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By Ravi Nagarajan

It appears that MidAmerican Energy Chairman David Sokol has taken on a higher media profile in recent weeks.  MidAmerican is a subsidiary of Berkshire Hathaway and David Sokol has often been mentioned as a front runner to take over the CEO position at Berkshire in the future.  Could this media exposure signal something about Berkshire succession plans?

It is probably best to avoid reading into Sokol’s recent media exposure in terms of Berkshire succession plans.  It would be entirely out of character for Warren Buffett to float trial balloons regarding management succession.  However, Sokol’s recent statements on the economy and housing should carry some weight given the fact that MidAmerican owns Home Services of America which is the second largest real estate brokerage in the United States.  Let’s take a brief look at Sokol’s recent comments on housing and the economy.

No Green Shoots Yet

Pronouncements of “green shoots” appearing in the economy have been common over the past two months since the stock market hit multi year lows in early March.  This optimism is obviously a factor in the broad market recovery.  But is the optimism justified, particularly in housing?  Sokol does not seem to think so:

“We’re not seeing the green shoots,” said Sokol, head of MidAmerican Energy Holdings Co., which owns HomeServices of America Inc. “We don’t see improvement.”

Homes in the process of foreclosure are creating a “shadow backlog” of unsold properties that will continue to hang over the market, Sokol, 52, said in a speech yesterday at the Ira W. Sohn Investment Research Conference in New York.

While official statistics show a 10- to 12-month supply of unsold homes, “we believe the backlog of homes for sale is twice that.”

It appears that Sokol is pointing out one of the worries that has often been cited by those with a bearish view on housing.  Given the large number of properties in foreclosure or near foreclosure,  a flood of new inventory may be waiting on the sidelines and could appear in the coming months.  This could snuff out any price improvement and lead to further declines.

Counterproductive Government Actions

In recent interviews, Sokol appears to be much more critical of government policy than either Warren Buffett or Charlie Munger.  This has been particularly true on the “cap and trade” policy that will impact MidAmerican’s public utilities and was a subject of a recent article related to MidAmerican’s partnership with BYD.   It appears that Sokol is equally unimpressed with government action in the housing arena:

Sokol suggested government efforts to ease the crisis are actually drawing out the recovery. “We really need to let the economics work through the system,” he said.

Many people who want or need to sell their homes haven’t put them on the market yet because the outlook for sales has been poor, he said. “It will be mid-2011 before we see the market in balance,” with no more than a six-month backlog, he said.

If Sokol’s predictions prove to be accurate, the economy is in for a much longer recession than the market consensus appears to reflect.  If depressed housing conditions persist for another two years prior to staging a recovery, it is difficult to see how a consumer led recovery will be possible.  With consumer spending representing around 70% of GDP, confidence is unlikely to return and any recovery will need to be led by other components of GDP if a recovery is to occur prior to 2011.

Bloomberg Video

Here is a video from Bloomberg with a report on Sokol’s recent comments that may be of interest to readers:

Whether Sokol’s predictions are accurate remains to be seen but his words should at least be carefully considered by those making investments that assume that a quick economic recovery will begin in the second half of this year.  If we are two years from a housing bottom, it is highly unlikely that any sustained economic recovery will begin this year.

I am a believer in Warren Buffett’s advice to not allow macroeconomic factors to be the predominant criteria for investment in well selected businesses.  Generally I make investments based on criteria specific to a business or industry rather than the overall economy.  However, it is still interesting to follow macro trends and the divergence of macro trends from “consensus” market expectations.

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By Ravi Nagarajan

Hurco Companies provided a press release this afternoon with results for the second fiscal quarter of 2009 which ended on April 30.  The 10Q report has yet to be posted to the SEC website.  While the results reflect significant weakness in Hurco’s business, this is hardly a major surprise given the continued turmoil in the global economy.  This was to be expected under the circumstances and a superficial look at the press release shows that Hurco only sustained a minor loss of four cents per share.  However, a closer look reveals some potentially larger problems.

Summary of Results

Hurco reported a net loss of $281,000, or $0.04 per share compared to net income of $5,467,000, or $0.85 per share for the corresponding period in 2008.  Sales and service fees for the second quarter came to $20,489,000, a jarring decrease of 65% compared to the second quarter of 2008.  While part of the decrease can be attributed to the stronger dollar, this was a relatively minor impact at around 5% of second quarter sales.

Sales were most impacted in Europe where a decline of 69% was posted.  North America experienced a 47% decline in sales while the small Asia Pacific business reported a 67% decline.  The picture does not look great going forward with new order bookings in the second quarter at $18,135,000, a decrease of 69% compared to the prior year period.

Gross margin declined to 26% compared to 35% in the prior year primarily due to lower sales volume and the decline in sales of higher priced VMX machines in Europe.  Competitive pricing pressures also had a negative impact.  Hurco cut selling, general, and administrative expenses by 36% from the corresponding prior year period.  However, cost cutting could not occur quickly enough to offset the dramatic decline in sales. SG&A expenses as a percentage of sales rose to 36.7% from 20% in the corresponding prior year period.

The balance sheet, at least at first glance, continues to reflect significant strength.  As of April 30, Book Value was $18.99 per share, tangible book value was $16.88 per share, Current Assets less All Liabilities was $14.72 per share, and the company had $4.34 per share in cash and short term investments.

Concerns

As noted above, the fact that sales declined rapidly is not a major surprise.  However, digging deeper into the press release reveals some key concerns that must be examined in more detail:

Realized Gains on Derivatives

As Hurco reported in their latest 10K report, the company enters into foreign currency contracts periodically to hedge sales denominated in foreign currencies.  The purpose of the hedges is to mitigate against the impact of adverse exchange rate movements on cash flows.  As of January 31, 2009, the company had $2.8 million of unrealized gains, net of tax, related to future cash flow hedge instruments.  Deferred gains are normally recorded as an adjustment to cost of sales in the period when the sale that is subject to the related hedge contract is recognized.

In today’s news release, the company reported that $2,202,000, or $0.34 per share, of net realized gains on the hedge contracts were recognized on the income statement as other income.  Presumably, this gain was recognized in this manner because the size of the hedges the company entered into reflected a higher level of sales than now appears realistic.  Therefore, the hedges were closed out and recognized as income in the second quarter.

Obviously, investors must note that the net loss for the quarter would have been much larger had it not been for this one time gain on the derivative instrument.  Indeed, operating income reflects this weakness.  It would be wrong to conclude that Hurco can expect to repeat this quarter’s experience of a small loss going forward assuming current sales and expenditure levels.

Inventory Concerns

Inventories at the end of the second quarter rose to $64,880,000 from $63,294,000 at the end of the first quarter, despite the fact that sales for the second quarter declined 27.6% compared to sales in the first quarter.  Days Sales of Inventory (DSI) rose from 291 to 387 days.  This is historically very high for Hurco.  DSO averaged 162 days for the five fiscal years from 2004 to 2008.  The obvious question is whether Hurco is going to face any inventory obsolescence in the coming quarters.  The failure to significantly reduce inventory levels despite the large drop in sales over the past two quarters is a red flag indicating potential inventory write downs going forward.

Accounts Receivable

While Accounts Receivable fell to $15,903,000 from $18,587,000 at the start of the quarter, Days Sales Outstanding (DSO) rose from 60 to 71 days.  This could indicate trouble collecting from customers that are under stress from the impacts of the global recession.  In Hurco’s Q1 report, the company notes that many customers were impacted by tight credit during the quarter.  Given the nature of Hurco’s customer base, it is reasonable to suspect that uncollectible receivables may increase.  The question is whether Hurco has a sufficient reserve in the allowance for doubtful accounts based on current conditions.

Capitalized Software Development Costs

Over the first six months of the fiscal year, the company’s account for capitalized software development costs has increased by $386 million and now stands at $6,097,000.  While the capitalization of software development costs is in and of itself not an illegitimate practice, one must carefully examine this type of capitalized cost since if it was expensed during the current period, the net loss would have been that much wider.  Hurco’s capitalized software development costs have steadily risen from $2,920,000 at the end of fiscal 2004 to $6,097,000 at April 30.  Given Hurco’s reputation for having the best in class software for their products, I am not overly concerned about the legitimacy of the capitalized costs other than to note the potential manipulation that could potentially take place.  A healthy skepticism is not out of place in such situations.

Warranty Reserves

In the first quarter 10Q report, Hurco reported a $57,000 provision for warranties during the period which was sharply down from the prior year period’s provision of $669,000.  I inquired about the significant reduction given the impact a much larger provision would have had on Fiscal Q1 earnings.  I did not receive a response.  I am less bothered  by the company not wanting to comment on this than I am regarding the total lack of any response at all.  We must wait for the second quarter 10Q report to determine whether warranty provisions were back to more normal levels in Q2.  A continued pattern of small warranty reserve provisions could signal that management is attempting to smooth earnings.

Does the Investment Rationale Still Hold?

Does the investment rationale I wrote about in April still hold?  Obviously, I did not anticipate the continued weakness in Hurco’s operating results, although I had no illusions about a quick recovery to pre-recession levels.  I was more optimistic about management’s ability to cut operating costs to match the downturn in sales.  I was also more optimistic about management’s ability to bring inventories into line with lower sales volumes.  However, these are extraordinary times and Hurco still has significant strength from a balance sheet perspective.  While it is true that inventories and receivables may suffer from write downs if the current recession persists, I believe that downside is limited by the strong balance sheet position.  Management is also in place that has experienced the prior economic downturn earlier this decade and the overall track record outlined in the prior article still holds.

One of the main lessons I have learned from studying Benjamin Graham’s writing over the years is to view the balance sheet as the anchor of value for a business.  An overemphasis on current income during any quarterly or annual period is very common, and investors who do not insist on a solid balance sheet can suffer badly in downturns.  In this particular case, Hurco’s balance sheet provides a great deal of downside protection, although it obviously does not eliminate risk.  Management could certainly make decisions that will erode the balance sheet in the coming quarters, although their overall track record provides some reason for optimism.

In my opinion, Hurco should still perform very well over the next three to five years provided that the worldwide recession does not degenerate into a depression and the company’s technological superiority is not eroded by competitors during this timeframe.  I am holding my shares at this point, although my enthusiasm for continuing to hold if price recovers to tangible book value has been significantly reduced.

For interested readers, The Inoculated Investor has posted equity research on Hurco that I found very well written and worth careful review.

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Disclosure:  The author owns shares of Hurco Companies, Inc.

Ravi Nagarajan is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

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By Ravi Nagarajan

The term “creative destruction” was used to promote countless business models of dubious value during the height of the dot com mania of the late 1990s.  In the ensuing collapse, many observers have grown weary of this term and attribute its use to exaggeration and hyperbole.  Nevertheless, the concept of creative destruction developed by Joseph Schumpeter nearly seven decades ago is impacting the newspaper publishing business like a category five hurricane.

In a nutshell, creative destruction refers to the process by which capitalism periodically replaces an established order through a disruptive change that redefines the competitive landscape.  Such a change is clearly taking place today for traditional news publishers.  This is true not only for print newspapers but for all traditional forms of news such as radio and television.  However, the most severe dislocations up to this point have impacted print media.

Print Newshounds:  The New Endangered Species

According to a very insightful article recently published by The Economist, the percentage of Americans who read traditional newspapers has dropped from 58% to 34% since 1994.  More people are now obtaining their news from cable and Internet sources, with the latter showing dramatic growth this decade.  However, some people are simply not getting news in any form and this is particularly true for younger people.  The Economist reports that the percentage of 18 to 24 year olds who did not get news in any form on a typical day rose from 25% to 34% over the past decade.

At the Berkshire Hathaway annual meeting, Warren Buffett made a number of bearish statements about the newspaper industry and even went as far as to say that investors should steer clear of the sector and that from an economic perspective, Berkshire would have been better off selling The Buffalo News years ago.

Warren Buffett and Charlie Munger are well known for being print newshounds reading five or more newspapers per day.  Personally, I read two newspapers on most days (HOW do they read five?) and prefer the concentrated focus of a physical newspaper to the distractions and eye strain associated with reading online.  I also read most magazines and investment publications in print form and I subscribe to the print edition of Value Line. This may be strange coming from someone who publishes a financial blog, but I simply do not like reading lots of content online.

I cannot imagine starting the day without reading a physical newspaper, but I believe that the days of print are drawing to a close.  What will replace the print newspaper?

Internet News Sources

On one hand, the Internet has dramatically reduced the barriers to entry for publishing and created a much more even playing field for writers.  However, this has also created major problems for traditional publishers who hope to capture readers online and to replicate the advertising revenue models that were the bread and butter of the print world for so many decades.  In many cases, there is simply too much information online and much of it is of dubious value.  Authoritative sources of information may get lost in the noise.  While financially oriented publishers such as the Wall Street Journal and the Financial Times have been able to charge subscription fees directly to readers, most newspapers have not been able to develop such a revenue model.

While the Internet provides numerous advantages over print media in terms of being able to link to related sources and maintain up to the minute accuracy in coverage, it also suffers from serious limitations.  In my opinion, one of the most serious limitations is related to the act of reading online.  Reading short articles online is not a problem, but few readers would be eager to read long form investigative reporting or analysis on a computer screen.  The eye strain and form factor of a computer is not appropriate for such reading, and computers provide too many distractions that do not come with a cup of coffee and a copy of the print Wall Street Journal.

Can E Readers Substitute for Paper?

I do not own a Kindle at this time but I am considering the Kindle DX which will be released later this year.  I have also published this blog on the Kindle.  Sony has also developed a Digital Book Reader that competes with Kindle.  I came across an interview with Amazon’s Jeff Bezos recently and found his comments on the future of newspapers worth sharing here:

It seems like the new Kindle may deliver something similar to the experience of reading a traditional newspaper with the advantages of electronic delivery.  Electronic delivery could be very attractive for someone who travels frequently.  I will have to reserve judgment on whether the Kindle DX can deliver on this until I read some updated reviews on how newspapers are being delivered and formatted.  I may purchase a Kindle DX as a book reader but I’m probably too set in my ways to part with newsprint until it either becomes prohibitively expensive or discontinued entirely.  Fortunately for those resistant to change, that day will probably not come for some time and Schumpeter’s forces of creative destruction will continue to exert influence with improved e reader technology.

Who knows, perhaps a future e reader will even replicate the cherished experience of having newsprint residue on your hands after finishing the morning paper?

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Artists such as Bruce Springsteen and legislators such as Orrin Hatch, Chuck Schumer and New Jersey Congressman Bill Pascrell have opposed the Ticketmaster / Live Nation merger on the grounds that it would create a near-monopoly in live music event promotion and ticketing. In March, the companies received a “second request” from the DOJ under Hart-Scott-Rodino. Management expects the deal to close in 2H09.

We analyze Ticketmaster, which is owned by David Einhorn's Greenlight Capital, in the upcoming "Superinvestor Issue" of Portfolio Manager's Review.

Read the American Antitrust Institute white paper.

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Pershing Square 2008 Annual Report

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Watch Mohnish Pabrai's lecture.

Thanks to Noise Free Investing for the link.

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Activist investor Bill Ackman's proxy fight against the incumbent directors of Target (TGT) didn't receive a ringing endorsement from Barron's this weekend. Always on the ball, Ackman wasn't slow to respond.

Read the Barron's article.

Read Ackman's response.

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A Wall Street Journal article dated May 23rd contains an interesting nugget about the potential marginalization of regional bank presidents who are members of the Federal Open Market Committee. Some FOMC members, including Richard Fisher of the Dallas Federal Reserve Bank, have criticized Fed Chairman Ben Bernanke's policy of "monetizing the debt," i.e., using electronically printed money to buy Treasury bonds, thereby essentially converting government obligations into dollars in circulation.

Such a policy has obvious inflationary consequences, something Fed officials have been loath to acknowledge. As the above-referenced article explains, there has apparently been some consideration of attempting to exclude officials such as Fisher from membership in the FOMC. Writes the Wall Street Journal's Mary O'Grady:

Voices like Mr. Fisher's can be a problem for the politicians, which may be why recently there have been rumblings in Washington about revoking the automatic FOMC membership that comes with being a regional bank president. Does Mr. Fisher have any thoughts about that?

This is nothing new, he points out, briefly reviewing the history of the political struggle over monetary policy in the U.S. "The reason why the banks were put in the mix by [President Woodrow] Wilson in 1913, the reason it was structured the way it was structured, was so that you could offset the political power of Washington and the money center in New York with the regional banks. They represented Main Street.

"Now we have this great populist fervor and the banks are arguing for Main Street, largely. I have heard these arguments before and studied the history. I am not losing a lot of sleep over it," he says with a defiant Texas twang that I had not previously detected. "I don't think that it'd be the best signal to send to the market right now that you want to totally politicize the process."

When we read stories like this one, it seems only logical that investors have started dumping Treasuries.

Disclosure: Short 30-year Treasury bond futures.

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While there have been countless books written regarding Warren Buffett’s track record in business and investing, along with many books of variable quality seeking to find formulas to replicate his success, there are only two full fledged biographies that have been written:  The Making of an American Capitalist by Roger Lowenstein and The Snowball by Alice Schroeder.

Lowenstein’s book was published in 1995 and I read it shortly after it came out.  Along with reading The Intelligent Investor around the same time, Lowenstein’s work was an inspiration for me to pursue a more careful study of value investing.  Schroeder’s book was published in 2008 after several years of work that included unprecedented access to Buffett’s private papers and circle of business and personal contacts.  I have read The Snowball as well and found it very insightful.  In my opinion, students of Buffett should first read Lowenstein and then proceed to Schroeder.  However, which book should be selected for those who only intend to read one biography on Warren Buffett?

Buffett:  The Making of an American Capitalist

Roger Lowenstein began his study of Warren Buffett in 1991 during the Salomon Brothers rescue and had followed Buffett for years as a Wall Street Journal reporter and shareholder of Berkshire Hathaway.  His book is a comprehensive account of Buffett’s life with an emphasis on aspects of the story that pertain to his development as a businessman and investor.  While there are certainly abundant insights into Buffett’s formative years and personal life, it appears that the author was primarily focused on delivering the insights that a reader of a business book would wish to see covered in detail.

Obviously, due to the publication date of the book, the events of the past 14 years are not included.  However, there is in depth treatment of the critical events of Buffett’s life up to the mid 1990s including his association with Benjamin Graham, his initial investment in Berkshire Hathaway, Buffett’s association with Charlie Munger, Berkshire’s entry into insurance, and much more.  Those who wish to learn more about Buffett’s sense of business ethics will appreciate Lowenstein’s extensive coverage of the Salomon scandal and Buffett’s rescue of the firm.  Overall, Lowenstein’s book is a very well written and concise account of Buffett’s life with an emphasis on his business dealings.

The Snowball:  Warren Buffett and the Business of Life

Alice Schroeder worked as a Wall Street analyst and managing director at Morgan Stanley.  She covered Berkshire Hathaway and impressed Warren Buffett with her insights regarding the company.  Schroeder’s January 1999 report on Berkshire Hathaway pioneered the float based valuation model that many analysts use to estimate Berkshire Hathaway’s intrinsic value.  In contrast with Lowenstein’s access to Warren Buffett (he elected to neither collaborate nor obstruct Lowenstein’s work), Schroeder had extensive access to Warren Buffett himself, his files, and network of business and personal contacts.

The result is a much more extensive portrait of Buffett as an individual, particularly in his formative years.  While Lowenstein only had two relatively brief chapters on the first two decades of Buffett’s life, Schroeder devotes much more space to Buffett’s early years.  The outcome of Schroeder’s greater access to Buffett’s family and friends is a very complete picture of Buffett’s early years.  This alone makes purchasing the book worthwhile.

Schroeder goes on to cover the Buffett Partnership years in great detail, covering much of the same ground that Lowenstein included in his book.  In my opinion, Lowenstein is more concise than Schroeder in terms of describing the Buffett Partnership as well as subsequent business events related to Berkshire Hathaway.  Schroeder clearly interviewed more people and the result is that the book contains more quotations in many areas.  Both approaches have merit.  Suffice it to say that those who are looking for a more streamlined account of these years would favor Lowenstein, while those seeking a more personal account of these years would likely appreciate Schroeder’s detail.

While Lowenstein does include many details of Buffett’s personal life, Schroeder places a much more significant emphasis on topics such as Buffett’s unconventional arrangement in his marriage.  While these topics have some interest from a human interest perspective, I did not really find the details insightful in terms of understanding Buffett’s genius as a businessman and investor.  At times, I felt that the details provided were too extensive.  I suppose that personal preference for such details may cause the reaction of other readers to differ from mine.

Of course, Schroeder’s book benefits from being written in 2008 rather than 1995 and the events of the last 13 years receive significant coverage.  I particularly enjoyed the coverage of Buffett’s 1999 speech at Sun Valley warning about high stock valuations as well as the general coverage of Buffett’s business activities during the current decade.

Which to Choose?

In my opinion, readers would be well served to read both books.  However, if a choice must be made, I would favor Snowball because of the more extensive coverage of Buffett’s youth as well as the coverage of the past decade.  In conjunction with one or both of these biographies, readers should review Buffett’s letters to shareholders either as they were written or by reading Lawrence Cunningham’s The Essays of Warren Buffett which I reviewed last month.

Ravi Nagarajan is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

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Staley Cates, President of Southeastern Asset Management, provided his view on the compensation package of Aubrey McClendon, CEO of Chesapeake Energy (CHK), during an annual presentation of Southeastern on May 7. In light of our recent critique of the scandalous dealings between Chesapeake and McClendon, we believe it is appropriate to bring you the most eloquent argument to the contrary. Says Staley Cates:

"Most recently, like in the last week or so, Chesapeake and Aubrey McClendon are hitting all these compensation lists for highly paid CEOs. There are two big misconceptions in the current discussion around McClendon being number one on that list. First, the payment of 75 million bucks to him is a lump sum allowance towards drilling that applies to the next five years. In other words, it should be viewed as 15 million per year, not 75 million in one year. While in societal terms, of course that’s absurd compared to what teachers make, but it’s less than all of his peers at similar companies like XTO and Devon. But the second point and the most important is the concept of pay for performance. Many of the people in the highly paid list did poor jobs in 2008 and did nothing to de-risk their companies where things, when things were good. By contrast, McClendon made shareholders about 30 billion dollars on three of his big four shale plays. He had paid 4.6 billion for three shale play land positions and last year he sold less than a third of those for 8.6 billion, which implicitly valued what they kept at 25.9 billion. In addition to highlighting 30 billion dollars of value created, these sales brough in a lot of cash to de-risk the balance sheet. Because gas prices plunged in ‘08, his stock did  poorly, then it did even worse when his big margin call took him out. At no point did he endanger the company with his bad personal decision, and he certainly couldn’t control gas prices. Over the long term, his company has built the most per share value of almost any company in the world. So for this, it’s probably okay to pay him industry average, but his Board has framed this poorly, then they made smaller bad decisions on peripheral compensation that muddied the water. The bottom line is this is a fantastic company, he has done a terrific job, and if you were on that comp committee, you would have leaned towards rewarding him handsomely for his 2008 performance."

The argument Cates makes obviously does not change the very significant compensation figures involved, nor does it eliminate the company's unjustifiable purchases of the CEO's art collection, hiring of his catering company, and sponsorship of a sports team in which McClendon has an equity stake.

Nonetheless, Staley Cates makes some good points. We respect Cates's partner Mason Hawkins and believe Hawkins and Cates are the types of investors who pay attention to the quality and compensation of management. If they views McClendon's compensation as appropriate, we are certainly inclined to soften our stance on it.

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On May 7, Mason Hawkins, Staley Cates and other members of the Southeastern Asset Management investment team met with investors in the Longleaf Funds and other accounts managed by Southeastern. The annual presentation has been posted online, and we are pleased to bring you the following links:

Annual Presentation Transcript

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By Ravi Nagarajan.

I was first introduced to the writings of Benjamin Graham shortly after graduating from college with a finance degree in 1995.  I picked up a copy of The Intelligent Investor and found the investment philosophy very compelling and in stark contrast to most of the books I read as part of my finance coursework.

Perhaps because I ended up working in the technology sector for many years and was part of that culture, I did not entirely take value investing to heart during the late 1990s and invested in technology stocks such as Intel that Graham would never have touched.  I felt like a genius when my position in Intel tripled in just a few years, yet I kept coming back to the ideas Graham wrote about in The Intelligent Investor. I eventually came to the conclusion that I was just speculating rather than investing.

Fortunately, during this timeframe, I also read Warren Buffett’s shareholder letters and by early 2000, I liquidated my Intel shares and purchased Berkshire Hathaway stock with the proceeds.  This was not due to any brilliance on my part and entirely due to the insights provided by Buffett and Graham that I finally decided to put into practice.

Security Analysis:  1934 Edition

I am not sure why it took several years for me to decide to read Security Analysis when I should have pursued this right after reading the Intelligent Investor.  In early 2000, I finally decided to read the book and purchased a reproduction of the 1934 edition.  I have to admit that while I found the “Survey and Approach” material in Part I very compelling, I started to get the impression that I was dealing with an outdated book by the time I started reading about fixed income securities and railroad bonds.  In retrospect, it would have been better to read a later edition of Security Analysis that contained Graham’s experience of the full impact of the Great Depression.  I found the book useful but considered The Intelligent Investor to be a far more relevant text for today’s security analyst.

Security Analysis:  Sixth Edition

The Sixth Edition of Security Analysis was published in 2008 and is based on Graham’s Second Edition which was published in 1940.  I have read most of this new edition and the experience is far different from reading the 1934 reproduction.  The editors of the sixth edition have succeeded in keeping the text of Graham’s work completely intact while adding a significant amount of new content that adds context to the book that is very helpful to modern day readers.  The fact that Graham’s own text was written in 1940 rather than 1934 allows the reader to benefit from Graham’s observations throughout the Great Depression period which is invaluable in today’s environment.

The foreword, preface, and introductions to each section add great value as well.  Warren Buffett provides a brief introduction and tribute to Graham’s impact on his own career, while Seth Klarman and James Grant provide the preface and introduction which places the importance of Graham’s work in context for modern readers.  Each of the seven sections of Graham’s text includes an introduction.  I found Roger Lowenstein’s introduction to Part I, Bruce Berkowitz’s comments on Part IV, and Bruce Greenwald’s analysis of Part VI to be particularly insightful, although all of the introductions are well worth careful study.

Graham’s Insights are Relevant Today

Anyone who takes the time to carefully read this book will soon discard the notion that a 75 year old textbook would have little to add to the toolkit of a modern security analyst.  If an investor does nothing more than read Part I, it is highly unlikely that he or she will be susceptible to the pitfalls that could result in a large permanent loss of capital.  Many investors will be surprised to read that Graham would consider much of what they do to be “speculative” based on Chapter 4.  Graham sets a very high bar in terms of what it means to be an investor rather than a speculator.

I found the material in Part VI covering balance sheet analysis particularly useful in my attempts to identify bargain priced securities.  Graham’s concept of purchasing stocks under net current asset value has become a viable activity for the security analyst in the current bear market.  However, it is hardly sufficient to create a computer screen for such securities and to place trades.  One needs to approach the activity with the skeptical eye that Graham would have used to search for hidden pitfalls and other dangers.  I have found that the search for stocks that truly meet Graham’s criteria is a tiny fraction of what comes up in simplistic screens.

Anyone who thinks that the outrageous accounting scandals of recent years are new innovations will realize that there is nothing new under the sun after reading Graham’s account of income statement manipulation in Part V.  Chapter 32 and 33 contain several examples of blatant accounting manipulation that would probably embarrass even the most unrepentant modern day white collar criminal (well, maybe not … these people typically have no shame).  For example, read about Park and Tilford’s accounting in 1929 and 1930 that included such innovations as charging current advertising expenses to goodwill without any disclosure to stockholders in an attempt to inflate reported earnings.  Graham’s advice to examine reported net income in conjunction with a comparative analysis of the balance sheets at the start and end of the reporting period still holds true today.

Timeless Concepts Lightly Followed

Despite the timeless quality of Graham’s insights in Security Analysis and The Intelligent Investor, practitioners who follow this approach are still in the minority today.  Part of this is due to the fact that most investors are ill suited for the profession due to temperament that is overly impacted by the need to obtain peer approval and to see immediate results.  For example, it was considered very cool to own Intel and other technology stocks (particularly dot com stocks) in the late 1990s, and very stodgy and old fashioned to invest in a company like Berkshire Hathaway.  Human nature probably guarantees that investors who are able to follow Graham’s approach will continue to be in the minority in the future as well.

Ravi Nagarajan is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 10:17 AM | Permalink | Comments (0)

Zeke Ashton of Centaur Capital Partners spoke eloquently on the topic of value investing and risk management at the Value Investing Congress in Pasadena earlier this month. We found Zeke’s presentation enlightening and asked him to elaborate on some of his key points.

Last week, we conducted an exclusive interview with Zeke, and it’s our pleasure to bring you a preview here. The full interview will be published in the upcoming issue of Portfolio Manager's Review, the acclaimed monthly investment idea publication of The Manual of Ideas [sample] [subscribe].

Before we proceed to the interview, we should point out that Zeke’s approach to risk management has worked. In 2008, the Centaur Value Fund was down 6.9%, trouncing the 37.1% and 40.0% declines of the S&P 500 and Nasdaq Composite indexes. From inception in August 2002 through the end of 1Q09, the Centaur Value Fund gained 134.6%, net of fees and expenses, versus returns of 15.1% for the Nasdaq Composite and -0.3% for the S&P 500 Index.

MOI: You spoke recently on the topic of value investing and risk management. The “backdrop” was the somewhat surprising fact that a number of prominent value investors suffered debilitating losses in the market collapse of 2008 and early 2009. Adherence to “margin of safety” principles apparently didn’t help. Why?

Zeke Ashton: I think that is a very good question, and I don’t think there is any one easy answer. Part of it was simply because very few investors were prepared for such an extreme negative scenario as the one that ultimately played out. I know we didn’t foresee things deteriorating as much as they did. What transpired in late 2008 and early 2009 was so far outside of the range of experience for most people that it didn’t seem like a plausible scenario twelve months before. With perfect 20/20 hindsight, of course, it is easy to see the warning signs that were present, but most investors simply continued to do the things which had rewarded them in the past, not knowing that this time might be different.

We and many other value investors have historically been rewarded for buying in times of fear and uncertainty, as well as for purchasing stocks that were cheap relative to asset values or normalized earnings power. However, in 2008 it wasn’t enough to buy stocks that looked cheap based on low multiples to book value or normalized earnings. Many companies, particularly in the financial sector, won’t get the chance to recover to normalized earnings because they got wiped out or were forced to dilute their shareholders to the extent that the losses are effectively permanent. In the end, it appears to me that when faced with an extreme environment like 2008 and early 2009, there are really only two things that can save you: the luck or skill to see it coming and get out of the way, or a portfolio structure and risk management approach that is specifically designed to promote survival in a catastrophic scenario that you didn’t see coming. I feel very fortunate that we had a portfolio that was able to take some hits and survive to play another day.

MOI: How do you generate investment ideas?

Zeke Ashton: We get ideas from all sorts of places. We used to get a sizable number of leads from statistical screening, and we still use screens, but we have found them in recent years to be more productive in sourcing short ideas rather than long ideas. Nevertheless, we still scan through lists of stocks that appear to be cheap from a statistical basis and occasionally we find a good one.

One of our major idea sources these days is from the inventory of the many ideas we’ve owned or researched at some point in the past – many times, after we’ve sold those stocks, the price will come back down to a level that makes them very interesting again. Since we generally already know the company, it is just a matter of getting quickly up to speed with the latest developments to determine if it is actionable.

We also find occasional ideas by doing industry overviews to get to know a number of players in a specific sector or niche that we think may be out of favor or neglected for some reason. Often we will find a gem or two.

Finally, we get some ideas through our network of value investing contacts, and through a number of specialized research publications that we have found are compatible with our approach, of which your own publication would be one example.

But no matter the source, the ideas are merely candidates until we’ve actually produced a piece of internal research that covers the bases and gives us confidence that we understand the business, can reasonably value it and also gauge the risks factors involved.  And of course, the stock has to be cheap.

MOI: What books have you read in recent years that have stood out as valuable additions to your investment library?

Zeke Ashton: In my opinion, the most important investing book to come along in many years has been Fooling Some of the People All of the Time by David Einhorn. In writing a story about a “garden variety fraud” at a company called Allied Capital and his efforts to expose it, this book sheds a lot of light on the ugly realities of our financial regulatory system and how that system has become so terribly dysfunctional. The system is particularly unjust to short sellers who do the difficult and thankless work of uncovering fraud or excess risk at publicly traded companies. To those who wonder how a fraud on the scale of that perpetuated by Bernie Madoff could have gone undetected for so long, this book provides some answers. As an aside, it took a lot of courage for Mr. Einhorn to continue his struggle against Allied Capital and to publish this book, as the personal risks to his business and reputation were very real. For that, he has my respect and admiration.

The investing book I read most recently was More Mortgage Meltdown by Whitney Tilson and Glenn Tongue of T2 Partners. The book is a very readable and accessible discussion of how the mortgage crisis happened, and more importantly, offers some very good perspective on how the credit crisis may develop from here. In addition, there are a number of timely investment ideas presented in the form of detailed case studies that will be valuable for both beginner and advanced investors. I should disclose that Whitney and Glenn are friends of mine and that my firm manages the Tilson Dividend Fund through a joint venture with T2 Partners. So while I am no doubt a bit biased, I enjoyed the book and found it very stimulating food for thought.

MOI: You have stated that top-down risk management policies “can make the difference between survival and failure in a year like 2008.” What do those top-down policies look like at Centaur? What factors would cause them to differ from one investment manager to the next?

Zeke Ashton: Well, first of all I want to be clear...

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Posted by manualofideas at 12:01 AM | Permalink | Comments (0)

We are pleased to bring you a FREE excerpt from 10x45 Bargain Hunter, the bi-weekly stock screening report of The Manual of Ideas. Each issue of 10x45 Bargain Hunter contains 10 stock screens showing 45 companies each. The report is based on screening techniques utilized by value-oriented investors. Annual subscription rate: $99 (26 issues).

Sample Stock Screen: Value with Catalyst: Cheap Repurchasers of Stock

Click here to download the screen results in PDF format.

View this stock screen in PDF format.

Learn more about 10x45 Bargain Hunter.

Posted by manualofideas at 08:21 PM | Permalink | Comments (0)

A truly amazing letter by the Chesapeake Energy (CHK) general counsel ("GC") is making the rounds among investors concerned with public companies' corporate governance practices. While we have not followed CHK's corporate actions to date, the above-linked letter caught our attention.

In the letter, CHK's GC attempts to justify paying a $75 million bonus to CEO Aubrey McClendon in 2008, a year in which Chesapeake's stock price declined by 5.9%. Actually, we stand corrected: the price dropped by an order of magnitude more -- it finished 2008 down an impressive 59%. Mr. McClendon's total compensation during such a notable year? 100 million sixty-nine thousand two hundred and one U.S. dollar (see it for yourself in CHK's proxy statement).

As if the compensation issue was not sufficient, the GC felt it necessary to justify another use of corporate funds as follows:

"In December 2008, the Company purchased an extensive collection of antique historical maps of the American Southwest from [CEO] Aubrey [McClendon] for $12.1 million, which represented his cost. The collection includes over 500 museum quality pieces. A dealer who had assisted Aubrey in acquiring this collection over a period of six years advised the Company that the replacement value of the collection in December 2008 exceeded the purchase price by more than $8 million. The maps have been displayed at the Company's Oklahoma City headquarters for a number of years, during which the  Company has been insuring the maps in exchange for their display."

We are relieved that they bought "museum quality" pieces. Anything less would have been a waste of shareholder funds.

Least but not last, the GC explains another use of corporate funds as follows:

"In 2008, the Company paid Deep Fork Catering approximately $177,000 for food and beverage catering services, primarily for two large events sponsored by the Company. Deep Fork Catering is an affiliate of the Deep Fork Grill, an Oklahoma City restaurant in which [CEO] Aubrey [McClendon] is a 49.7% owner. Aubrey is not involved in decisions to hire Deep Fork Catering and has requested that the Company’s future use of Deep Fork Catering be limited."

How could anyone think that McClendon might be "involved" in hiring his own catering company? Don't these ignorant shareholders know that there are only a handful of catering companies around in Oklahoma City? Besides, isn't it reassuring that McClendon wants future hirings to be "limited"? They will surely not exceed CHK's cash balance and borrowing capacity, so what's the big deal?

Last but not least, the GC indulges shareholders with another wholly unnecessary explanation of a surely optimal use of shareholder funds:

"In 2008, the Company became a founding sponsor of the Oklahoma City Thunder, a National Basketball Association franchise owned and operated by The Professional Basketball Club, LLC ("PBC"). [CEO] Aubrey [McClendon] has a 19.2% equity interest in and is a non-management member of the PBC. The Company paid $3.5 million in 2008 and $1.2 million in 2009 pursuant to its sponsorship agreement for the Thunder’s 2008-2009 season. As a founding sponsor, the Company received valuable
television and radio advertising for local broadcasts of Thunder games, arena advertising space, advertising in game-day programs and on the team website, team participation in a Company-sponsored community event, game tickets and use of an arena suite. Our sponsorship level is consistent with that of other major employers in Oklahoma City, some of which also have ownership ties to the franchise. In addition to the advertising and promotional activities related to its sponsorship of the Thunder, the Company believes the sponsorship provides valuable support to the local community and contributes to employee morale."

We don't doubt for a second that it contributes to the morale of at least one employee. Go Aubrey!

Disclosure: No position (you seem surprised).

Posted by manualofideas at 12:15 AM | Permalink | Comments (0)

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The Milken Institute hosted a conference on credit markets on April 27-29. View a 71-minute video of a discussion hosted by former "junk bond king" Michael Milken. The Milken Institute described the event as follows:

Moderator Michael Milken convened this timely panel before a packed house, exploring the current crisis in the credit markets and a host of possible solutions to solve it.

David Malpass of Encima Global opened with a basic rundown of the importance of credit as the underpinning of any healthy economy, stressing the importance of proper valuations and accurate ratings. Without well-functioning credit markets and proper credit allocation, he warned, expansion will be limited.

According to James Walker of Fir Tree Partners, the core of the crisis came from off-balance-sheet securitizations in mortgages; cars and credit cards; and securitization of securitization (i.e., CDOs). This securitization phenomenon was driven over the past 15 years by a combination of financial institutions, investment management firms and rating agencies with little skin in the game operating under misaligned incentives to generate fees rather than execute accurate, well-considered analysis. Through this process, Walker said, these asset managers essentially became "asset gatherers," and the world became a global casino with governments acting as the house and taxpayers taking the losses.

Milken turned the discussion to the question of ratings, pointing out that almost 17,000 instruments received AAA ratings in 2007, while today we only have four U.S. companies holding that distinction. He noted that much of the exuberance in ratings was driven by analysts' over-reliance on historical asset appreciation, pointing out that schools typically teach students backward-looking regression analysis as a way of charting the future. The flaw in this model is that raters really need a realistic grasp of future dynamics to understand where things are headed. "The past can't pay you interest," Milken remarked.

Echoing points raised by Milken and the other panelists, Stephen Nesbitt of Cliffwater noted that many institutional investors were hurt because they looked to the past and trusted the ratings firms to provide realistic evaluations of risk. Over the past 35 years, credit has been a bad deal for these investors, Nesbitt said, pointing out that Treasuries actually would have provided a better return. He cautioned that just because an instrument has a high rating or good spread doesn't mean it's attractive. Milken summarized these points by noting the importance of looking at "facts rather than perception."

To round out the discussion, Milken challenged the panelists to focus on solutions. Walker said the key lies in the equitization of debt, otherwise known as deleveraging. Currently there is just too much debt out there at the institutional, corporate and consumer level. To remedy this, Walker proposed banks build tangible common equity and deleverage through asset sales. Corporations must swap debt for equity, pursue secondary equity offerings and enter bankruptcy if necessary. Finally, Walker argued that consumers need to similarly raise their savings rate, restructure debt and enter bankruptcy if needed.

Stephen Tananbaum of GoldenTree offered his thoughts, focusing primarily on the corporate side since he feels it’s easier to change the balance sheet for corporations than consumers, at least in the near term. He spoke of his experience in working with distressed firms, noting that companies are generally receptive when approached with a reasonable offer. He also made the point that the market may be willing to value debt equity at a higher price.

Milken seized on this last point, noting that in good times, a firm's value will likely go up when it takes on debt. In the current environment, however, enterprise value may actually go up when equity is swapped for debt.

View a video of the event.

Posted by manualofideas at 10:23 PM | Permalink | Comments (0)

Bill Miller prominently underperformed the market last year by betting big on financials just before they collapsed. As of March 31, the largest holdings of Miller's Legg Mason Value Trust included AES Corp. (AES) (6.3%), Aetna Inc. (AET) (5.8%), UnitedHealth Group Inc. (UNH) (5.1%), eBay Inc. (EBAY) (4.3%), Yahoo Inc. (YHOO) (4.2%), CA Inc. (CA) (4.1%), Sears Holdings Corp. (SHLD) (4.0%), Amazon.com Inc. (AMZN) (4.0%), Cisco Systems Inc. (CSCO) (3.9%), and IBM Corp. (IBM) (3.9%).

Miller continues his bullishness on select financial stocks and appears to suggest that the recent market rally could be the beginning of a new bull market. Writes Miller in his Q1 letter,

The rally that began following the March 6th bottom at 666 on the S&P 500 has had a different character from those embedded in the bear market that began with the credit disruptions of August 2007. Whether it is the beginning of a new bull market, which it will be if the economy begins a sustainable period of growth later this year, or if it is just a solid rally in an ongoing bear market, which appears to be the overwhelming consensus, is of course unknown at this point.

If it is a bear market rally, it is one we have not seen since the late 1930s. Its behavior is much more like the rally that ended the 1973-1974 bear market, or the one that began off the bottom in 1982, or even that which erupted in March 2003 from the last debt deflation scare. It has been longer and broader off the bottom, with fewer chances to get in, than the bear market rallies that characterized the post-war period. We have had six straight weeks of gains (seven for the NASDAQ), whereas the most we could muster in 2008 was three weeks of gains.

This move has been led by the classic early cyclicals: financials, housing, and consumer discretionary names such as retailers and restaurants - an encouraging sign that may be signaling the end of the long period of economic decline that began in December 2007. Another hopeful note is the strength of stocks in emerging markets, which are highly sensitive to incremental economic growth. China is up over 30 percent this year, Korea over 20 percent, India 17 percent, and most other Asian markets are higher by double digits on the year. In the Americas, Brazil and Venezuela are up over 20 percent, Chile and Argentina are up double digits, Canada is up 6 percent, as is the NASDAQ in the U.S.

The breadth of the rally globally is a good sign. The S&P 500 is still down 4 percent, and the Dow Jones Industrial Average is down almost 8 percent, but it will be hard for them to remain down if most other global markets are able to hold their gains. This global bear market and financial crisis have shown how interconnected and correlated the world’s economies and asset values are: Just as decoupling was wrong on the downside, it almost certainly will prove to be wrong on the upside.

As much as we'd like to agree with Bill Miller, his commentary may reflect wishful thinking as much as reality. Comparing the recent up-move in the stock market to historical rallies has almost zero predictive value, in our view. What matters is whether the economy is on a sustainable upswing. We have not seen convincing evidence to this effect, leaving us skeptical that the bear market is over.

Don't get us wrong. We invest for the long term and don't try to time the market. As such, we are betting that Bill Miller will be right -- eventually. However, if Miller is picking investments with the view that the recent rally will continue unabated in the short term, he may be in for another rude awakening. In our view, investors should choose companies that will do well even if the bear market continues for quite some time to come.

Read Bill Miller's Q1 letter.

Posted by manualofideas at 09:40 PM | Permalink | Comments (0)

Mason Hawkins' commentary is always a worthwhile read, and it is no different this quarter. Writes Hawkins,

Never in our investing careers has the obsession with macro economic trends so overwhelmed the interest in fundamental analysis. People ask about our forecasts on interest rates, economic growth, inflation, currencies, government debt, geopolitical events, commodity prices, and the stock market. Our answers surely disappoint because we tell them we offer no unique clairvoyance that has a high probability of being useful. When we discuss the characteristics of the businesses we own, something we can talk about with a degree of certainty, many lose interest. Market commentators’ remarks often imply that the old-fashioned approach of buying and holding individual undervalued securities as a protection against future events is not only antiquated but worthless in this environment. Because macro events indeed dominated returns in all asset classes in 2008, people illogically are extrapolating that macro events will exclusively dictate all future performance.

Read the Longleaf Q1 letter.

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Read an article

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The inaugural issue of Watheeqa Investment Journal

Posted by manualofideas at 08:32 PM | Permalink | Comments (0)

Inoculated Investor recently posted an interesting analysis of Movado Group (MOV), a public company that owns a number of recognized consumer brands. The company has a solid balance sheet and trades well below book value.

Posted by manualofideas at 07:44 PM | Permalink | Comments (0)

FDIC chair Sheila Baer explains the FDIC's process for seizing failed banks in an interview with 60 Minutes.

Posted by manualofideas at 07:24 PM | Permalink | Comments (0)

Download the video in WMV format.

Posted by manualofideas at 07:05 PM | Permalink | Comments (0)

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Microsoft co-founder Bill Gates recommends the following books:

• Showing Up For Life, by Bill Gates Sr. ("he did a great job on it," said Bill Gates on May 4, 2009)
• Word Hard. Be Nice., by Jay Mathews ("fantastic," says Bill Gates)
• Direct from Dell, by Michael Dell (says Gates, "I've long admired Dell's pioneering use of the World Wide Web. In Direct from Dell, you'll find strategies for using the Web to enhance your sales and empower information throughout your business. If you want to capitalize on cyberspace, you should read this book.")
• My Years with General Motors, by Alfred Sloan
  
• Shipping News, by Annie Proulx
• The Blind Watchmaker, by Richard Dawkins
• The Gospel of Wealth, by Andrew Carnegie
  
• The Language Instinct, by Steven Pinker
  

• Business @ the Speed of Thought, by Bill Gates

Books about Bill Gates:

• Creative Capitalism, by Conor Clarke
• Hard Drive, by James Wallace
• Bill Gates (Up Close), by Mark Aronson
  

Speech in which Bill Gates recommended Word Hard. Be Nice.:

Posted by manualofideas at 03:06 PM | Permalink | Comments (0)

Warren Buffett has done a great job educating Berkshire Hathaway investors about the art and craft of investing over the past several decades. Here are some of the books he has recommended:

• Poor Charlie's Almanack: The Wisdom and Wit of Charles T. Munger -- said Buffett on May 4, 2009: "it's got all kinds of wisdom in it"
• Katharine Graham's autobiography -- said Buffett on May 4, 2009: "you'll learn a lot"
• Common Stocks and Uncommon Profits, by Phil Fisher (said Buffett: "I highly recommend his books, especially the early ones")
• John Bogle on Investing: The First 50 Years, by John Bogle (said Buffett, "Any investor who owns or is thinking of owning shares in a fund should read this book cover to cover.")
• Sam Walton: Made in America, by Sam Walton (Buffett recommended it in 2003)
  
• The Essays of Warren Buffett, by Warren Buffett, edited by Larry Cunningham (said Buffett: "The most representative book on my thinking is what Larry Cunningham put together.")
• The Intelligent Investor, by Ben Graham (said Buffett, "the most important investment book, especially chapters 8 and 20")
• The Smartest Guys in the Room, by Bethany McLean (recommended by Buffett in 2003 annual letter)
• Showing Up for Life: Thoughts on the Gifts of a Lifetime, by Bill Gates Sr. (said Buffett in 2009, "Bill Senior is as wise as his son is brilliant. I’ve learned a lot from both of them and believe everyone can benefit from the insights Bill Senior shares in this book.")
  

Posted by manualofideas at 03:00 PM | Permalink | Comments (0)

Berkshire Hathaway Vice-Chairman Charlie Munger has recommended the following books on various occasions:

• Outliers, by Malcolm Gladwell -- said Munger on May 4, 2009: "terrific" and "perfectly marvelous book"; Gladwell "has collected a lot of interesting facts and drawn a lot of interesting conclusions"; watch recommendation -- starts at 3:40
• A Matter of Degrees, by Gino Segre
  
• Benjamin Franklin, by Carl van Doren
• Darwin's Blind Spot, by Frank Ryan
• Genome, by Matt Ridley
  
• Guns, Germs, and Steel, by Jared Diamond
• How the Scots Invented the Modern World, by Arthur Herman
  
• Influence, by Robert Cialdini
• Living within Limits, by Garrett Hardin
• Poor Charlie's Almanack, by Peter Kaufman
  
• The Selfish Gene, by Richard Dawkins
• The Third Chimpanzee, by Jared Diamond
  

Posted by manualofideas at 02:54 PM | Permalink | Comments (0)

Charlie Munger, vice chairman of Berkshire Hathaway and founder of law firm Munger, Tolles & Olson, recently interviewed with Stanford Lawyer Magazine. Highlights:

SL: As we look at the current situation, how much of the responsibility would you lay at the feet of the accounting profession?

Munger: I would argue that a majority of the horrors we face would not have happened if the accounting profession developed and enforced better accounting. They are way too liberal in providing the kind of accounting the financial promoters want. They’ve sold out, and they do not even realize that they’ve sold out.

SL: Would you give an example of a particular accounting practice you find problematic?

Munger: Take derivative trading with mark-to-market accounting, which degenerates into mark-to-model. Two firms make a big derivative trade and the accountants on both sides show a large profit from the same trade.

SL: You and your partner, Warren Buffett, have for years warned about the dangers of the modern derivatives markets, particularly credit derivatives, and about interest rate swaps, currency swaps, and equity swaps.

Munger: Interest rate swaps have enormous dangers given their size and the accounting that has been allowed. But credit default derivatives took that danger to new levels of excess—from something
that was already gross and wrong. In the ’20s we had the “bucket shop.” The term bucket shop was a term of derision, because it described a gambling parlor. The bucket shop didn’t buy any securities. It just enabled people to make bets against the house and the house furnished little statements of how the bets came out. It was like the off-track betting system.

SL: Until the house lost its money and suddenly disappeared. Or the house made its money and suddenly disappeared.

Munger: That is right. Derivatives trading, with no central clearing, brought back the bucket shop, because you could make bets without having any interest in the basic security, and people did make such bets in the billions and billions of dollars. Some of the most admired people in finance—including Alan Greenspan—argued that derivatives trading, substituting for the old bucket shop, was a great contribution to modern economic civilization. There’s another word for this: bonkers. It is not a credit to academic economics that Greenspan’s view was so common.

SL: The Federal Reserve is today buying assets that it wouldn’t have even considered looking at a year ago.

Munger: I think the problem is so extreme that nothing non-extreme has any chance of working. I like the fact that it is so willing to do things that have never been done before, because we have problems that we have never seen before. I am a right-wing Republican, and I like the fact that Obama has put into the White House Larry Summers, who is a ferociously smart human being and will try to do the right thing even if it offends some people. I think that’s a quality that we need right now.

SL: How and why do you think economists have gotten this so wrong?

Munger: I would argue that the economists have not been all that good at working concepts of good and evil into their profession. Nor do they understand, at all well, the economic consequences of bad accounting.

SL: In fact, they’ve made a profession of driving value judgments out of the subject.

Munger: Yes. They say it’s not economics if you think about the consequences of good and evil, and good and bad business accounting. I think what we’re learning is that when you don’t understand these consequences, you don’t have an adequately skilled profession. You have big gaps in what you need. You have a profession that’s like the man that Nietzsche ridiculed because he had a lame leg and was very proud of it. The economics profession has been proud of its lame leg.

Read the entire interview, including Munger's views on President Obama, investment mistakes, and China. Watch an excerpt of the interview.

(Thanks to David Lau for bringing the above interview to our attention.)

Posted by manualofideas at 09:20 AM | Permalink | Comments (0)

David Brooks recently wrote an interesting op-ed in the New York Times entitled, Genius - The Modern View. (Thanks to David Lau for bringing it to our attention.)

Writes Brooks,

Some people live in romantic ages. They tend to believe that genius is the product of a divine spark. They believe that there have been, throughout the ages, certain paragons of greatness — Dante, Mozart, Einstein — whose talents far exceeded normal comprehension, who had an other-worldly access to transcendent truth, and who are best approached with reverential awe.

We, of course, live in a scientific age, and modern research pierces hocus-pocus. In the view that is now dominant, even Mozart’s early abilities were not the product of some innate spiritual gift. His early compositions were nothing special. They were pastiches of other people’s work. Mozart was a good musician at an early age, but he would not stand out among today’s top child-performers.

What Mozart had, we now believe, was the same thing Tiger Woods had — the ability to focus for long periods of time and a father intent on improving his skills. Mozart played a lot of piano at a very young age, so he got his 10,000 hours of practice in early and then he built from there.

The latest research suggests a more prosaic, democratic, even puritanical view of the world. The key factor separating geniuses from the merely accomplished is not a divine spark. It’s not I.Q., a generally bad predictor of success, even in realms like chess. Instead, it’s deliberate practice. Top performers spend more hours (many more hours) rigorously practicing their craft.

Read the full article.

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Download Bill Ackman's presentation on Target, dated May 11th.

Watch video of Bill Ackman presenting his ideas on Target.

Posted by manualofideas at 05:18 PM | Permalink | Comments (0)

Randolph B. Cohen of Harvard Business School, Christopher K. Polk of the London School of Economics and Bernhard Silli recently published a paper entitled, Best Ideas. Here is the abstract:

We examine the performance of stocks that represent managers' "Best Ideas." We find that the stock that active managers display the most conviction towards ex-ante, outperforms the market, as well as the other stocks in those managers' portfolios, by approximately one to four percent per quarter depending on the benchmark employed. The results for managers' other high-conviction investments (e.g. top five stocks) are also strong. The other stocks managers hold do not exhibit significant outperformance. This leads us to two conclusions. First, the U.S. stock market does not appear to be efficiently priced, since even the typical active mutual fund manager is able to identify stocks that outperform by economically and statistically large amounts. Second, consistent with the view of Berk and Green (2004), the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers. We argue that investors would benefit if managers held more concentrated portfolios.

Download the paper entitled Best Ideas.

Posted by manualofideas at 01:09 PM | Permalink | Comments (0)

By Nadav Manham

In January I linked to a WSJ interview with David Swensen in which he attacked hedge funds of funds.  Here is the relevant excerpt:

In last Monday's FT, Paul Isaac, the CIO of fund of funds company Cadogan Management, answered Swensen's accusations.  Cadogan has a good track record, and a reputation for being a "non-mainstream" FoF company, down to its choice of office location near the Flatiron building.  When the Madoff news hit, Cadogan put out a statement that it had successfully avoided any exposure, something many of its peers did not do (avoid exposure I mean, not put out a release). Isaac spoke at the 2003 Grant's Spring Conference, so he is a legitimate spokesman for his industry, not just any geek off the street.

Go read the Swensen interview, then read Isaac's rebuttal, then come back and we're going to have a little trial, with moi as judge and jury.  I used to evaluate litigation for a living (actually I was the guy who helped the guy who evaluated litigation for a living) so I'm a trained professional at this, sort of.

Oh, I almost forgot: I went to Yale and am a proud alumnus, consider Swensen my manager selector role model, and, um, I interviewed at Cadogan once, with an emphasis on the "once."  So think of me as the uglier version of this guy.  If this were any state except New Jersey, I'd no doubt have to recuse myself from this trial.  Fortunately, I happen to be from New Jersey.   So let's begin:

First let's summarize Swensen's case against funds of funds.  FoFs are a cancer because :

1)  They facilitate the flow of ignorant capital, as unsophisticated investors who can't pick managers themselves cannot pick manager selectors either.

2)  They charge an extra layer of fees and deliver nothing in return for it.

3)  Fund of fund money is unreliable, therefore the best hedge fund managers don't want it, and you can't be successful investing in hedge funds unless you invest in the best.

Issac does not address these assertions in order.  Instead his first rebuttal one is a clever one:

Yes, but . . . we need first to define our terms (it's remarkable how many legal battles turn on differing definitions of a single term).  Per Isaac, a fund of funds is simply a pool of capital that maintains a staff to research, vet, select and monitor investments in a number of hedge funds.  By that definition, Yale's endowment is a fund of funds, as is Cadogan, as is a family office that invests in a number of hedge funds, etc. 

But is Isaac's definition of a "fund of funds" the same as Swensen's?  No it is not.  Let's go to Swensen's own words on the subject, from pages 309-310 of the new edition of Pioneering Portfolio Management. This section of the book is called "USE OF INTERMEDIARIES," and the relevant excerpt is as follows (my emphasis added):

Isaac's definition of a fund of funds turns on WHAT it does.  Swensen's definition turns on FOR WHOM and WHY it does it.  Per Swensen, a FoF is defined by its role as agent, a paid intermediary that performs a task (manager selection) on behalf of a principal (an investment fiduciary) who is unwilling or unable to do it by itself.  By Swensen's definition, Yale's endowment is not a fund of funds, as Yale performs manager selection entirely in-house, without the use of any agents, and commits substantial time, energy and resources to do so.  Cadogan, on the other hand, most certainly is.  When you and I and the world think of what a fund of funds is, we think of the Swensen definition, not the Isaac definition.  All of Swensen's problems with FoFs stem from his (and our) definition of it as an agent, so Isaac creates a straw man by creating his own definition.  

Round 1 to Swensen.

Isaac's next argument is that hedge funds of funds can add substantial value to their end-clients:

Those "remarkable" numbers certainly sing a seductive siren song, don't they?  But tie yourself to the mast and let your consigliere set you right:

1)  Isaac's second sentence is a non-sequitur.  Extrapolating from Swensen's common-sense definition, a fund of funds adds value not by outperforming equity markets via investment in hedge funds.  A fund of funds adds value by outperforming (after fees) what a fiduciary could do on its own by investing in hedge funds directly.  Isaac is arguing the wrong thing. 

2)  Isaac errs by invoking an INDEX of FoFs to justify the ACTIVE investment fund of funds industry.  That such a thing as the HFRI Composite FoHF Index even exists is strong evidence that it's possible for a fiduciary to construct a hedge fund portfolio WITHOUT having to pay an intermediary a lot of money to do it for you, and belies Isaac's claim that "index investments in alpha generating strategies are in their infancy and have yet to prove themselves".  Just do your best to replicate the index.  You won't do it perfectly, but you don't have to in order to benefit from saving 1 and 10.  What Isaac should have argued is that there are many funds of funds like Cadogan that add value by exceeding the performance of the index.  That he did not is telling.  That Yale does (see page 23 of the pdf, aka page 21 of the report) is also telling.

Round 2 to Swensen.

Isaac's next two arguments concern Madoff.  Here is the first one:

I believe the legal term for this argument is "WTF?"  Given what they charged and their purported expertise, the correct number of funds of funds that should have invested in Madoff is precisely zero.  The correct number of "quality" funds of funds should have been less than zero--they should have led the fight to unmask him.  The actual number was way higher than zero, AND included some of the leading names in the industry (Bramdean, Fairfield Greenwich, Maxam, UBP, EIM, Merkin, etc.). I can't see how the fund of funds industry distinguished itself in the Madoff affair.  I can only see the opposite.

Round 3 to Swensen. 

Here is the second Madoff-related argument:

Several things come to mind when I consider this argument.  I could, for instance, recall how many Jewish/Chinese/Armenian/etc. tax collectors died at the hands of angry peasants while providing a layer of protection for the reputation for the rulers who were reluctant to put themselves in the spotlight by collecting taxes directly.  I could even point out how the Pharisees of Judaea were an important tool for their Roman overlords who could not afford to put themselves in the spotlight and required a layer of protection for their reputations when it came to dealing with a certain itinerant rabble rouser.  But I won't, because I'm not an expert in those subjects and am sure to say something incorrect.  It will suffice simply to point out that you should always look through, and that the imposition of a middleman does not absolve an investor of any of its fiduciary or ethical obligations. 

Round 4 to Swensen.

How does Isaac respond to Swensen's assertion that FoFs represent unreliable capital, and that therefore the best hedge fund managers shun them?  He responds as follows:

There is no common definition of a “best” hedge fund. Certainly, more than 10 per cent of all managers can be potential parts of a given portfolio when the goal, and not just the components, define the objective. The ability to substitute managers, rather than being wedded to an underlying manager, can be useful for FoHF managers seeking to represent their investors’ interests.

Isaac is correct that FoF managers should be judged on their portfolios as a whole rather on the the performance of their component parts, and that theoretically it's possible for a hedge fund portfolio that consists of less-than-top-decile funds to combine in such a way as to produce an attractive portfolio return.  But the combination of the typical 2 and 20 charged by the underlying hedge fund, and the typical 1 and 20 charged by the FoF, makes it almost impossible for the end user to get a value-added product unless both layers are in the top tier of what they do.

Round 5 is a tie.

Regarding Swensen's assertion that fund of funds fees are unjustified, Isaac correctly points out that "the fees charges by FoHF's vary," and that "They key is to find value for fees paid."  I believe Swensen would reply that empirically, most FoFs fail to provide value for money.  2008 is good evidence for that.  It's hard enough to beat the market via direct active investing; doing it via an extra layer of fees is even harder.  Also, it's generally true that the lower the fee charged by a FoF, the more closely it resembles one of the "index investments in alpha generating strategies" that Isaac derides.

Round 6 goes to Swensen on points.

Finally, as the recipient of a Jesuit education (thank you Dr. Stewart!), as the descendant of a distinguished family of talmudic scholars, as a former copy editor, and as an admirer of George Orwell, I must point out this example of Mr. Isaac's tortured language:

Strip out all the double negatives and you'll find that Isaac meant the opposite of what is written, i.e. the idea that only Mr. Swensen should invest in active vehicles is condescending and limiting.  Giving Isaac the benefit of the doubt that the sentence was just a typo, it still misstates Swensen's position.  Swensen's position is that those who wish to invest in active vehicles should not hire agents to do so on their behalf, but rather must devote the time, energy and resources to do it themselves.  Be a principal, not an agent.

Final round to Swensen. 

Overall verdict: David Swensen.  Go Bulldogs.

P.S.  In a future post I hope to play devil's advocate regarding Swensen and his record.  Is it really as good as his drooling idolators (I'm wiping my mouth as I write) assume?  Stay tuned.

The author of this post is Nadav Manham, president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

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By Ravi Nagarajan

Berkshire Hathaway reported results for the first quarter following the close of trading today.  While Berkshire reported a loss in terms of GAAP net income for the quarter, the underlying results for the operating business are actually quite solid given the global economic recession.  Berkshire’s operating earnings per share declined 11.8% to $1,100 per A Share, down from $1,247 in the first quarter of 2008.  Net earnings per share were recorded as a loss of $900 per A Share compared to profits of $607 per A Share in the first quarter of 2008.

Since the “headline numbers” reflected in GAAP net income fail to adequately describe the underlying health of the operating businesses, let’s take a closer look at Berkshire’s results for the quarter.

“Headline Numbers” Are Misleading

Berkshire reports operating earnings each quarter in addition to the GAAP presentation of net earnings.  This is done in order to allow investors to focus on the underlying health of the operating companies without regard to the timing of realized gains and losses as well as the impact of mark to market accounting on Berkshire’s derivatives positions.  By providing operating earnings, Berkshire is not trying to suggest that investment gains and losses are not relevant to Berkshire’s intrinsic value.  Although long term investment gains and losses are relevant, the timing of these gains and losses during a specific accounting period holds no special meaning and management does not attempt to “time” the realization of gains and losses to manage earnings.

Investments and Derivatives Gains and Losses

Berkshire’s Q1 net earnings includes capital losses of $241 million as well as mark to market losses on derivatives positions of $986 million.  I have previously explained why I disregard the mark to market changes for the derivatives positions due to the long term nature of the derivatives as well as the fact that the equity put derivatives are “European options” which cannot be exercised until the expiration date.  The credit default positions, however, appear to be seriously impaired based on Buffett’s comments at the annual meeting and information in the 10Q report.  The credit default positions account for the majority of the mark to market loss in Q1.

ConocoPhillips Impairment

Normally, an equity investment such as ConocoPhillips would not impact earnings until the position is disposed of through a sale.  However, accounting rules have forced Berkshire to take a $2,012 million hit to GAAP net earnings in Q1 because the company has indicated that the position is likely to be sold at a price below original cost.  From the press release that accompanied the 10Q, it appears that Berkshire intends to use the losses on the Conoco position to offset realized capital gains in prior tax years, thereby obtaining a tax benefit.  The company intends to recover approximately $690 million in federal capital gains taxes paid in 2006 by realizing losses on Conoco.

As Buffett has admitted, the ConocoPhillips investment last year has turned out to be a serious mistake.  The position was acquired at a time when oil prices were near record highs.  The majority of the loss on the position was already reflected in Berkshire’s book value as of December 31, 2008, so the fact that the loss is now being realized as an impairment does not imply a further hit to book value.  While the loss itself is obviously real, the accounting treatment of the loss is arbitrarily causing GAAP net income to show the loss this quarter.  Had Berkshire not declared an intent to liquidate the position for tax reasons, the portion of the Conoco position that was not sold during the quarter would have remained an unrealized loss and would not have impacted net income for the quarter.

Insurance Business Posts Solid Results

Berkshire’s insurance businesses posted solid results for the first quarter.  In aggregate, net underwriting profits increased to $219 million from $181 million in the first quarter of 2008.  GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group all posted underwriting gains while General Re posted a small underwriting loss.  Although GEICO posted lower underwriting profits compared to the prior year, the number of in force policies increased by 430,000 over the course of the quarter as customers switched to GEICO to save money during the recession.  It appears that GEICO’s advertising expenditures have registered with consumers eager to save some money on a non discretionary purchase.

Net investment income increased by 28.8% to $1,033 million compared to $802 million in the first quarter of 2008.  These results reflect earnings from Berkshire’s large investments in Goldman Sachs, General Electric, and Wrigley in Q4.  These investments, and other smaller investments initiated on similar terms in recent months should bring in approximately $2 billion per annum which is far higher than the returns on the cash that Berkshire was holding previously.

Utilities and Energy

MidAmerican posted net earnings attributable to Berkshire of $203 million for the quarter.  This is a 35.8% decline in reported income compared to the $316 million reported in the first quarter of 2008.  However, Berkshire booked a $56 billion pretax loss associated with the Constellation Energy common stock investment and a $125 million noncash stock based compensation charge in connection with Berkshire’s acquisition of MidAmerican in 2000.  Putting these charges aside, the health of the underlying utility business appears to be solid.  As Buffett said at the annual meeting, the utility business is relatively insulated from the worldwide recession and, along with the insurance business, provides Berkshire with relatively stable sources of earnings regardless of the economic climate.

Manufacturing, Service, and Retailing

Berkshire’s manufacturing, service, and retailing segment suffered a 47% decline with net earnings for the quarter reported at $258 million compared to $487 million in the first quarter of 2008.  In fact, the comparison would have been even worse if one accounts for the fact that Marmon contributed to earnings for the entire quarter in 2009 and for less than half of March in 2008.

The news may be grim, but the silver lining is that none of the reporting segments posted losses.  In addition, there was some surprising strength in certain areas.  For example, although Shaw’s revenues declined by 18.1%, earnings increased by 7.8% due to improvements in operating margins resulting from lower raw material costs.

All Things Considered, Not a Bad Quarter

Considering the turmoil of the first quarter and the fact that GDP most likely shrank significantly, I consider Berkshire’s operating results to be relatively strong.  While the headlines will show net losses from a GAAP perspective, my view is that it is necessary to look beneath the headline numbers to get a grasp of the real condition of the business.  When you do that, what becomes quickly apparent is that Berkshire’s insurance and utility businesses did very well during the quarter and the non insurance operating companies posted reasonable results even if they fell short of last year’s results.

It is also worth noting that the decline in book value experienced during the first quarter is probably entirely offset by the gains in Berkshire’s investment portfolio so far in the second quarter as I wrote yesterday.

During times like this, it pays to have high quality businesses and Berkshire has demonstrated the ability to operate profitably even in the worst of times.  I’m sure that Warren Buffett would have preferred to avoid the mistake related to ConocoPhillips and surely he would have preferred to write the equity puts at a lower strike price.  The reality is that no one can achieve perfection, particularly in this type of economic climate.

Ravi Nagarajan is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

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Third Point Q1'09 Investor Letter

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Whitney Tilson and Glenn Tongue, Managing Partners of T2 Partners and the Tilson Mutual Funds, recently finished their speech at the Value Investing Congress, entitled An Update on the Mortgage Crisis and a Discussion of Wells Fargo. The following are our notes from the presentation.

Opportunities for Long Investing

• Blue-chips: Coca-Cola (KO), McDonald’s (MCD), Wal-Mart (WMT), Altria (MO), ExxonMobil (XOM), Johnson and Johnson (JNJ), and Microsoft (MSFT)
• Out-of-favor blue-chips: Berkshire Hathaway (BRK.A), Wells Fargo (WFC), American Express (AXP), Target (TGT)
• Balance sheet plays: EchoStar (SATS), dELiA’s (DLIA)
• Turnarounds: Wendy’s (WEN), Winn-Dixie (WINN), Huntsman (HUN), Crosstex (XTXI), and Resource America (REXI)
• Special situations: Contango Oil and Gas (MCF)
• Mispriced "options": General Growth Properties (GGWPQ.PK), TravelCenters of America (TA), Ambassadors International (AMIE), Borders Group (BGP) and PhotoChannel Networks (PNWIF.OB).

• Idea is not as attractive as it was two weeks ago.
• Whitney and Glenn were short WFC at $30/share and covered around $10/share. They are now long.
• WFC net income spread was 4.8% and could be seen as a competitive “moat.” Believes the combined earnings power (normalized) of WFC/Wachovia is $3.55 to $4.26/share.
• Bull case: $4.00/share in earnings power. Implies a $40-$50 stock price at 10-12x earnings. Enormous yield spreads. Wachovia portfolio already significantly marked down. Buffett recently touted the stock and said he would have been willing to put 100% of his net worth in WFC when it was trading at lower levels earlier in the year.
• Potential risks: Wells Fargo has a minimal amount of tangible equity to absorb losses—Glenn and Whitney think they have no tangible equity (which makes them cautious). Expect losses to be between $47 billion and $120 billion in the future. They have provisions in the low $20 billion range right now.

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Mortgage Market Analysis and Outlook

• About two-thirds of homes have mortgages. Of those homes, 56% are owned or guaranteed by the two government sponsored enterprises (Fannie Mae, Freddie Mac). There was a surge of toxic mortgages over the past ten years. The wave of resets from subprime loans is mostly behind us.
• What is ahead of us? Alt-A = $2.4 trillion category (much larger than subprime—known as "liars loans"). Alt-A mortgages and their resets are mostly ahead of us. Alt-A delinquencies by vintage show the collapse in lending standards in 2006 and 2007. About $750 billion of Option ARMS were written in 2007 and three-fourths were written in the four housing bubble states. Option ARMs are beginning to soar.Delinquencies on jumbo prime mortgages are soaring. This is the next big wave to hit California. Delinquencies on prime mortgages are beginning to soar.
• HELOCs and home equity loans were also popular during the bubble. This is a $1 trillion market. Of the $1trillion loans, only $200 billion were securitized—so much of this is still on many of the banks' books. 30% of all cars purchased in CA in 2007 were purchased with HELOCs.
• Housing outlook: Existing homes sales are falling and foreclosures are rising, leading to a surge in inventories. Whitney says there’s a huge amount of "shadow inventory" on banks' books. The current month’s supply numbers greatly understate the severity of the housing environment.
• Foreclosure filings have increased dramatically. Foreclosures in March rose 48%, y-y and 17% sequentially. RealtyTrac estimates that over 1.5 million bank-owned properties are on the market, representing around a third of all properties for sale in the U.S.
• Home prices are in a freefall. Whitney uses the Case/Shiller national index to gauge home prices.
• Whitney said that home prices need to fall another 5-10% to approach the long term trend line. He says the real danger is not returning to trend, but overshooting the trend line. Home prices in California have already overshot the trend line.
• Outlook for housing prices: Prices are down about 30%; "trend" would be down about 40%. Prices could go down 45-50%, and it will take another year or so to get there.
• Total estimated financial sector losses will be about $3.8 trillion. Institutions have been able to raise capital to mostly keep up with write downs, but this is not likely to continue.

About the Speakers

Whitney R. Tilson is the Founder and a Managing Partner of T2 Partners LLC, which manages three private investment partnerships and the Tilson Mutual Funds. He is Co-Editor-in-Chief of Value Investor Insight. Tilson has been a guest on Lou Dobbs Moneyline and Wall $treet Week, has been profiled by the Wall Street Journal and is a regular columnist for Financial Times. He is the Co-Founder and Chairman of the Value Investing Congress.

Glenn H. Tongue is a Managing Partner of T2 Partners LLC and the Tilson Mutual Funds. Mr. Tongue spent 17 years on Wall Street, most recently as an investment banker at UBS, where he was a Managing Director and Head of Acquisition Finance. Before UBS, Mr. Tongue was at DLJ for 13 years, the last three of which he served as the President of NYSE-listed DLJdirect. Prior to that he was a Managing Director in the Investment Bank at DLJ, where he worked on over 100 transactions aggregating more than $40 billion.

Disclosure: No positions.

Interesting Links

1. T2 Partner's 13F-HR filings 
2. Value Investor Insight
3. Seeking Alpha articles
4. 60 Minutes interview

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

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J. Carlo Cannell, founder of Cannell Capital, has just completed his presentation, entitled Hydrodamalis Gigas, at the Value Investing Congress. The following are our notes from the presentation.

Extinction and Investing

• Example #1: The Steller’s Sea Cow is known as Hydrodamalis Gigas (which is extinct) and is the title of the presentation. Before humans arrived, they ranged along the North Pacific coast. By the middle of the 18^th century, they were restricted to the Bering Sea with a population of around 1,500. They were hunted for food, skins, and fat oil and went extinct in just 27 years after being discovered. How does this relate to investing? Sometimes new circumstances come into the equation or investment situation. Some species (companies) can have a more difficult time adapting to a changing environment. For example, a restaurant would have a more difficult time adapting to a slowdown in the economy than an oil/gas company.
• Example #2: Irish Elk (Megaloceros Giganteus)—extinct. Became extinct due to maladaptive traits. How does this relate to investing? Some corporate creatures are struggling for survival. We cannot predict when the environment will change. Companies that have fallen victim to this form of extinction include: Orange 21 Inc, Bakers Footwear, Heelys, and Design Within Reach.
• Example #3: The California Condor (Gymnogyps Californianus) – critically endangered. Carrion scavengers like the condor were taxonomically diverse in North America during the Pleistocene. The Pleistocene was a colder time with wide open grasslands, sustaining “megafauna” including mammoths, bison, and ground sloths. Condors feasted on the abundant carcasses. The combination of warmer climate and the arrival of humans drove the species to the verge of extinction. How does this relate to investing? Example American Automakers—akin to the condor?
• Example 4: The Red Queen Effect: for an evolving system, continued development is needed in order to maintain viable fitness relative to a system it is co-evolving with. For example, faster cheetahs result in selection for faster antelopes, faster antelopes select for faster cheetahs. This relates to business through price wars. For example, Best Buy vs. Circuit City and how a reduction in prices can have a negative spiral effect. Relates this example of extinction to the semiconductor equipment industry as well.
• Buffett avoids many of these risks by investing in companies that are more essential (i.e. razor blades). Carlo tries to observe the patterns which govern nature—and makes investments based on his conclusions. It’s easier to benefit from the laws of nature than to try and predict the next Coke.
• Industries he finds attractive: agriculture –mentions irrigation companies (mentioned two based in Omaha) , oil/gas (equipment service companies)—mentions sandridge-quicksilver-pioneer, some precious metals and the death care industry (cremation).

About Carlo Cannell

Cannell has 16 years of experience investing in small caps and over 19 years of experience in analysis of technology companies. A graduate of Princeton, he attended New College, Oxford, and studied business at Templeton College. Mr. Cannell, a third generation investment manager, is the Managing Member of Cannell Capital LLC in Jackson, Wyoming.

Interesting Links

1. Cannell Capital's 13F-HR filings 
2. Cannell discusses a potential proxy fight with MFRI

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

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Scott Klein, Managing Partner of Beach Point Capital Management, recently completed a compelling presentation entitled Opportunities in Stressed and Distressed Credit. The following are our notes:

About Beach Point Capital

• Specializes in high yield bonds, corporate loans, distressed debt and other credit related strategies.
  
• The firm has over $3.7 billion in AUM.
  
• Investment team includes 15 people with offices in Los Angeles and New York.

• The distressed debt market is currently presenting an “opportunity of a generation.” The key in distressed debt is the ability to analyze legal documents and bond covenants.
• The high yield market is currently yielding 16%-18%.  Distressed debt can offer investors better downside protection than many equities.
• On the high yield side, Klein sees companies with mid teens yields that are attractive. Example: Dole Foods. The company missed a window of opportunity to refinance some of its debt. This particular example is yielding 16% and the downside is par (very safe, high yielding piece of paper).
• The high-yield default rate is increasing (about 10%-12%)—default rates are a lagging indicator.
• One of their largest distressed holdings is called Digital Globe. They are a content provider for Google Earth (satellite imagery). They filed for bankruptcy after a failed satellite launch. In this situation, Beach Point turned its private debt into equity and the company recently filed an S-1  and should go public soon.
• The high yield market has gained 35% on average during the two years following a monthly decline of 5% or more.
  

About Scott Klein

Scott Klein is Managing Partner and Portfolio Manager for Beach Point Capital Management with $3 billion under management. He has over 17 years of experience in managing high yield bonds, bank loans and distressed debt portfolios and restructuring companies in financial distress. Before founding Beach Point, Mr. Klein was Senior Managing Director at Post Advisory Group, where he spent over 12 years helping grow the company from under $200 million in assets to over $10 billion. In the early 1990s, he spent four years as a bankruptcy attorney at the law firm of Murphy, Weir and Butler.
Mr. Klein received a bachelor's from Wharton (magna cum laude) and a J.D. from UCLA.

Disclosure: No postions.

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

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William Waller and Jason Stock, founding partners of M3 Funds, recently wrapped up their presentation at the Value Investing Congress, entitled Banks: Have We Seen the Worst of It? The following are our notes.

M3 Funds: Investing in Under-followed Banks

• Manage a long/short equity fund focused on the U.S. Banking Thrift Sector. M3 focuses on under-followed banks. There are 1,300 publicly traded banks, 5,500 private banks, 700 mutual banks and 7,900 credit unions. M3 focuses on publicly traded banks—93% of which have a market cap below $500 million. Jason believes he has a competitive advantage in investing in under-followed banks.
• He views a bank as a leveraged play on the market in which it operates. M3 conducts research on individual banks through extensive travel, public records searches, private banks and credit unions, FDIC data—call reports, real estate agents and developers.

• Sector is significantly under-capitalized. This the sector's #1 problem.
• Credit quality has deteriorated and will continue to deteriorate.
  
• The number of bank failures is accelerating.
  
• Tangible equity/asset ratios have “fallen off a cliff” in 2007-08 and are 4%-5% vs. historical levels of 6%-7%. These ratios are not sufficient to handle the losses that will come in the future.
• Total delinquencies: Construction 12%, 1-4 Family 8%, CRE 2.6%, C&I 2.8%, consumer 5%.
• Jason says that call reports are the best way to analyze banks.
• Where we are headed: Commercial real estate (CRE), consumer loans (auto, credit cards)—have yet to see meaningful deterioration on many banks' balance sheets. Auto loans have held up rather well but he’s starting to see deterioration in this category of loans.
• Jason sees a significant amount of bank failures in the future. There have been about 30 bank failures YTD. He sees this number rising to 150+ by the end of the year. He said that regulators might be overwhelmed (not enough staff) and thinks that they could shut down over 100 banks right now if they had enough people.
• Can TARP, TALF, PPIP, accounting changes help? They will help some banks, but not all.

• Unemployment will continue to rise and commercial real estate is the next shoe to drop.
  
• Roughly 25% of all CRE is securitized, most of which was originated between 2002-07 and is now beginning to come due.
• CRE vacancies are rising—commercial foreclosure process is just beginning, which will impact all commercial values and CAP rates.
  
• The primary problem areas include: retail strip centers and office.

• Low price to tangible book value, excess capital
• Low loan to deposit ratio
• Attractive markets (looks at real estate and employment trends—likes state capitals and university towns for longs since these provide a very stable job base)
• Bearish management team
• Share repurchase plan
• Attractive deposit base
  
• Excess capital is the number one statistic that M3 focuses on
  
• Jason also said that a bank’s biggest asset is its liability base (deposits) and a bank’s biggest liability can be its asset base (loans)—he views the deposit base as a hidden asset.

• $1.25 billion asset bank headquartered in Glen Head, NY.
  
• 140% of tangible book value and 11x LTM earnings. Hidden value in branch ownership would increase TBV by 15%.
• Excess capital: 8.5% common tangible equity/assets.
  
• 68.5% loan to deposit ratio—very disciplined underwriter. $1 billion of high quality deposits with a 1% cost. Pristine credit quality: very low non-performing assets at 3/31/09.
  
• Near term catalyst: Russell 2000 addition requires 400K+ shares.

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Investment Approach: Criteria for Short Positions

• Overstated or declining tangible book value, thin capital structure
• Negative credit trends—rising early stage delinquencies, out of market exposure—high severity loss markets
• Bullish management team
• High-cost deposit base and wholesale funding
• Aggressive underwriting—high growth rates and risky securities portfolio

• Do not think it’s a zero, just trading too high given credit risk they have.
  
• Trades at over 2x tangible book and 20x LTM earnings.
  
• Thin capital structure—4.5% common tangible equity/assets ($357M). $294 million of loans in FL of which 50% are land loans.
  
• Credit quality is deteriorating—over 2% of assets are non-performing.
  
• High severity of loss on the FL exposure—reserves are insufficient.
  
• Loan mix—33% consumer, 30% CRE, and 20% C&I.
  
• The company should trade down to book value and will need to raise additional capital in the future.

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Key Takeaways

• The U.S. banking sector remains under-capitalized.
  
• Commercial real estate and C&I loans pose a serious threat to the banking sector.
  
• The Fed’s current actions are creating long-term risks for the banking sector and the broader economy. Common stockholders are at risk in the majority of banks.
• Recommendations for investors: Find a niche and become the ultimate expert. Utilize technology and creative strategies to gather information. Timing the market is difficult; develop a firm thesis and be disciplined. Manage risk well—never concentrate a portfolio in one investment. Always ask yourself if you have a competitive advantage. Don’t just read it or hear it—go see it for yourself.
• Q&A: Which banks do you think are zeros? Very small, obscure community banks would be high on the list. He thinks that Citigroup (C) and Bank of America (BAC) common shareholders could potentially get wiped out.

About the Speakers

William C. Waller is a founding partner and Managing Member of M3 Funds, LLC. He has over 10 years experience analyzing and investing in the bank and thrift sector. Prior to M3, he was employed by Hovde Capital Advisors LLC, in Washington, DC, where he spent over six years working with the firm’s series of financial services sector investment funds. At Hovde, Mr. Waller worked in portfolio management, investment analysis, and risk management. Mr. Waller spent two years working on the floor of the New York Stock Exchange as an analyst and trading assistant at the firm of Dippell & Company, a registered competitive market maker. Mr. Waller has studied the banking and credit union system in the United States. Mr. Waller received his Bachelor of Science in Accounting from the University of Utah.

Jason A. Stock is a founding partner and Managing Member of M3 Funds, LLC. He is responsible for managing the trading and operational functions for the firm while actively participating in the portfolio management process. He has over 10 years of experience in the investment field with specific expertise in the banking sector. Prior to founding M3, Mr. Stock was the Head Trader at Hovde Capital Advisors, an investment manager for the Financial Institution Partners series of funds, where he was responsible for the trading and analysis of investment opportunities with an emphasis on community banks, thrifts, and mutual holding companies. Mr. Stock spent 6 years at Fidelity Investments in both Salt Lake City and San Francisco. Mr. Stock earned a Bachelor of Science degree in Finance from Westminster College in Salt Lake City, Utah. 

Disclosure: No positions.

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

Posted by Zain Griffith at 01:36 PM | Permalink | Comments (1)

David Rabinowitz, who runs Kirkwood Capital, spoke at the Value Investing Congress today. The following are our notes from his presentation, entitled Stock-picking for the Scared and the Ignorant: Notes from an Expert.

Investment Approach

• David focuses on the downside of an idea more than the upside.
  
• He takes a very long time to understand an idea before taking a position.
  
• He often holds large amounts of cash—often for extended periods of time. Also, it takes him a very long time to find ideas.
• He believes in specializing in a few industries—he specializes in restaurants and retailers.
  
• He conducts extensive research, including reading 10-Ks, industry publications, even bankruptcy filings of former companies—which he says can be more helpful in understanding an industry or the competitive landscape than reading current annual reports.
  
• Understanding an industry very well will help an investor capitalize on an idea when it presents itself. It helps him act quickly when he sees opportunity.

• David does not own any restaurants or retailers right now.
  
• From his experience at looking at retail over the past 10-15 years, he does not feel that individual opportunities are currently as exciting as they’ve been in prior years (i.e. 1994-1995). 
  
• Retail valuations are currently much higher than in the recession of 1994-1995.

Investment Idea: LONG Lancashire Holdings (LCSHF)

• Four year old Bermuda based insurance company (specialty insurer) trading at book value. 
  
• Trades on the LSE under the ticker LRE. $1.27 bil market cap. Founded in late 2005.
  
• Not like a normal insurer. Only 14% of book is reinsurance, 86% of current business is primary.
  
• LRE is not “part hedge fund” 85% of investment book is “risk-free.” LRE has a very conservatively run investment portfolio
• CEO Richard Brindle has a very successful track record. The CEO cares more about underwriting, maintaining a strong balance sheet, managing capital through the cycle, and staying nimble. They’re not trying to rule the insurance world.
  
• Investment portfolio returned 3.1% in 2008, duration consistently below 2.0, $300mil in corporate bonds (none below investment grade) in $2bil portfolio. 
  
• Management has stated that they’re willing to walk away from premiums.
  
• Operating expense less than 10% of premiums and has about 91 employees.
  
• Gross written premium down 16% in 2008, Q109 GWP down 20-25%. Returned about $397 million of capital in 2007 and 2008. CAGR of book value since inception has been ~18%. 
  
• Management ROE goal = 13% plus risk free rate.
  
• Valuation: Believes it could trade between 1.5x-2x book value (profits made in the mean time are being returned to shareholders). Bases this multiple on: 1) reserve additions being highly unlikely, 2) investment book is not at risk, 3) Bermuda taxation, 4) Conservative management.
  

About David Rabinowitz

Dave Rabinowitz runs Kirkwood Capital, the Atlanta-based investment fund he founded with Gotham Capital in 2002. Prior to founding Kirkwood, he worked as an attorney with the Special Matters department of King & Spalding in Atlanta. Mr. Rabinowitz has also been an adjunct professor at Columbia Business School's Value Investing program. He is a graduate of Binghamton University and Emory Law School.

Disclosure: No positions.

Interesting Links

1. Kirkwood Capital's 13F-HR filings 
2. Recent SC 13D filing

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

Posted by Zain Griffith at 11:59 PM | Permalink | Comments (1)

Jed Nussdorf, founder of Soapstone Capital, recently finished his presentation at the Value Investing Congress. The following are our notes of the presentation, entitled In Search of Pricing Power.

• Jed sees opportunity (pricing power) in certain lines of reinsurance.
  
• Equity market participants have not recognized the pricing dynamic and reinsurance equities are trading at historical low valuations relative to earnings and book value, excluding distressed carriers.
  
• Reinsurers that are most interesting include RenaissanceRe Holdings (RNR), Validus Holdings (VR) and Lancashire Holdings (LCSHF).

Economic Context and Investment Approach

• Global recession has pressured demand for most goods and services, while supply/capacity for those goods has yet to respond, pressuring pricing across the economy.
  
• Excess capacity exists in most areas of transportation, power and energy, real estate, and consumer services given declining demand for goods, electricity, space, and discretionary expenditures.
• Jed looks for industries with more inelastic demand functions, preferably with static or decreasing supply, enabling pricing to hold, if not rise. He looks for evidence of pricing power, which is typically accompanied by accelerating revenue growth and operating margin expansion.

About Soapstone Capital

• Backed by Joel Greenblatt (founded Soapstone Capital four years ago). In sourcing ideas, he looks for companies with pricing power.

About Jed Nussdorf

Jed Nussdorf is the Managing Member of Soapstone Capital. Prior to founding Soapstone in 2005, Mr. Nussdorf was a managing director at Force Capital Management from 2003-2005. He earned an M.B.A. from Wharton.

Disclosure: No positions.

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

Posted by Zain Griffith at 08:42 PM | Permalink | Comments (0)

Guy Spier, founder of Aquamarine Capital, gave a presentation at the Value Investing Congress today, entitled Investing in Global Education - From China to Brazil. The following are our notes from his speech:

Non-U.S. For-Profit Education

• The world is becoming more developed (meat consumption, milk, etc. are increasing). Not so sure about the "trends" in iron/oil—may not want to bet on these since iron can be recycled and there are alternatives to oil. He believes that food is a better trend to bet on.
• People will demand more education in the future. This bodes well for education companies such as Raffles Education, Corinthian Colleges (COCO), etc.  
• Bullish on Brazil: has $2 trillion GDP, 200 million population, largest iron ore mine in the world. Brazil does not have a system of community colleges. Gross enrollment rate in Brazil is 24% vs. 80%+ in USA.
• Guy sees a lot of potential in non-US based education companies.

• Largest player in the private post-secondary education sector in Brazil.
  
• GP Investments is involved with Estacio.
  
• The founding family acquired many “mom and pop” education companies.
  
• Trades at a single digit to EBITDA, has low EBITDA margins (room for improvement), management is intent on creating a lot of value.
  
• Thesis relies on: Developing duopoly in Brazil for post secondary education, low penetration, no community colleges, undeveloped consumer finance sector, natural resource based economy. This is an investment that Guy plans on holding for the next 20 years.

• Headquartered in Singapore.
  
• They are different than other education companies in China in that they turn out English-speaking graduates.
  
• The company is cheap and has a dividend yield of 5-6%. Company is trading at a single digit multiple to EBITDA.

• Pay attention to concentrations of risk (credit, geography, customer, other..)
• Pay attention to hidden leverage,
• Tangible vs. intangible assets (he likes intangible assets—going forward he is going to pay more attention to tangible assets),
• Position sizing,
• Always carry lots of cash at all levels.

About Aquamarine Capital

• Aquamarine was down 46.7% in 2008, up about 2.9% in 2009. He describes himself as a “focused investor.” Guy’s fund has recovered 26% from March 1 through April 24, 2009. He feels prepared to hold his key positions.
• He uses checklists when investing, similar to Charlie Munger. A checklist he recently developed includes business specific questions as well as psychological factors. Guy has used a checklist for investing for many years, but since 2008, has had to rethink many of the factors he considers before taking a position. For investors, he stresses the importance of developing a checklist and continuing to add and improve the items one considers before investing in an idea.
  

About Guy Spier

Since 1995 Guy Spier has been running Aquamarine Capital Management, LLC. Investors include friends and family, high net worth individuals, and private banks investing on behalf of their clients. The fund has market beating returns - and has received mentions by Lipper and Nelson's world's best money managers. The investees can be obscure or they can also be very well known.The fund has also done well owning the shares of less understood, but very high quality, cash generative businesses. It currently owns several credit rating companies as well as several post secondary education companies. The ratings business (whether of debt securities, or of individuals, through education) is one of the best businesses that Guy has ever seen, and is consistently underestimated by investors.

Disclosure: No positions.

Interesting Links:

1. Examiner.com interview
   
2. Recent comments on Warren Buffet's performance
3. Guy's blog
   

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

Posted by Zain Griffith at 08:31 PM | Permalink | Comments (0)

John Burbank, founder of Passport Capital, recently concluded his speech at the Value Investing Congress. The following are our notes from the presentation, entitled China and the U.S. Dollar: "Should We See Other People?"

Key Themes and Conclusions

• Fiat money is questionable
  
• Gold is on the rise
• Tailwinds for scarce natural resources and emerging market currencies are in place.
• China’s growth should become increasingly independent (they have the cash and knowledge).
  

Investment Ideas

• Current Passport Capital holdings -- fertilizers: Mosaic (MOS), Potash (POT). Crude oil: Petrobank (PBG CN) and EFG Hermes (HRHO EY).
  
• Burbank believes in being long financial services in the Middle East. 
• Gold (see below)

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On China and the Big Picture

• China is “the world’s marginal provider of liquidity.” (See recent Economist publication on China).
• You cannot only take a bottom up approach; you must understand the top down (macro picture).
• If you look at GPD to private debt, in China these two metrics have risen at about the same rate. In the US, total debt and private debt have risen much quicker than GDP.  He believes this will serve China well in the future. The US is currently printing money ($2.2 trillion in new government debt from TARP and other spending). Asks the question: Which would you rather own?
• China currently holds 24% of Treasuries, Japan about 21%, Eurozone 8%, Middle East 6%, Brazil-Russia-UK = 4%.
• China’s options for investment in the future: 1) Maintain status quo (consequences: continue purchasing treasury securities and have the US government be your primary capital allocator) 2) diversification, 3) invest in yourself, 4) invest in things you will need.
• Things China will buy for itself: Education, Entertainment, Leisure, Financial Services. Passport only buys companies trading in Hong Kong, Singapore or the United States.
• What China needs most: Iron ore, potash, crude oil, copper, soy beans. China is a net importer of these commodities and Burbank believes this should shape portfolio decisions with respect to commodities.
  

• Gold has an annualized appreciation rate of 13.2% over the past decade. China will be a very large buyer of gold in the future. Burbank believes that, from a game theory perspective, there is no reason for China not to purchase gold in the future.
  
• Lebanon has the highest gold/GDP percentage in the world at 28.8%. US and China Gold/GDP are 1.7% and 0.8%, respectively.
• How Passport owns gold: 1) Equities: challenging, as gold miners tend to make value-destroying acquisitions. Passport leverages team of analysts and geologists to identify earlier-stage assets. Detour Gold (DRGDF.PK) is a company they own. Passport also owns gold ETFs (proxy for physical gold) (GLD)

Burbank is the founder and Chief Investment Officer of Passport Capital, LLC, a San Francisco global hedge fund. The firm manages over $2 billion. Passport employs macro-economic and sector analysis to identify opportunities from the long term expansion of leading emerging economies, select natural resource scarcity, and network business models common to the technology and service sectors. Investments primarily emphasize public equity securities. Passport also makes highly targeted investments in equity derivatives, select private companies, and swap contracts. Mr. Burbank has over a decade of experience investing in global equity markets. Prior to founding the firm in 2000, he was a consultant to JMG Triton Offshore, Ltd. and before that was the director of research at ValueVest Management. He earned a B.A. from Duke and an M.B.A. from Stanford.

Interesting Links

1. Passport Capital investment strategy
   
2. Passport's Burbank Warns of Deflationary Bust
   
3. Forbes.com Profile
4. Passport Capital's 13F-HR filings

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

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Posted by Zain Griffith at 06:30 PM | Permalink | Comments (0)

Brian Gaines, founder of Springhouse Capital, just finished his speech at the Value Investing Congress entitled Low Risk Bets in a Risky World. The following are our notes from the presentation.

• Company is a supply chain management provider.
• Main products are consumer electronics (Sandisk, AMD, and HP are largest customers).
  
• Company does not take ownership of customer inventory.
  
• Largest player in outsourced space. The industry still has a large number of players who want to outsource for either strategic or legacy reasons. Several competitors are distressed, versus a strong balance sheet at MLNK.
  
• Largest risks here are management acquisition risk (company has a huge NOL), operational cash burn, and complete unwind of global growth and consumer electronics business.
  
• Company has been good at managing costs, running positive EBITDA ($9+mil EBITDA last quarter).
  
• Valuation: Low = $4.00/share (downside protection: there’s $4.70/share of liquid net working capital), Base $7.00/share, Homerun is $20/share. He only gives the NOL value in the “homerun” scenario.

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Investment Idea: LONG Market Leader (LEDR)

• One of Brian’s favorite ideas. They have a site called justlisted.com. Stock price is $1.90, cash/share is $2.40, cash burn = breakeven, views the business as a legacy in wind-down and small upcoming spend on option.
  
• Made $20mm in EBITDA when the market was good. Thinks it could do $5-7mil in EBITDA and could be worth more than $5.00/share.

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Investment Idea: LONG zipRealty (ZIPR)

• Brokerage agency, operates mainly online.
  
• Gives you a 20% kickback if you buy through ZIPR.
  
• Stock price is $2.80, cash/share is $2.32, losing $10-12 mil ($0.50 cents per share). A high risk/high reward opportunity.

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Investment Idea: LONG Tree.com (TREE)

• Spun off from IACI. Stock price is about $9.00, cash/share is $7.00, $8M EBITDA in last quarter, clear brand name in LendingTree (medium risk/medium reward).
  
• Company owns realestate.com, management owns a lot of shares. (Recent price increase makes the investment less attractive.)

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Investment Idea: Short-Sell Jack in the Box (JACK)

• He sees short opportunities in restaurant industry: Thesis is that multiples implying full recovery, cost cuts (which have boosted earnings) will end. Discounting is pervasive from QSR up to high-end dining.
• Jack and Qdoba have higher than average company owned restaurants,
  
• Qdoba was a growth engine.
  
• Nearly 1/3 of operating income is refranchising. Brian believes that weakness in the company operations will limit ability to refranchise going forward. Starting six months ago the company began providing mezz financing for the franchisees.
  
• Discounting is running rampant across the industry.
  
• Brian estimates than franchise margin is 1.5% or $21,000 on average unit volume of $1.4mm.  
• Valuation: Downside $26/share, Base $16/share, Homerun $10/share.

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Investment Idea: Short-Sell Blackboard (BBBB)

• Education software provider that claims to be mission critical -- basically, they set up a portal to share stuff (60% higher Ed/40% K-12).
  
• Management says future growth will come from upgrades and not new licensees (believes BBBB has fully penetrated its market and customers).
  
• Brian is looking out a year on this investment. He believes that BBBB is not as mission critical to the education system as the company claims it is.
  
• Schools have been cutting costs -- Brian mentions an extreme example of one school in Florida that cut purchases of toilet paper.
  
• Valuation: Downside $31.00/share, Base $20.00/share, Homerun $13.00/share.

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About Springhouse Capital

• Springhouse was down 10% in 2008, up 24% in 2009 YTD.
• What do they look for?  1) Longs - 20% maximum loss over time, 50% upside in a year (or some iteration of multi-years), Looking for 5-10 great ideas at any time and to ideally be 70%-90% invested on the long side but willing to hold significant cash. 2) Shorts: 10% loss, 30% upside, small positions of 1-3% and purely based on opportunities. Uses moderate leverage, and looks for multiples on normal earnings.
• What are they finding? Longs: Few true good stress tested mid-cap/large cap ideas (35% invested on the long side). Seeing opportunities in small and micro-caps with strong balance sheets where you can look out 1-2 years. Also sees opportunity in mediocre but clearly real businesses, possibly great businesses but unproven and flexible operating models able to adjust to new levels of demand. Shorts: Many stocks priced for perfect execution and economic rebound, approximately 30-40% gross short.

About Brian Gaines

Gaines is the Founder and Managing Partner of Springhouse Capital. Prior to founding Springhouse in 2002, he worked for Gotham Capital. Mr. Gaines is also an adjunct professor at Columbia Business School. He earned his BA from Brandeis and his MBA from Wharton.

Interesting Links

1. Springhouse Capital's 13F-HR filings
2. Brian Gaines discusses his investment thesis for Greenfield Online (SRVY) in 2006
   

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

Posted by Zain Griffith at 06:04 PM | Permalink | Comments (0)

Value Investing Congress speaker Charles de Vaulx of International Value Advisers gave a presentation today, entitled A Cautious and Opportunistic Approach to Global Investing: Where Are We Finding Value Opportunities in the World Today. The following are our notes from his presentation.

Investment Idea: LONG SECOM (JP: 9735)

• Japanese, steady, stable cash flows
• Has “diworsified” over the past few years so there has been some value destruction.
• Has a strong balance sheet, with net cash.
• At 7x EBIT, company is cheap.
  

Investment Idea: LONG Nestle (NSRGY.PK)

• If you strip out stake in L’Oreal and other stakes, you pay 9x EBIT for food business.
• Good balance sheet.
• Accused of overpaying for acquisitions.
  
• The company appears cheap and safe.

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View of Markets and Economic Outlook

• Too many financial stocks do not offer “safety.”  Charles uses gold as an insurance policy (gold bullion—insurance against inflation/deflation—banks go bankrupt during deflation and bank “IOUs” become worth less). Cash is viewed as a residual. Would like to have twice as much capital employed in Japan but would like to see cash-rich companies be able to maintain dividends and buy back shares—needs more evidence of caring for shareholders than strictly clients, before investing more. He’s seeing very many “net nets” in Japan—not as much in the US and Europe.
• His idea of a good business is natural monopolies. Many companies in China are very capital intensive.  Favorite way to play emerging markets is through commodities, either directly or through bonds.
• Outlook: May remain bleak, yet some pockets of value have emerged.

• Too many people focused on the upside, not enough focus on the downside.
• Monitoring credit cycles – following these cycles can be helpful and help determine when a bubble is forming (said he reads Grant’s Interest Rate Observer, Shilling, Marc Faber)

About International Value Advisers

• IVA takes a cautious and opportunistic approach to global investing. 
• It is owner operated (22-23 people)—not outside seed capital, they “eat their own cooking” ($30 mil+ of principals own money in fund) and long only.
  
• Willing to make large negative bets/build portfolios that have nothing to do with a benchmark.
  
• Gold is an 8% position. Uses gold bullion, money shares, or other proxies to invest in gold. About 1% of funds are in UltraShort 20+ Year Treasury ProShares (TBT). Japan is 12%.
• Main objective is not to lose money.
  
• Believes in some form of diversification. Uses calls and puts to create cheap entry prices (recently sold puts on GE, 3M and Comcast to create an entry price that makes sense to them). Since markets are higher, will most likely collect the premiums on those positions. $2.3 billion AUM.

• Diversification argument  [for international investing] is getting weaker—especially in a more global world,
  
• The real attraction is that foreign markets remain less efficient than US markets.
  
• At the margin, he believes accounting is more reliable outside the US (the real issue is poor disclosure (no 10-k’s, divisional breakdowns, etc)
• Corporate governance outside the US needs to improve—there have been some improvements in the field of takeovers (French have improved quite a bit).
• Small foreign stocks are not as risky as they appear—many are family controlled businesses. Family controlled businesses can be better run (less leverage, more willing to bring in outside managers) than non-family owned businesses.
• Another argument people make against international investing is that you are exposed to fluctuations in currencies. Even though domestic investors have exposure to currency risk, his firm mitigates currency risk through hedging policies, pays attention to the types of companies he owns (i.e. export company in Japan might not need to be hedged—already has its own natural hedge).
• Currently has cash level of 23%, 7% US, 34% high yield bonds, 8% gold, Europe 12%, Asia 15%, >1% Energy.
• Believes on average that European stocks are 15% cheaper than U.S. stocks.

About Charles de Vaulx

Charles de Vaulx joined IVA (International Value Advisers, LLC) in May 2008 as Partner and Portfolio Manager. He is responsible for all investment decisions jointly with Charles de Lardemelle.
Until March 2007, he was Portfolio Manager of the First Eagle Global, Overseas, U.S. Value and Variable Funds, together with a number of separately managed institutional accounts. He was also solely responsible for the management of the Sofire Fund Ltd. during the time in which the fund won the Absolute Return Award back to back in 2005 and 2006 for “Fund of the Year” in the Global Equity category. Altogether, assets under Charles de Vaulx’s management totaled approximately USD $40 billion. In addition to sharing Morningstar’s “International Stock Manager of the Year” award in 2001 with his co-manager, Charles was runner-up for the same Morningstar award in 2006.

Interesting Links

1. Barron's Profile 
2. BusinessWeek Profile
3. SmartMoney's "3 New Mutual Funds Worth a Look"

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

Disclosure: No positions.

Posted by Zain Griffith at 04:00 PM | Permalink | Comments (0)

Zeke Ashton, founder and Managing Partner of Centaur Capital, recently concluded his presentation at the Value Investing Congress. Here are our notes from the presentation, entitled Surviving the Worst Case: Risk Management and Value Investing:

• Holding company that operates primarily in the specialty and property & causualty insurance industry.
  
• Long term track record of value creation by building, acquiring, and selling businesses—particular expertise in the insurance, investment management, and natural resource areas.
  
• Investment results are in high teens. Alleghany uses a “total return” approach to investing its float and has a good investment track record. Over the past five years, the company has produced a 10.6% annualized return vs. a -2.2% annualized return for the S&P 500 Index.
  
• The company has a $4.1 billion investment portfolio and has a portfolio of valuable assets.
  
• Valuation:  Sum of Parts: RSUI (insurance with 80% combined ration in 2008) 1.5x book = $1.65 bil. Capitol Transamerica – 1.2x book = $360 mil. EDC .75x book = $125 mil. Cash and investments at parent = $800 mil. 

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LONG Investment Idea: Odyssey Re (ORH)

• Globally diversified insurance and reinsurance company, one of the top 20 reinsurance companies in the world.
  
• 71% owned by FFH, investment portfolio managed by Prem Watsa.
  
• Grown BV/share by more than 20% annually since going public in 2001.
  
• Buying back a ton of stock below book value. ORH spent $351 million on share buybacks in 2008, ~13% of shares outstanding in 2008.
• Bottom Line: ORH is classified as a medium risk stock. Current book value is about $43.80/share (as of Mar. 31), thinks BV/share should increase to $47-$48. At 1.3x book, company would be worth upwards of $55+/share.
  

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Risk Management & Value Investing

• Many value manager downfalls may have been due to complacency. Asks the question: If the core principle of value investing is "margin of safety" then how did so many well-known value investors lose as much or more than the market average during the bear market that began in 2007? Did they do something wrong or are they unlucky? Why did their value investing principles, years of experience, and long track records of success fail to protect them? Did they become overconfident?
• Value investors previously assessed risk at the individual position level. This was all the "risk management" that seemed required. A lesson he recently learned was that risk must be assessed from the portfolio level—looking at the portfolio from the "top down" can be a useful exercise. He believes managers should try to determine if a bubble is building and where the economy is at in the business cycle.
• Centaur doesn’t want: 1) excessive concentration—never wants the outcome of any one or two ideas to determine their ability to survive or dominate results in a given period, 2) Excessive portfolio-wide exposure to any one specific factor or theme (i.e. inflation, interest rate/currency fluctuations), 3) Excessive leverage at the portfolio level or the individual idea level, 4) Political risk – does not want investments to be overly vulnerable to change in government regulations, laws, tax codes, etc, 5) Liquidity risk, 6) Shorting stocks—wants to avoid “blow-up” risk. Believes we will see some short funds blow up due to recent market rally.
• Concept of Risk Limits: Zeke thinks that limits prevent investors from taking unacceptable risks, which should be thought about in advance. Home run style investors will have a different risk management style than high probability investors.
• Helpful Limits: 1) Position size limits, 2) Total Exposure Limits (long and short), 3) Leverage Limits, 4) Limits on illiquid stocks.
• Example of Fairfax Financial Holdings (FFH): Many people were short FFH in prior years when it really should have been a long (due to their large CDS portfolio). –Not a typical insurance holding.
• Centaur’s ideal position is about 5%, i.e. 20 stock portfolio. Believes that 20 names in a portfolio is better than 6 or 100, thinks 20 is the sweet spot. The ultra-concentrated model increases the odds of experiencing occasional periods of outstanding performance, but also increases odds of really terrible performance.
• Diversifying by idea doesn’t necessarily help if there is excessive sector or single factor correlation. “If you owned a bunch of different stocks in different industries that all had leveraged balance sheets, you probably didn’t benefit much from diversification in a year like 2008.”
• Two types of leverage: 1) Recourse (high-risk leverage) 2) Non-recourse (smart leverage). Best way to achieve non-recourse leverage is by using in-the-money LEAPs—which offer reasonable implied borrowing costs as well as an implied put below a certain price.

Two Schools of Value Investing

1. Home run (i.e. Eddie Lampert) – magnitude of winners is the success factor. If one idea triples, you can afford to have a few ideas that do not do well.
2. High-probability (i.e. Seth Klarman) – Less concentrated portfolio, but more concentrated relative to the rest of the world. Centaur has 15-30 positions—1-2 big winners will not drive portfolio performance.  Zeke follows the high-probability approach.

• Each style depends on the type of investor. Key is matching investment style to the type/characteristics of the capital base and manager philosophy.
• It is important to match the attributes of the capital base to the investment style of the manager. The "home-run" style investor must have stable, long-term capital in order to compensate for higher volatility of fund performance. These types of investors are at the highest risk of business failure.
• "High probability" investors can operate with a much more fluid capital base—business failure is driven more by showing favorably divergent returns over time.
• Centaur risk limits: Position 7.5% --10% maximum size at market. Sector – no more than 20% in any one sector—25% at market.
• Ingredients of a blow up: 1) excessively sized bets, 2) excessive leverage, 3) unexpected negative event, 4) inadequate liquidity to unwind the position without negatively affecting price.
• Take away from Kelly Formula: 1) The better the idea, the bigger you can go. 2) The more undervalued the idea, the lower the risk, the bigger the position should be. Believes that investors who rely on the Kelly Formula as intellectual support to take excessively sized bets will accelerate gambler’s ruin, not avoid it. 
  

About Zeke Ashton

Ashton is the founder and Managing Partner of Centaur Capital Partners, a Dallas-based value-oriented investment firm. He and co-portfolio manager Matthew Richey are the advisors to the Centaur family of private partnerships using a long / short equity strategy, and are the sub-advisors to the Tilson Dividend Fund, a mutual fund utilizing a unique, income-oriented value investing strategy.

Interesting Links

1. Mr. Ashton comments on bargain priced retailers in this Fortune article 
2. Motley Fool interview
3. Motley Fool articles

The author of this post is MOI research associate Zain Griffith, who is attending the Value Investing Congress in Pasadena this week. Contact Zain directly at zain@manualofideas.com.

Posted by Zain Griffith at 03:38 PM | Permalink | Comments (0)

David Chu and Igor Lotsvin, of Soma Asset Management, spoke today at the Value Investing Congress entitled The U.S. Banking Sector: Chaos and Opportunity. The following are our unedited notes from their presentation:

• Wave of foreclosures is beginning to pick up and we will see a massive wave of foreclosures over the next several months.
  
• Next shoe to drop is commercial real estate (more alarming than subprime). Size of commercial market in US is $3.5 trillion vs. $1.5 trillion subprime. Banks have exposure to $700 billion in construction loans (the most combustible portion of the CMBS market). Total bank’s capital is about $1 trillion.
  
• The worst of the banking crisis is ahead of us. Banks are not lending. There is a massive reduction in all lines of credit, which will suffocate growth. By 2011, cards capacity will be down by $2 trillion. SBA loans are down 60%. Deposit insurance fund will run out shortly.

• ZION focuses on the Southwest (bubble states). 22^nd largest bank in the US. 7x tangible equity in RE loans and 2x tangible equity in commercial. Company’s credit is deteriorating fast, reserve coverage ratio is dropping quickly (reserves taken so far are inadequate)—holds true for the entire industry. AZ and NV are responsible for about 50% of chargeoffs.

• Bottom Line: Banking crisis unlike anything seen before, there is deleveraging on a massive scale, disconnect between credit and equity markets, extreme correlation and volatility, banks are a proxy for all credit markets, no recovery till banking function is restored. Remain concerned and very bearish. Believes you should position your portfolio with this macro lens.
  

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About Soma Asset Management

• Investment philosophy (foundation of the firm): 1) Value Investing Bias (limited downside) 2) Investing (Looking) Across The Capital Structure, 3) Long Term Bias
• 2008 performance, net, was 26%. Returns driven by focus on credit markets. Saw structured products as a leading indicator (RMBS, CDOs, CLOs, etc). The collapse in ABX preceded fall in banks. Took very large short positions in LEH, BSC, FNM.  Says the recovery rate for many loans issued by banks is 35 cents on the dollar—the carrying value on most bank balance sheets is above this level.

About the Speakers

David Chu. Prior to co-founding Soma Asset Management LLC, Mr. Chu was most recently with Scion Capital, LLC, a fundamental analysis, deep-value hedge fund with over $500 million in assets under management (AUM). While at Scion, Mr. Chu launched that firm's Asia office and served as the company's Executive Director responsible for overseeing the day-to-day operations in Asia. Mr. Chu also worked extensively on Scion's large credit default swap portfolio. Mr. Chu began his career as an investment banker at Goldman Sachs & Co. in New York in the Leveraged Structured Finance Group, where he completed high yield securities offerings and project finance transactions across numerous sectors. Additionally, Mr. Chu was a private equity executive both domestically and internationally, specializing in bankruptcy and distressed opportunities, and worked in financial operations for a technology company. Mr. Chu graduated magna cum laude from Georgetown and earned an MBA from Harvard Business School.

Igor Lotsvin. Prior to co-founding Soma Asset Management LLC, Mr. Lotsvin was a portfolio manager with Symphony Asset Management, LLC, a multi-strategy hedge fund and an asset management firm with over $7 billion in AUM. While at Symphony, Mr. Lotsvin was part of the portfolio management team working on the firm's flagship long/short equity hedge funds (with over $1 billion in AUM) and was lead portfolio manager on several long-only strategies. Mr. Lotsvin was instrumental in building Symphony's long-only strategies, having helped develop this business from concept to over $1.2