost of gas is also less, now $866. (that is, $1040*[2.50/3.00]) My effective annual cost of gas in this scenario is now $866+$230 = $1096, so again I have locked in a price of around $3.00/gallon.

Of course there are other ways to hedge against this risk. Purchasing oil futures contracts is perhaps the most direct, but is probably not practical. However anyone with a brokerage account can easily set up this hedge right now. Then again, if you are bearish on oil stocks, then this hedge doesn’t make sense. But I don’t think you will find many people bearish on oil for some time.

So if gas prices hurt you as they do many people, I would suggest a purchase in the oil sector. For me, it would be a rational, but yet emotional, decision. I really hate paying a lot for gas. But if I can fill up my gas-guzzling SUV while knowing that my XOM stock is going up, I won’t hate it nearly as much.

A few thoughts on dividend policy

2006-07-24T08:00:00.000-07:00

Famously, Berkshire Hathaway has never paid a dividend. In theory, dividends represent a way to distribute money to the owners of a business should the business have no better use for that money. A textbook might say that in the absence of any “positive NPV projects” a company is better off paying a large dividend. Again, the analogy to the small business owner is one that I think best illustrates the theory behind a dividend policy.

Imagine you are a sole proprietor and, as such, have a right to all the income your business earns. You would then have two options as to what to do with this newly acquired cash. You could reinvest the income in the business (retain earnings) or you could pay yourself, the individual, a large dividend. Which would you prefer?

Your preference ought to be determined by where you could best deploy that excess cash. If you as an individual see a great investment opportunity outside your business – say for instance shares of WAG selling at a huge discount - you might want to pay yourself a dividend to take advantage. But you should only do this if your business looks to be an inferior investment. That is, it would make no sense for you to pay yourself a dividend and buy WAG if your business is growing wildly, say for instance at a 40% annual rate and you could expand it should the business retain those earnings.

Such is the justification for Berkshire’s no-dividend policy. Mr. Buffett has always felt that he would be able to earn a return for Berkshire in excess of what the typical investor could earn should Berkshire pay them a dividend. Additionally, there is an obvious tax advantage to avoiding dividends, all else equal.

But in my opinion, this dividend-avoiding strategy only will work in the presence of rational, level-headed managers like Warren Buffett. Far too many managers will pay too small a dividend merely to leave themselves extra cash to play with, potentially squandering the funds through excessive compensation for themselves or perhaps poor acquisitions (which lead to higher compensation under the empire-building assumption).

Too much cash sitting around is very dangerous for the typical company, inviting managers to do foolish things with it as mentioned above. This phenomenon has come to be know as the “free cash flow problem” and was first documented by Harvard Professor Michael Jensen in “Agency costs of free cash flow, corporate finance and takeovers,” American Economic Review, 1986. Not everyone agrees with this theory, but to me it makes intuitive sense and is well-supported empirically.

So a dividend-paying stock is often an attractive investment to me, not just for the quasi-guaranteed return, but because it makes it that much harder for management to waste my money. Ideally, all managers would behave like Warren Buffett and allocate capital in such a way as to maximize my (the shareholder’s) return. But that is simply too idealistic. Perhaps this is one reason why, as is widely recognized, over time dividend paying stocks outperform.

And who says you can't predict the market?

2006-07-18T07:30:00.000-07:00

Occassionaly Mr. Buffett teams up with his good friend Carol Loomis of Fortune to write a piece in his own words. Two of the most notable articles were written 1999 and 2001, and despite the very different market environments existing at each time, the message was the same: The markets cannot do as well in the future as they have in recent history. The reason is simple, interest rates will be going up.

Discouraging insight, for sure. Let us take a closer look, though. A value investor believes that a stock is worth the present value of some stream of cash flows that it will produce in the future. Mr. Buffett calculates this value by projecting out future “owner earnings” and discounting them back to present. The key variables, therefore, are the future owner earnings and the discount rate.

First, assume that our opinion of future owner earnings doesn’t change so as to isolate the effect that the discount rate will have on value. You can think of the discount rate as the opportunity cost of investing in Stock A over Stock B or Investment C. Now, if interest rates rise, so should our discount rate, since we would have more opportunities to do more with our money elsewhere. And since discount rates and present values are inversely related, value will decline, all else equal, as the result of a rise in interest rates.

From 1964 to 1981, the stock market went exactly nowhere. In aggregate, no money was made by investors during this period. But yet GDP nearly quadrupled. How is this possible, you may ask. Well, also during this period, interest rates rose dramatically. The rate on long-term government bonds went from a mere 4.2% in 1964 to 13.65% as the 1980s began. This had a devastating effect on stock prices. Then, as we are well aware, from 1981-1998 stocks rose more than tenfold. This can easily be explained by the remarkable drop in interest rates – all the way from that 13.65% in 1981 to next to nothing at the start of this decade. (GDP growth, by the way, was actually lower in this second period than it was in the first.)

It is easy to understand how interest rates affect bond prices. No one will want to buy a bond paying 6% if the going rate has risen to 8%, so the price drops. But keep in mind that the fundamental source of value for a stock is derived in the same way. Investors buy bonds to receive coupon payments in the future. Well, investors buy stocks to receive “coupons” that take the form of earnings per share, or perhaps “owner earnings” per share.

So the recent rise in short-term rates should dishearten the bullish stock investor to some extent. There are plenty of variables that will affect the stock market, but the one most fundamental to value is nearly certain to hurt stock prices, especially after long-term rates catch up to the recent increases in short-term rates. A 10% clip in your portfolio looks to be somewhat optimistic, at least until the rate hikes stop.

And by the way, just because I can predict the market doesn't mean I can predict it correctly. ;)

Warren Buffett to give his money away... now!

2006-06-26T13:09:00.000-07:00

A lot of people have been asking me “What do you think of Buffett’s decision to give away his money?” I can only answer that if he has made that decision, it must be the wisest thing to do. In case you haven’t heard, Mr. Buffett announced over the weekend that he would begin giving away nearly all of his fortune this year with the majority going to the Bill and Melinda Gates Foundation. This was a surprise, since for a long time Mr. Buffett held that he would not make any major donations until his death, and that when that happened his estate would go to his foundation, now called the Susan T. Buffett Foundation in honor of his late wife. This attitude offended some, particularly those ignorant of his rationale, as it seemed he was selfishly holding on to more than he needed.

To me, though, his rationale always made sense. The longer he waited to give to charity, the more he could give when the time came. Mr. Buffett is truly a money machine, so he could give, say, $40 billion today at age 75 or he could wait and give more than $160 billion upon death - assuming he dies at age 85 and a conservative (for Berkshire) growth rate of 15% per annum. That is, $40 billion * (1.15)^10 = $161 billion

Why would he do this? Presumably because he felt there were issues so pressing that it was more important to address them now than to address them later with more money. This issue arose several years ago when he became involved with the Nuclear Threat Initiative (NTI), which tackles “the single largest threat to mankind” as Buffett himself described it, nuclear weapons in the hands of terrorists. In an interview with Ted Koppel last year, Buffett explained his departure from his general policy to withhold charitable giving until his death by saying that there simply wasn’t time to waste, that this issue needed to be addressed immediately.

And so I would expect that this was the primary reason why he decided to give early, although it is speculated that the untimely death of his wife in 2004 was a contributing factor as well. Susan Buffett was the champion of the Buffett Foundation, and Warren always expected her to carry out its purpose upon his death. But now that she is gone, apparently, Mr. Buffett feels most comfortable leaving his fortune in the hands of the Gates Foundation. This is quite a compliment to his friend Bill Gates, who just recently left most of his responsibilities at Microsoft so he could focus on his foundation.

I think it is emblematic of Mr. Buffett’s truly outstanding character and humility that he would choose to disperse his wealth in such a philanthropic way. His children will get little of it, since they are already so fortunate themselves. Moreover, as he himself once said, “When society showers money upon you just because you have some peculiar talent, I think society has a large claim on that wealth.”

It is easy to assume that a man so wealthy is arrogant and selfish, but Warren Buffett is not. In fact, he is one of the most pleasant and genuine personalities I have been exposed to. When I first began to learn about the man, I expected that eventually I would uncover an objectionable and disappointing quality that would sour me on my admiration of him. But in all this time, I have found only good things. Mr. Buffett once said “Tell me who a person’s heroes are and I can tell you how that person will turn out.” I hope he is right, because Warren Buffett is my hero…

Value investing, in a (very small) nutshell.

2006-06-23T10:01:00.000-07:00

People familiar with him will usually be able to identify a “Warren Buffett” stock when we see one, but at times I have been stumped as to explain why a certain company is consistent with his philosophy. Teaching the Warren Buffett Course at MU and being forced to design a framework for making investment decisions made things immensely clearer to me. For one, and contrary to popular belief, there is no set of rules that every company must follow in order to be a good Berkshire investment. Rather, there is an array of different structures and characteristics that when operating concurrently produce a profitable and value-producing business.

For example, we often think of a Buffett company as having tremendous brand equity – “franchise value” as Mr. Buffett calls it. Mr. Buffett prefers to avoid companies that sell commodity products on which a customer will base his purchase decision primarily on price. How then, do we reconcile this principle with his investments in insurance or energy, neither of which has an important brand identity? The answer to the insurance question is simply “float” and the answer to the energy question is the favorable regulatory outlook that Berkshire foresaw. The point is, however, that there are numerous variables, all of which may make for a good investment. Not every company needs to a have a strong brand, nor does every company need management that behaves a certain way, say for instance one that expenses stock options.

This is because all of the characteristics we think of as prerequisites for a Berkshire investment, are nothing more than an indication of value. In the end, every purchase comes down to this one word. After all, Mr. Buffett is the world’s greatest value investor. A strong brand adds value. Good management adds value. The existence of float adds value and a favorable regulatory outlook adds value. The way we measure this value, in my opinion, is a general assessment of all the qualities that a make a company good, adjusting for all the other qualities that make it bad. If, after careful thought and consideration, Mr. Buffett decides that on the whole the company has more value than its current price would suggest, he will consider buying. It is that simple.

What is up with this market?!?!

2006-06-14T07:04:00.000-07:00

This market is really hard to take. Every day, lower prices. But one stock that has hung in there is Old Dependable, Berkshire Hathaway. I won’t begin to speculate why the market has been doing so poorly the last couple months, whether this is a correction or the start of a bear market, but the fact that BRK has outperformed is a testament to the trust its shareholders have in its operations and the strength of its portfolio.

To illustrate, ask yourself this question, Do you have any doubt that Berkshire is not a strong as its price would justify? For me that question is no, but for many of my other holdings, I can’t say that with as great of confidence. BRK pays no dividend, but has the lowest turnover ratio on the NYSE and attracts a faithful horde of 20,000+ individuals to its annual meeting. Clearly, these shareholders are something special.

As a value investor, I try to keep an eye on the “biggest losers” list, to try to catch stocks unfairly punished by the market, particularly when everything is going down. But this can be a risky strategy to follow without very careful diligence.

For instance, Jos. A. Banks (JOSB) shares got slaughtered when the company released some disappointing earnings last week, but it was likely the timing of the announcement – right in the middle of a market downturn when investors were already uneasy – that caused the 35% drop. Or take Monster (MNST) who is currently center stage in the stock options backdating scandal. Had this scandal broken in January, perhaps the shares wouldn’t have fallen nearly 40% as they have.

A more conservative and appealing strategy is to try to pick up some shares of great companies at a small discount. Coach Inc. (COH) comes to mind. This is a great, consistent, well-positioned company, which I have always had an eye on but has always seemed expensive. At $28/share, down from a recent high of $36, the company now stands at 23 times ttm earnings. Still pricey, but much cheaper than it was only a few weeks ago. And the fundamentals, if anything, have only improved.

To summarize, there still doesn’t seem to be a lot for the picking at the moment, but certainly we have a longer watch list. So buffer your portfolio with BRK, and watch for bargains…

What is behavioral finance?

2006-06-12T08:51:00.000-07:00

Efficient market theory has been around since the 1960s and gained considerable steam during the long bear market in the 1970s. It was standard dogma in universities for several decades and was never directly challenged. Meanwhile various professors began publishing papers that documented real-world anomalies, phenomena that seemed to be impossible under the assumptions of EMT. That is, they found cracks in the efficient market foundation. As more and more anomalies were documented, more and more doubts grew about the validity of the theory and an alternative notion, behavioral finance, was born.

EMT was never that popular on Wall Street anyway, of course. If EMT held, a good portion of those whose livelihood was made there would be out of business, an unattractive notion for sure. It was much more appealing to them to go about their lives assuming that, at least, it was possible to beat the market, even if they weren’t beating the market themselves. Ironically, this sort of self-denial, whether it was true or not, is a great example of the type of bias that plays a role in behavioral finance.

Behavioral finance has been around now for about twenty years, but only widely accepted recently. As I see it, it is the natural evolution of academic finance generally. Indeed, Professor Richard Thaler – the most prominent name in behavioral finance – even authored a paper entitled “The End of Behavioral Finance,” (Financial Analysts Journal, Nov/Dec 1999 – a great summary which I highly recommend) suggesting that eventually the modifier “behavioral” won’t even be needed.

Traditional theory assumes that decision makers act rationally, that the make unbiased judgments and that they always act in a way to maximize their individual well-being. Most psychologists will tell you this is an unrealistic assumption to make about human behavior, and so a great deal of behavioral finance research has been done in conjunction with psychologists.

Two psychologists, Amos Tversky and Daniel Kahneman, set the stage in the late 70s with “Prospect Theory” which examines how individuals make decisions. Within this framework, they developed the notion of “loss aversion.” Individuals aren’t afraid of risk, they are just afraid of the risk of losing. When confronted with gains, people are more likely to seek risk than when confronted with equally probable losses. That is, investors aren’t risk-averse, they are loss-averse. Thaler later performed an experiment that demonstrates this tendency. Students were told to assume they had just won $30 and were offered a coin-flip upon which they would win or lose $9. Seventy percent of the students opted for the coin-flip. When other students were offered $30 for certain versus a coin-flip in which they got either $21 or $39 a much smaller proportion, 43%, opted for the coin-flip. EMT holds that individuals weigh these probabilities without bias, and under such assumptions results like this would not occur.

There are two key points to the idea of behavioral finance: 1) investor irrationality/psychology and 2) limits to arbitrage. EMT does not rule out the possibility that investors act irrationally, but only that if they do their actions will be exploited by rational investors and arbitraged away. For example, in the case of Palm/3Com, where Palm shares were dramatically overpriced, EMT proponents would have expected short sellers to continue to sell the shares until they fell in price, making a quick arbitrage profit. But because there were simply not enough shares available to be shorted, the price remained high, as ordinary selling pressure was not enough to offset the irrational optimism of buyers.

If we can assume that there are times when arbitrage opportunities are limited, and that there are times when investors give in to behavioral biases and make irrational decisions, then an entire new world of finance just waits to be explored. How and why do investors make irrational decisions? Are these behaviors predictable? These are the types of questions that are starting to get answered in financial literature today.

My take on the Burger King IPO

2006-05-22T14:21:00.000-07:00

Over the past few months, one could not help but hear about the IPO of BKC, but the general sentiment was mixed. This seemed strange to me, since generally the bulls are out in force for a large IPO such as this, so I did a little investigating. A little investigating is all that I needed, it turns out, because this stock looks like a loser all around.

I have no doubt Burger King is a good company. It has enormous brand equity, the second largest market share among burger joints, and, I feel, a pretty flipping good product. Pun intended. But the new company, the one that now trades shares on the NYSE, has been stripped down to pad the wallets of the consortium of private equity folks that took it private in 2002. Not to mention a CEO that just split and a struggling burger market.

The biggest red flag, or should I say “proof”, that this proposition is a loser for individuals is the $367 million dividend the owners paid themselves, financed by $350 million in debt, immediately before the IPO. This could be justified if it is true that the consortium contributed a like amount of equity themselves since the buyout, but what it leaves is a dangerously overleveraged firm in an unfavorable market.

I say unfavorable because burgers seem to be losing popularity in favor of other foods such as subs (Subway) and tacos (Taco Bell). Such was the momentum behind the overwhelmingly successful IPO of the legitimately stellar business Chipotle. Given that Chipotle had whetted appetites of investors for big fast food IPOs, this was a logical time for the consortium to cash out.

So lets review. The Burger King owners take out a $350 million loan and pay themselves roughly a $350 million dividend, then take the company public to raise $350 million in equity capital, which they purport to use to repay the loan. Translation: $350 in, then out, then back in, then back out. So absolutely no value has been added to the firm through this offering, it has all gone to the original owners. The icing on the cake for them is that they emerge from this with the 75% of the company that was not sold in the IPO.

The right reason to take a firm public is to raise capital. Good firms can usually do this rather inexpensively. The wrong reason to take a firm public is to cash out, or sometimes pawn-off, a mediocre business on to the unsuspecting public.

Permanent Holding - Part 2

2006-05-19T13:05:00.000-07:00

Walgreens is still hovering around $40/share. Should we buy? Consider the following.

Two things happened in 2005 that hurt sales and increased costs, yet the company thrived nonetheless. The first is Hurricane Katrina, which cost the company about $55 million in addition to the lost sales at the 74 locations that were temporarily or permanently closed. The second is substantial costs in preparation for the launch of Medicare Part D. The company spent a great deal educating both its employees and seniors about the upcoming changes.

But Medicare Part D will benefit Walgreens tremendously as the program takes off. First of all, many more seniors will be filling prescriptions simply because they now have prescription drug coverage, whereas they did not before. According to the Kaiser Family Foundation, the 28% of Medicare recipients without prescription drug coverage spent 42% less on prescriptions than their covered counterparts. Should these individuals get coverage, it stands to reason their spending will increase significantly.

Second, as Walgreens management points out in the 2005 Annual Report, these new beneficiaries should be indifferent among pharmacies since their copay will be the same at every retail location. This is when Walgreen’s competitive advantage – outstanding convenience and location – will generate value. I expect that most new pharmacy patients will gravitate towards Walgreens over its competitors.

So is Walgreens still cheap? Let’s look at the financials. The company, which has no debt, has maintained a return on equity in excess of 15% as far back as I can calculate (at least ten years). So these equity shareholders, who supply capital at a cost much less than 15%, are getting a healthy, consistent and reliable return.

Same-store sales have increased in every category for the last two years, contributing to a growth in gross margins as well. Margins are up to 27.9% in 2005, from 27.2% and 27.1% in 2004 and 2003 respectively.

So when we calculate owner earnings for this company, I think we can have great confidence that optimistic projections are attainable. But it will take those optimistic projections to come up with an intrinsic value in the ballpark of the current $40 stock price.

Overstock CEO Loco

2006-05-11T14:52:00.000-07:00

I bought overstock.com a few years back and doubled my money in about three months. I bailed immediately because I could tell the sudden runup in price was not justified. Boy am I glad I did, because to agonize over what is going on at that company today is more that I am willing to undertake.

What originally attracted me to the stock was the legitimate Buffettness of it. The now-loco CEO Patrick Byrne is the son of Jack Byrne, the longtime head of GEICO and close friend of Mr. Buffett’s. The company seemed to be managed in a Berkshire type fashion, complete with an owners’ manual and straightforward, from-the-hip commentary from the management. It also seemed to be reasonably cheap. Although it wasn’t profitable, it was gaining ground quickly and was considerably cheaper than its closest peer, amazon.com on a price-to-revenue basis.

Well, it now seems that all those good things mentioned above have dissolved, except for Patrick still being Jack Byrne’s son – so far as I know he hasn’t disowned him yet.

I am sure it started earlier in life, but Patrick Byrne’s hysteria culminated last year in his “jihad” against naked shortsellers. Yes, he actually called it jihad. Shortsellers severely depressed the price of overstock stock, he said, and did so through the unethical and often illegal practice of naked-shorting. This means the shares that were being shorted were not even borrowed – they didn’t exist at all. Apparently this is possible because of structural inefficiencies in the stock exchanges. It is not something that I really understand, nor have any desire to understand to the extent that I would want to do such a thing myself.

So the stock price crashes, and Patrick was probably somewhat correct as to why. But his response was just, well, crazy. I mean really crazy, crazy in a Tom Cruise crazy kind of way. Instead of welcoming the drop in price as an opportunity to buy shares for himself, or better yet for his company, he sued one of the firms accused of the naked shorting. In fact, he did buy quite a few shares for himself, so why is he whining? He then announces that he is declaring “jihad” against them, claiming that the crash in overstock stock was caused not just by naked shortselling, but by a conspiracy coordinated by the "Sith Lord." Ok, Pat, now you are starting to lose me.

In an interview in December, he was able to divert conversation away from Overstock's disappointing holiday sales by suggesting he had, among other things, herion and a dead body in the trunk of his car. Later in that interview he verbally attacked Mark Cuban, who successfully shorted Overstock shares.

In March Patrick issued a press release entitled “Overstock.com to Gradient Analytics and Rocker Partners: Where's the Countersuit You Threatened?”, the text of which is hilariously unprofessional.

http://www.shareholder.com/overstock/ReleaseDetail.cfm?ReleaseID=189876

Today, he released a press release reading “Overstock.com Celebrates Receipt of SEC Subpoena.” I can’t help but think that such a preoccupation with such an inconsequential problem can’t be good for the company.

Moreover, blaming others for a fall in your own stock price, no matter how justified, is just tacky. Did it not occur to Patrick that, despite escalating sales, earnings remained negative? Is it not possible that folks were just losing faith in the prospects of the company? If he were truly to follow in his father’s footsteps, Pat Byrne would either brush off the stock’s fall and start buying, or own up to his failure to put up better numbers – since better numbers logically would serve to dissuade short sellers anyway.

Small-Cap Profile: Varsity Group, Inc.

2006-05-03T08:19:00.000-07:00

This is a company that recently underwent an operational restructuring that I am confident will prove much more profitable to the firm. The firm started out as varsitybooks.com selling college textbooks over the internet and employing college students to promote the company on campus. This was at the height of the dot-com bubble and the company targeted any and every university in the country – including mine – but could never penetrate the market. This industry was and is extremely competitive and the firm did fairly poorly. Varsity Group today, however, has identified an altogether different niche, one that will afford them competitive advantages that would have never been possible under the old business model.

Today, the company contracts with private high schools to provide all the textbooks for the school. The key to this model is contracting. Once the company contracts with the school, the individuals purchasing the books or uniforms have little to no buyer power. This is not to say, however, that the company can ignore potential competition, but only that it will be protected by temporary barriers to entry.

The most exciting benefit from the change in business model is the new customer base. As opposed to the stereotypical “starving-college-student,” to which the company previously marketed its product, the company now is selling to affluent parents, parents rich enough to send their kids to private school in the first place. The typical private high school student will visit the school bookstore with his parents, often buying more than he needs, including every accessory that strikes his fancy. It is a highly price-insensitive clientele. This, of course, compares favorably to the college student I often see so strapped for cash that he will forego buying textbooks altogether.

Additionally, just last year Varsity Group began selling uniforms, through its acquisition of a private uniform provider, with great success. Sales of uniforms are equally as profitable as sales of books, so the company can maintain its strong margins while adding to its product mix. More importantly, though, the company will be able to increase sales per school by providing more than just books.

The Varsity Group annual report is presented clearly and comprehensively. I especially like and appreciate how the company presents its financial statements. Varsity presents each source of revenue and expense separately. This makes it really easy to see how profitable each revenue stream is, and where the growth in total sales is coming from.

It is apparent from a glance at the company’s income statements since its IPO in 1999 that this model is dynamite, as its earnings have exploded, from zero around the time of the change in 2002, to over $12 million in 2005, all on the original $88 million of paid-in-capital. The company has yet to use debt financing, and founder and former CEO Eric Kuhn retains 8% of the outstanding shares. The current P/E of only 8 will get your attention, but a DCF valuation with conservative assumptions yields an intrinsic value high above the current price of $5. For this reason I think there is a considerable margin of safety in and investment in this company.

I own quite a bit of this stock. Bought it back in February at $3.85.

Annual Meeting

2006-05-01T13:40:00.000-07:00

I am traveling with seven students to the annual meeting this weekend in Omaha. We would love to meet any readers of this blog that may be in attendance as well. We should arrive Friday afternoon around 5:00, and plan to attend the Borsheim's reception Friday night. After the meeting on Saturday we will be attending the NFM BBQ. I can be reached via email at andrewekern@aol.com

Budweiser gets some recognition and triggers a thought

2006-04-26T12:44:00.000-07:00

The stock that Buffett has been buying for over a year now (and I started buying before him) finally looks to breaking out of the basement that it has been in for the last couple years. Of course, it took a blockbuster earnings announcement from AB to get it to move, but this is the type of thing patient investors have to wait for. In the short run, the market is a voting machine, in the long run it is a weighing machine. In my opinion, BUD is clearly a good investment, but it will take positive sentiment from the masses in order for the stock if any large cap to move. Hopefully, today's announcement and flattering front-page WSJ article do just that.

All this got me very interested in another stock I have been watching lately and which took a big hit yesterday. Wrigley's is a Buffett stock if I have ever seen one, and is similar to AB in a remarkable number of ways. Family-owned and run for nearly a century, a comparable dividend yield, consistent growth for decades, easily-understood consumer product, an impenetrable moat and ubiquitous brand. I finally broke down and bought some shares today at $46.75, the lowest the stock has been in over two years.

The stock took a big hit yesterday after the company announced its first quarter earnings were down sharply, due first to the costs of its newly-acquired brands and second to its expensing of stock options. With the latter clearly being irrelevant, we can focus on the expenses associated with the former. Last summer was big for the company. It issued debt for the first time in recent memory to finance the acquisition of the Kraft confectionary group, which includes such products as Altoids and Lifesavers.

With its stellar credit rating, the company was able to finance this purchase for less than 5%. After the purchase, the company began advertising its new brands heavily and attributes these costs to the reduction in profitability – gross margins fell from 56% a year ago to 51%. So despite record sales, net income was off. I see this as a very short-term problem, and one that has appropriately been priced in to the stock. With these costs behind it, now is an excellent time to buy.

Time will tell, of course, but it wouldn’t surprise me a bit to see this stock behave the same way BUD has for the past couple years. Give the market time and it will realize how strong this company is. WWY is a bargain, I think, at $47 and worth a place on everyone’s watch list if not in a portfolio.

Should we try to play ethanol?

2006-04-17T13:19:00.000-07:00

Yes. But be careful. Once it becomes widely known how easily this nation can switch away from gasoline and toward ethanol, plenty of traders will be eager to snatch up every small supplier or research firm with any connection to the fuel. This approach is a crap shoot and very unwise. The best approach, I feel, is to invest in an established, profitable company that is currently trading at a reasonable price. And I’ll be darned if there isn’t one sitting right in front of us. It’s called Archer Daniels Midland.

What prompted this post of mine is an article a friend of mine told me about by know-it-all trend maven Jim Cramer. Apparently Cramer’s rant of choice this morning was how foolish buying anything and everything ethanol can be. Seems like a legitimate take, but then he goes on to dismiss ADM as becoming “such a momentum play it makes a mockery of the fundamentals.” Mockery of fundamentals? Seems like a little bit of a stretch for a company selling at 23 times ttm earnings and less than three times book value. So, as if you need any convincing that Cramer hasn’t fully thought an idea through, let me explain why this is not true.

Ethanol is, admittedly, not what ADM has traditionally produced. It would be a huge overhaul of the current business model were the company to rely solely on ethanol sales. But at present, this is not the case and this makes the company stable and reliable. ADM has grown in to the premier food supplier in the country and consistently grown for many years. But ethanol is enormously more profitable to the company than its food products - whereby it contributes only 5% to the company’s total sales, according to Fortune magazine, ethanol contributes nearly 23% of total income.

The reason I think ADM is a reasonable investment is because even in the absence of any growth as the result of ethanol the company is selling at a reasonable price. The type of basic discounted cash flow valuations I have run on ADM’s numbers using assumptions based on no increased benefit from new ethanol sales, produce values roughly equal to the current price. To be specific, I assume free cash flow grows at 5% indefinitely and I assume a discount rate of 10% (approximately ADM’s cost of capital). Therefore what I am assuming is that current government ethanol subsidies will persist and that sales and capital expenditures will continue to grow at historic rates. This will not prove to be the case, however, as the company has announced plans to nearly double its rate of capital expenditures by 2008 in an effort to expand ethanol capacity.

What we are left with is a company that is appropriately priced given its current operations but with a speculative component that seems to have been given little added value. So long as the ethanol expansion produces a positive return on investment, the stock is a good buy at the current price of $35. However, if ethanol proves to produce nothing or negative returns, the stock is not a good buy, although no one stands to lose his shirt on it either because of the strength of the company’s traditional operations. Is this a good roll of the dice? I would say so. Moreover, ADM is the only prudent attempt to play the ethanol phenomenon, which I have been convinced is real, occurring and will continue to occur. Most other investment alternatives are entirely speculative.

Permanent Holding - Part 1

2006-04-05T13:30:00.000-07:00

Today one of my personal permanent holdings, Walgreens, released its quarterly results. As shareholders have come to expect, sales increased 9.2% over the year-ago period. Better yet, same store sales rose 4.3% -- but the shares barely budged. No surprise though, the stock of this “boring company” has gone nowhere in the last twelve months and another buying opportunity is quickly approaching. I originally bought Walgreens on a dip three years ago in March and April of 2003. As expected, the stock quickly rebounded. I could expect this because I was confident in the future performance of the company.

Buffett likes stocks with consistent growth. In my experience very few companies beat Walgreens in this regard. The company has grown its earnings and sales every year for the last thirty-one years, with earnings averaging around 15% growth over this time period. How many other companies can say that? I would be willing to bet you could count them on one hand (but I am not a betting man.)

The company has no debt. And it is growing by leaps and bounds – 432 new stores opened last year to bring the total to 4953. That it can do this solely with equity financing is remarkable, and indicative of the strength of the firm.

I feel Walgreens is doing to the pharmacy industry what Wal-Mart did to retail. I don’t like what this does to a small town spiritually any more than the next guy, but like it or not, mom-and-pop stores are inefficient and will eventually go by the wayside. The independent pharmacy will not be able to compete with Walgreens any more than the old-fashioned dry goods store can compete with Wal-Mart.

Which is an interesting comparison since Wal-Mart competes with Walgreens for pharmacy services. First off, make no mistake about what is Walgreens’ core business. It is prescriptions. The “front-end” sales that might seem more significant are not at all – they comprise only 36% of total revenue. What the photo shop, convenience mart etc do for the company is keep customers regularly visiting the store and much more likely to rely on it for their prescriptions. Walgreens stores are ordinarily located on the corners of major roads in predominately residential areas. Most also have drive-thru service. It should be obvious that Wal-Mart will never be able to offer this type of convenience.

Moreover, the company currently only has 15% market share and thus tremendous room for growth. This is one stock I think will definitely outperform the market over the next 10-20 years.

More on Walgreens later…

Is Coke underappreciated?

2006-03-31T08:13:00.000-08:00

I don't know the answer to that question. All I know is that the stock has done nothing for Berkshire Hathaway or any other investor over the last ten years. Yet its sales and earnings are up. Without question Pepsi has done better, in both terms of earnings and stock performance. But does that mean Coke should actually be down for the decade? Might this be a case of undue pessimism? Coke still is the strongest brand in the world...

The failure of invariance

2006-03-29T09:11:00.000-08:00

Anyone with any doubt that psychology plays a role in the behavior of the stock market should closely examine his or her own trading behavior before jumping to any conclusions. I believe that nearly everyone can find examples of times when he made an irrational financial decision as the result of biases that may even be at the subconscious level. Economics and finance are social sciences – they are affected primarily by the way people interact with each other.

Behavioral economists warn of the “failure of invariance,” a mistake that just about every investor will make from time to time. But the best investors are aware of it and minimize its impact on their decisions. This is the phenomenon of an investor answering a question under identical circumstances differently simply because the question was framed differently.

Example adapted from Nofsinger’s The Psychology of Investing: Suppose you bought a ticket to a show for $40, but when you arrive you discover you have lost the ticket. Would you pay $40 for another one? Now suppose you intend to buy the ticket at the door, but when you arrive you discover you have lost $40 while on your way. Do you still buy the ticket? If your answer is different under the two scenarios, then invariance has failed. The economic consequences are identical (you are out $80 but see the show) but because of the way the question is framed people often make different decisions. By the way, the above example has been proven empirically by financial economists.

The biggest name in behavioral finance is Professor Richard Thaler of the University of Chicago. He has done a number of really interesting studies on this topic. One of my favorites is when he asked one group of students, “How much would you be willing to pay to eliminate a 1-in-one-thousand chance of death?” He then asked a different group of students, “How much would you require to accept a 1-in-one-thousand chance of death.” On average students said the would only pay $200, but would require $50,000!

Of course the all-time best example is a tale from the tech bubble. It involves the equity “carve-out” of Palm Inc. from 3Com.

Palm was wholly owned by 3Com. In March 2000, 3Com had an IPO for a fractional stake in Palm. In this offering, 3Com sold 5% of Palm to the public. It also announced it intended to sell the remaining 95% after IRS approval. At that time, 3Com shareholders would get 1.5 shares of Palm for each share of 3Com. Immediately before the IPO, 3Com closed at $104. After the first day, Palm closed at $95, so 3Com should have correspondingly risen to $145. But it didn’t . Instead, it fell to $82. Thus, the market was effectively pricing 3Com’s non-Palm operations at negative $23 billion.

Thaler eventually published a paper based on this entitled “Can the Market Add and Subtract?”

A stock for the watch list.

2006-03-22T15:40:00.000-08:00

H&R Block has had a rough time lately. First it was the refund loan scandal a few years ago whereby Block charged usurious effective interest rates to clients who wanted their refund immediately, rather than six weeks later when the IRS got around to sending them. Block weathered that one ok by fixing the program and eventually rebounded to post record earnings.
But things turned south quickly thereafter, and the company began an effort to transform itself into more than just a tax preparer by originating a few mortgages. In the near term, this appears to have hurt its profitability. Indeed, sales were up considerably in FY2005, but income was down sharply. All indications for 2006 seem to be similar, and will be hurt even more by the legal costs the company now has to deal with.

Another of its areas of expansion has been investments, which seems to have gotten the company into yet another pickle. Today Block is defending itself against a $250 million Eliot Spitzer lawsuit for yet another of its take-advantage-of-the-idiots practices – the “Express IRA.” It seems this was a deal in which clients were encouraged use their refund check to open an IRA held by Block. Sounds good to me, but the always-politically driven New York Attorney General took exception to this practice since the fees Block charged often amounted to more than the account was earning.

There is little debate that Spitzer lawsuits usually have more to do with getting voters' attention in preparation for a gubernatorial bid than they do with trying to clean up business. A case can be made that he has resolved a lot of ugly problems, but more often than not a Spitzer lawsuit is nothing more than extortion. AIG worked out this way exactly. Nobody outside the insurance industry really understood what the heck was wrong with the transactions in question, so it was easy to paint Hank Greenberg as the bad guy and Eliot Spitzer as the hero. Needless to say, it is not certain that this new lawsuit has much merit.

So now we are dealing with the Spitzer lawsuit, several copycat class action suits and news that Block will have to restate its financials because it inaccurately calculated its own tax liability. Yikes. I can’t imagine Wall Street rewarding this company anytime soon.

None of this, though, changes the fact that H&R Block is without question the strongest franchise in the industry. Nearest rival Jackson Hewitt doesn’t even come close - compare Block’s 2005 revenue of $4.2 billion with the $233 million of Jackson Hewitt. The company produces boatloads of free cash flow and the potential threat of tax software has never really materialized. That is, the company is not going anywhere, but its stock price has been falling steadily for a few months.

So let’s watch this one and see if all this negative publicity doesn’t drive down the share price a little further. At its current price of around $21/share, the company’s 2005 free cash flow (owner earnings) would need to grow at less than 2% on average indefinitely in order for the present value of that free cash flow to equal the current stock price (assuming k=10%).

I remember at the 2002 annual meeting, Mr. Buffett mentioned a good investment idea was to buy shares of companies whose price was beaten down by asbestos litigation. Had I listened to him I might have bought Halliburton (yes, I realize there is a lot more to that company's stock price than an asbestos settlement but my point is made). It will be interesting to see if he adds to Berkshire's H&R Block position. Given that H&R Block is indeed in pretty bad shape right now and its near term prospects uncertain, I’m not to anxious to buy at $21, but should the stock continue to fall it may prove to be an ideal value purchase.

As of now, I do not own any shares of H&R Block.

A few thoughts on portfolio construction

2006-03-17T19:28:00.000-08:00

The notion that owning a few stocks is much wiser than owning many stocks should be self-evident to the Buffett follower. If an investor concentrates in a small number of stocks, he is far more likely to critically analyze and track each one. In other words, limiting one’s decision making ensures that each decision will be given more thought.

Mr. Buffett has long advocated this philosophy and often uses his punch-card analogy to explain it. He recommends that every investor should invest as if he or she has a punch card with only twenty punches available over the investor’s lifetime. Each investment represents a punch, so once the investor has used all twenty punches, that’s it. This mindset will help the individual reduce the rashness of his decision making and increase his confidence in each decision.

If you are familiar with Mr. Buffett’s strategies, you probably already know this. But what you may not know is that this theory is supported by – believe it or not – academic research. Not all academics ardently sing the praises of modern portfolio theory and efficient markets. There is a wonderful trend towards alternative explanations of market phenomena. Whether or not this trend is the result of the undeniable success of Mr. Buffett we will never know.

Two professors from the University of Michigan and one from the University of Illinois collaborated on a paper entitled “Portfolio Concentration and the Performance of Individual Investors.” The paper explores differences in concentration among portfolios of individuals. It ignores institutional investors and simply compares investments of households using data provided by a discount broker over a five year period. It finds that, in general, investors with portfolios containing a small number of stocks outperform comparable portfolios consisting of a larger number of stocks.

More specifically, large portfolios that are concentrated in a few stocks perform significantly better than the more typical diversified portfolio of equivalent size. If we can assume that investors with large portfolios (that is, wealthy investors) are typically more financially sophisticated, then these findings provide evidence that financial sophistication and critical analysis can work to help an individual beat the market.

The paper further finds that individual investors who concentrate in local stocks tend to outperform others to the greatest extent. Might this suggest that familiarity leads to better decision making? It would certainly seem to follow. The authors of this paper are quick to clarify, however, that concentration in a few stocks is only rational if the investor has above-average stock picking acuity and a sufficient informational advantage. That is, unless you know exactly what the heck you are doing, it is best to diversify.

This is consistent with advice Mr. Buffett has given as well. Diversification is protection against ignorance, he says, but if the investor is not ignorant then a focused portfolio is best. If the investor is ignorant, then a low-cost index fund is the best route.

The new Chairman's letter and FORTUNE

2006-03-10T13:50:00.000-08:00

The March 20 issue of FORTUNE starts off with a piece on the old, but important, notion that frictional costs can only hurt investors in aggregate. It is taken, interestingly enough, from the Berkshire Chairman’s Letter that was released last week. In it, Mr. Buffett provides another great market allegory and in typical Buffett fashion makes it fantastically easy to understand.

First of all, if the owners of equities are to earn much on their holdings in the future, business will have to expand at least at an equivalent rate. This is a simple but often overlooked principle. Businesses will become more valuable if they are more productive. This productivity provides earnings - capital - for investors to put into other investments. But investors cannot put all of this capital into new investments because of frictional costs. Although the most basic frictional cost is the broker commission that you pay every time you purchase a stock, we should consider any expense made in an effort to outsmart other investors a frictional cost. It is these costs that contribute nothing to the profitability of our business, but that eat away at what we take home. Notice too, that if businesses in aggregate do not expand, the stock market cannot either because there will be no new capital to reinvest in the market.

As Mr. Buffett indirectly points out, every vehicle out there to “aid” in the ownership of businesses - whether it be a mutual fund, costly investment advice, consultants or private equity funds – only prevents all of the business productivity from ending up in the pockets of the owners. In recent times, the level of frictional costs has increased horrifically. For this reason we should expect the owners of equities to see their wealth grow at a rate much lower relative to the level of business productivity growth than they have in the past.

Alarmingly, Mr. Buffett contends that frictional costs now may amount to as much as 20% of all business productivity. So investors today are earning only 80% of what they could if they worked for themselves, rather than hiring "helpers" to work for them. That remaining fifth of the pie is going straight to the helpers.

You may be surprised to read that the rate of return on the market over the last 100 years is only 5.3%, plus dividends. So should investors expect to earn even less than this much in the next 100 years? Not necessarily. It is reasonable to assume that we live in a much more productive economy than we did on average in the 20th century and thus we can expect business to grow at a higher rate than it did last century. But for shareholders to see their holdings fully reflect this growth, frictional costs will have to be reduced.

The individual, however, can see his wealth grow at or above the rate of growth of business generally. He can do this by simply avoiding frictional costs and investing in above-average businesses as Mr. Buffett has done so well over the years. This means selling only in extraordinary situations and making transactions through the lowest cost broker available. It also means avoiding the expensive consulting and investment advice promoted by brokerages. (Ironically, these services can actually be shown to hurt investors, but that is a topic for another day.)

Let's get things started.

2006-03-08T12:28:00.000-08:00

I thought it was most appropriate to make the innaugural post of this blog about a company that I am sure Mr. Buffett would like to own. In fact, I actually pitched the idea to Mr. Buffett himself. For purposes of disclosure, I must point out that upon discovering this company, I purchased shares for myself, which I still own.

The company is called Leggett and Platt. This fortune 500 company makes components - primarily for furniture and automobile interiors. This means everything from bed springs to lumbar systems. In fact, there is a good chance you are sitting on a Leggett component as you read this. This is a fairly simple business idea - the way Buffett likes them - and Leggett has consistently stayed in this industry throughout its 122-year history - another Buffett plus.

In my interaction with Mr. Buffett, in addition to most everything I have read, I understood that one of his primary concerns is the integrity of management. This includes its honesty, candor and rationality. A read through of the Leggett annual report is telling. The tone and content of the text sounds as if it could have been in the Berkshire annual report. The managers of the company own a large amount of Leggett stock, often representing a substantial portion of their net worth. Managers also frequently choose to forego a portion of their salary in exchange for stock options. Once these options are granted, they are expensed.

Although Leggett doesn’t have a "moat" around its business in the same way as Coca-Cola or See’s Candies, I assert that its moat is as large as any business-to-business enterprise’s could be. The company has a reputation for product quality and customer service, all while often being the lowest cost producer in the industry. Leggett also has very strong relationships with its customers. Many of its plants are located right next door to the customer, creating both efficiencies and loyalties for all parties.

The customer base is also diverse. No one customer accounts for more than 5% of company sales, providing each customer with relatively little buyer power.

Further, Leggett has experienced average annual growth in earnings of just over 15% since its IPO in 1967. However, as Mr. Buffett first pointed out in his 1977 annual report, strong earnings growth is not all that impressive without a comparable return on equity. Leggett’s ROE has averaged 15.9% since the IPO in 1967 and has been very consistent. The standard deviation in ROE over this time is only 3.5%. All this has been done without the undue use of leverage. Long term debt has historically averaged around 30% of total capital, although that ratio is currently closer to 20%.

As recently as last fall, Leggett stock was significantly undervalued. If we run a Buffett-esque discounted cash flow valuation we find that the current stock price still falls short of what such a valuation would produce. What do I mean by Buffett-esque DCF valuation? Consult his 1986 letter to shareholders in which he defines "owner earnings" as reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges less the average annual amount of capitalized expenditures for plant and equipment, etc. We project these future "owner earnings" and discount them to present. Using even the most conservative assumptions of growth and discount rate, Leggett stock looks cheap.

Welcome

2006-03-07T09:11:00.000-08:00

I am establishing this blog in response to the huge reception of an article in a not-so-huge newspaper. On March 5, 2006, an article was published in the Columbia Missourian that chronicled a trip I took to Omaha, Nebraska on October 17, 2005 with fifty of my closest friends. The purpose of the trip was to meet Warren Buffett, the most successful investor of all time. The publicity that followed us home elicited the interest of an impressive portion of the Columbia community.