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It has become relatively common to read annual reports of companies that previously engaged in regular share buybacks yet mysteriously decided to halt the practice during 2009 even as share prices hit multi-year lows.  As The Economist has noted, share buybacks are making a comeback in 2010 just as markets are approaching levels last seen prior to September/October 2008. Why is this happening now and how should shareholders evaluate management decisions on buybacks?

A Rare Skill Set

Shareholders employ a Chief Executive Officer with an expectation that he or she will intelligently run the business in a manner that is likely to maximize profitability over long periods of time.  Over time and depending on the nature of the specific business, a good manager should be able to generate cash flow above and beyond maintenance capital expenditure requirements.

Operational excellence should ideally result in a growing pile of cash on a company’s balance sheet.  However, simply because a manager is good at running a business and generating free cash flow does not mean that the manager will intelligently deploy the free cash flow for benefit of the company’s owners.  Great operational managers are rare and so are great capital allocators.  It is exceedingly rare to find a manager who is excellent in both areas.

Reinvest or Return Cash to Owners?

When a manager finds that cash is building up on the balance sheet, a choice must be made:  Either the funds will be reinvested within the business or returned to shareholders.  Reinvestment can be accomplished through internal growth or through acquisitions of other companies while returning cash to shareholders can take the form of dividends or share buybacks.

There are a number of factors that naturally predispose  most operational managers to retain cash for reinvestment purposes:

First, excellent operational managers are normally optimists who have a history of seizing opportunities and finding success in areas where others may have failed.  Accordingly, such individuals often have a healthy opinion of their own capabilities and feel that cash in their hands may be used in intelligent ways within their current business.

Second, it is natural for most managers to want to build up the size of the company they oversee in terms of annual sales, number of locations, number of employees, etc.  When a manager says “I run a $10 billion company”, he is normally referring to annual sales volume rather than profitability. Just from an “ego” perspective, there is perceived value in running a larger enterprise.

Finally, and possibly most importantly, financial incentives often reward managers for growing the size of a business even if incremental returns on invested capital are substandard.  If you start with a business earning high returns on capital, incremental investments at inferior returns will only show up slowly in overall results and only be apparent to alert shareholders who are paying careful attention.

Share Buybacks or Dividends?

In cases where the CEO (or the Board of Directors) has decided that there are no legitimate opportunities for internal investment, there are primarily two ways in which excess cash can be returned to shareholders:  Share buybacks and dividends.  Many managers prefer buybacks for a few reasons:

First, a buyback reduces the number of shares outstanding and can mask the effect of option grants to executives and others in the organization.  In the absence of a buyback program, the share count of companies providing options to employees will creep up over time and make it more difficult for managers to achieve growth in reported earnings per share.

Second, managers who hold stock options have a clear incentive to favor buybacks over dividends.  Paying dividends reduces the intrinsic value of options since cash is flowing out of the business to shareholders while the option strike price remains unchanged.  In contrast, a share buyback effectively invests the cash on behalf of remaining shareholders in stock of the company itself which has a positive impact on option holders.

When Buybacks Make Sense

If a company has reached the point where free cash flow cannot be invested internally or via acquisition at acceptable rates of return, the cash should be returned to shareholders either through buybacks or dividends.  Buybacks are only appropriate when management believes that shares are trading at levels under a conservative estimate of intrinsic value.  When such buybacks occur, all remaining shareholders are better off because the intrinsic value of each share will increase and eventually be reflected in market prices.  In contrast, shares purchased indiscriminately at any price can destroy value when managers buy shares at inflated prices.

This leads to the question of whether managers who were repurchasing shares in 2007 and 2008 at high prices but failed to repurchase shares in 2009 were acting in the best interests of shareholders.  There are no blanket answers since each situation is different.  Many companies that had positive free cash flow in 2007 and 2008 were burning cash in 2009 due to the economic downturn.  Continuing a repurchase program even at lower prices could be ill advised if doing so depletes working capital that could cause financial distress or collapse.

Red Flags

When red flags should appear are cases where a company remained profitable and generated free cash flow throughout the economic downturn but mysteriously halted buybacks as the share price declined.  Such managements should answer for why they considered it appropriate to buy back shares at higher prices in 2007 and 2008 but  not at bargain prices in 2009.  There could be valid reasons such as a desire to keep dry powder available for acquisitions made possible by distressed conditions or ensuring that the company builds up even more cash reserves in case of a longer recession or depression.  However, the burden should be on management to explain this decision to shareholders in a coherent manner.  Building up cash far in excess of any conceivable need to protect the business could simply indicate that managers were hoarding cash to sleep well at night at the expense of owners of the business.

The author of this post 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.

Michael Burry and John Paulson both made a killing betting against the housing market.

As a result, the fortunes of Burry, Scion Capital’s founder, and Paulson, of Paulson & Co., have earned them spots as the subjects of books: Burry, as the subject of Michael Lewis’s “The Big Short: Inside the Doomsday Machine,” and Paulson, as the subject of Wall Street Journal reporter Gregory Zuckerman’s “The Greatest Trade Ever.” Zuckerman also touches on Burry in his book.

But looking at the portraits from the two books, these two investors have more in common than their money. Here are some quirks Burry and Paulson share:

They were viewed as different, even socially awkward. Burry believed you had to be unusual to succeed. And he was. “He found it maddeningly difficult to read people’s nonverbal signals, and their verbal signals he often took more literally than they meant them. When trying his best, he was often at his worst,” Lewis writes.

Paulson, similarly, seemed different than his peers. They dressed casually; he wore ties and dark suits. They were making money; he wasn’t. “When he met with clients, they sometimes were surprised by his limp handshake and restrained manner, both unusual in an industry full of bluster,” Zuckerman writes.

Obsessive. Both lived inside their heads for hours at a time, reading hundred-plus-page mortgage-bond prospectuses and studying the housing market to plan their strategies.

“His mind had no temperate zone: he was either possessed by a subject or not interested in it at all,” Lewis writes of Burry.

Paulson’s growing fixation on housing even sparked doubts about his business, writes Zuckerman. “One long-time client, big Swiss bank Union Bancaire Privée, received an urgent warning from a contact that Mr. Paulson was “straying” from his longtime focus, and that the bank should pull its money from Paulson & Co., fast.”

But this obsessiveness likely helped the men in their search for investors supporting the risky bets against the housing market. By mid- 2005, “Burry’s fund was up 242%, and he was turning away investors.” And Paulson made $15 billion for his firm in 2007 alone. (Read an interview with Gregory Zuckerman in Newsweek.)

They did it their way. Neither Burry nor Paulson were experts in derivatives, mortgages or real estate. Burry, a former medical resident, was a self-taught investor, and Paulson focused specialized in corporate mergers.

“Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied [Warren] Buffett, the less he thought Buffett could be copied.” Lewis writes. “Indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual.”

In a guest post yesterday on the excellent Greenbackd blog, S. Raj Rajagopal made a case for shorting Berkshire Hathaway and followed up later with more details regarding valuation.  Mr. Rajagopal is an MBA student at Cornell and has work experience in the investment field.  It takes a great deal of courage to make a public case for shorting Berkshire given the company’s long history and loyal shareholder base.  We often discuss  psychological tendencies that harm investors and one such tendency is to dismiss opposing points of view without critical examination.  Mr. Rajagopal’s case deserves such examination before rendering a judgment.

“Adoration is not an investment strategy”

Mr. Rajagopal bases much of his initial post not on quantitative evidence but on the premise that adoration for Warren Buffett is not an investment strategy.  On this point he is clearly correct.  It makes no sense to simply purchase Berkshire Hathaway because of Warren Buffett’s track record.  Obviously some buyers of Berkshire stock make their decision purely based on Mr. Buffett’s track record.  However, any sophisticated investor understands that you do not purchase a security simply based on folksiness or admiration for a grandfatherly character. If Mr. Rajagopal intended his short case to be read by professionals, he begins with an obvious straw man argument.

Bailout Obsession

Having presented this initial warning against backward looking thinking, it is ironic that much of the rest of Mr. Rajagopal’s thesis simply looks at the past in an attempt to forecast the future without providing any substantial quantitative evidence.  For example, several slides in the initial presentation are devoted to Mr. Buffett’s investments in companies that were in financial distress in 2008.  Much is made of Mr. Buffett’s letter to Treasury Secretary Hank Paulson offering to help construct an investment fund partly using $100 million of Mr. Buffett’s own personal fortune outside Berkshire Hathaway.  Of course, Mr. Buffett’s offer was never acted upon by Treasury.

Mr. Rajagopal goes on to lambast Berkshire as a “bailout baby” simply because Berkshire took large positions in companies that were in financial distress and then allegedly manipulated the political process to stack the deck in favor of Berkshire.  Mr. Buffett received numerous phone calls throughout the financial crisis with offers to invest in distressed firms at very attractive prices.  Should he have ignored such opportunities?  How is Mr. Buffett a “welfare queen” (why not a “bailout king”?) based on investments in which Berkshire’s capital was clearly at risk of loss and actually helped provide the votes of confidence that stabilized the system?  None of this is clear from the presentation.

Incorrect Reading of Buffett’s Statement on Berkshire Valuation

Mr. Rajagopal completely fails to interpret Mr. Buffett’s recent statements on Berkshire’s valuation and claims that the “Oracle of Omaha says Berkshire is overvalued now”.  This is obviously not the case.  As we pointed out in January, Mr. Buffett actually stated that Berkshire was undervalued at the time based on its historical relationship to book value and in his latest letter to shareholders, Mr. Buffett explains his rationale regarding using stock for the Burlington acquisition in great detail.  Berkshire’s stock price has advanced since the conclusion of the Burlington acquisition but Mr. Buffett has made no further comments to support Mr. Rajagopal’s claim that he believes the stock to be “overvalued now”.

Derivatives:  Ticking Time Bombs?

Mr. Rajagopal directly calls Mr. Buffett a “hypocrite” for warning about derivatives in 2002 and then investing in derivatives for Berkshire’s account.  It does not appear that Mr. Rajagopal has any grasp of the nature of Berkshire’s derivatives exposure and he offers no substantiation whatsoever for referring to the derivatives as ticking time bombs.  We discussed the misunderstandings related to Berkshire’s derivatives over a year ago and suggest that Mr. Rajagopal review the article or numerous others which explain the nature of these instruments in detail.

Filling Buffett and Munger’s Shoes

Mr. Rajagopal notes that male life expectancy in the United States is 74 years but does not point out that this is life expectancy at birth.  Mr. Buffett is 79 years old and has an actuarial life expectancy of over eight years.  Mr. Munger is 86 years old and has an actuarial life expectancy of over five years.

At the top of his slide he has a subtitle reading:  “David ‘who’ Sokol” in an apparent reference to Mr. Sokol being one of the more frequently cited candidates for CEO at Berkshire.  It is unfortunate that Mr. Rajagopal has decided that Mr. Sokol is unworthy and we would suggest a review of Pleased But Not Satisfied as a good starting point for Mr. Rajagopal to educate himself on one of Mr. Buffett’s potential successors.

Mr. Rajagopal seems to also have issues with the Burlington acquisition which we have discussed here frequently over the past three months.  However, he provides no valuation information and simply comes up with an “inevitable conclusion” that Mr. Buffett is seeking to “protect his franchise with a mammoth acquisition” prior to handing over the reins.  We are also told that “volatility” will increase due to S&P 500 inclusion and the stock split which will cause Berkshire to become a “volatile middle aged and mature stock”.

Seriously Flawed Valuation Model

After facing a barrage of criticism regarding his initial case for shorting Berkshire, Mr. Rajagopal produced a follow up post with his valuation model.  Unfortunately, the valuation only reinforces the impression that Mr. Rajagopal does not understand Berkshire Hathaway.  The following problems were noted in the model:

1. Earnings per share are used in the valuation model even though reported earnings per share for Berkshire are inadequate for judging progress in intrinsic value on a year to year basis because of the volatility to earnings caused by the timing of capital gains and losses as well as the mark to market requirements for the derivatives book.  In addition, many of Berkshire’s publicly traded holdings have earnings far in excess of paid dividends and Berkshire’s share of such earnings are not reported in Berkshire’s earnings figures.
2. Projections for earnings per share going forward are based on an average of the past five years in reported earnings growth which is purely backward looking and fails to take into account any of the drivers of reported earnings that have changed in recent years (purchase of high yielding securities such as the Goldman Sachs and GE Preferreds, acquisition of BNSF, etc).
3. Book Value progress each year is apparently calculated by adding starting year book value to earnings for the year which fails to account for any changes in book value associated with unrealized gains in Berkshire’s portfolio of publicly traded securities.
4. The model uses a 9% discount rate even though the “notes” section states that an 8% rate will be used.  This has a material long term impact on the valuation.  Neither the 8% or 9% rate is ever justified.
5. Target ROE is set at 10% “since BRK is so big” which is an inadequate explanation of a key variable used in the valuation.
6. The model produces prices at a discount to book value but no explanation is provided regarding what element of goodwill is impaired or why Berkshire would trade at a discount to book value which would be unprecedented.
7. The model mysteriously produces declining valuations for Berkshire after 2016 even though book value continues to grow.  At 2021, we have an absurd calculation of an $84 valuation along with an estimate of $209 of book value leading us to believe that Mr. Rajagopal believes that Berkshire’s price to book value will shrink to 0.40 over the next ten years.

It is difficult to know what to make of Mr. Rajagopal’s short thesis in light of the obvious flaws in both the original presentation and the follow up valuation model.  It took some courage for Mr. Rajagopal to offer a short case for Berkshire but unfortunately he completely failed to justify his thesis.

The author of this post 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.

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Another snippet:

(Thanks to Yaser Anwar for the link.)

A Conversation with George Soros at HKU from JMSC HKU on Vimeo.

Roundtable w/ Soros et al: Make Markets Be Markets from Roosevelt Institute on Vimeo.

Q&A:

Q&A from Make Markets Be Markets from Roosevelt Institute on Vimeo.

In a pattern that would be amusing if it was not so disturbing, we are again witnessing the spectacle of lawyers for a disgraced CEO who claim that their client was “unaware” of key risks that led to the downfall of their firm.  The Lehman Brothers bankruptcy examiners report has been widely covered in the business media over the past few days and, at a minimum, paints a picture of shocking incompetence and an intent to mislead among Lehman’s senior management team.  It is the type of scenario in which a former CEO’s only defense appears to rest on claims that he was incompetent rather than criminally negligent.

Repo 105 Transactions

The Wall Street Journal reports that Lehman management routinely engaged in “Repo 105″ transactions in an attempt to dress up the balance sheet prior to the end of financial reporting periods.  In a normal repurchase agreement, a borrower uses a financial security as collateral for a cash loan.  The agreement generally involves the sale of the collateral combined with a commitment to repurchase the same security at a point in the future at a higher price.  In a “Repo 105″ transaction, Lehman was able to book the transaction as if it was an outright sale rather than an ordinary repo transaction because the assets the firm moved were worth 105% or more of the cash it received in return.

Through this accounting maneuver, Lehman was able to appear less leveraged than it really was.  According to the Wall Street Journal, no United States based law firm would sanction this accounting treatment so Lehman secured an opinion letter from a London law firm named Linklaters.  If a U.S. based Lehman entity needed to engage in a Repo 105 transaction, it would have to move the security to a European division to execute the transaction.

Lehman executives are on record acknowledging the necessity of such transactions as the following quote from a Wall Street Journal article clearly demonstrates:

Four days prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman’s fixed-income division, was searching for a way to meet his balance-sheet target, according to the report. He wrote in an email: “Can you imagine what this would be like without 105?”

A day before the close of Lehman’s first quarter in 2008, other employees scrambled to make balance-sheet reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: “We have a desperate situation, and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it.”

Grossly Negligent, Criminally Responsible, or Merely Incompetent?

Lehman’s CEO Dick Fuld is cited in the bankruptcy examiner’s report as being “at least grossly negligent” regarding the Repo 105 transactions:

The examiner wrote there was “sufficient evidence” to support a legal claim that Mr. Fuld was “at least grossly negligent for failing to ensure” Lehman filed proper financial statements about its accounting for the transactions, and that a key former executive of the firm, the chief operating officer, personally briefed him on the matter.

Of course, Mr. Fuld’s attorneys have decided to pursue the “incompetent” defense as opposed to taking any responsibility for the situation:

Mr. Fuld’s lawyer said on Thursday that Mr. Fuld “did not know what those transactions were” and wasn’t “aware of their accounting treatment.”

It is unclear what is more shocking:  The prospect of a CEO of a major financial institution willfully pursuing financial transactions designed specifically to mislead investors and counterparties into thinking that the firm was less leveraged than it really was or the idea that the CEO really had no idea that these maneuvers were taking place at all.

Buffett’s Decision on a Lehman Investment

The bankruptcy report also contains some interesting information regarding Lehman’s attempts to have Warren Buffett invest $2 billion in the company as a “stamp of approval”.  Of course, Mr. Buffett decided against doing so when he found problems in Lehman’s 10-K as well as negative signals from Lehman executives who were unwilling to invest in the firm on the same terms he was offered.

As is often the case, we can also look at Mr. Buffett’s statements regarding corporate governance to understand what went wrong at Lehman:

“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.”

– Warren Buffett’s 2009 Letter to Shareholders.

If Lehman’s story can be distilled down to its core problem, it seems to be that the company’s CEO did not regard himself as the Chief Risk Officer.  Based on Mr. Fuld’s own admission (if we are to believe him), he was not aware of critical accounting policies that misled investors and counterparties who were using Lehman’s financial statements to judge the health of the business.  Of course, the Repo 105 maneuver was only necessary because of other failures to control risk at the firm.

It would be a refreshing change if at least one CEO involved in the demise of a major financial institution would step up and admit that the responsibility was his rather than hiding behind the “incompetence” defense.

The author of this post 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.

Introduction

This month’s recommendation is an example of a company I considered as a potential stock purchase, but ultimately decided not to buy. This stock may represent a compelling investment opportunity for some, but it doesn’t fit with my investment philosophy, so I decided to pass. Note that I do not believe investors should short sell the stock, as it may appreciate in price.

Company Overview

KHD is an industrial plant engineering and equipment supply company for the cement, coal, and minerals processing industries. Their products and services include plant design, equipment design and development, engineering services, and automation services. KHD operates in India, China, Russia, Germany, the Middle East, Australia, South Africa, and the United States.

Valuation

Most investors who like this stock point to its seemingly attractive valuation. KHD is valued at $419MM based on Wednesday’s stock price of $13.93, but the firm had $402MM of net cash as of September 30, 2009 (latest financial statements). Typically, an investor could look at this information, and say that he or she was purchasing KHD for $17MM ($419MM market capitalization less $402MM of cash). However, in this instance that analysis is incorrect.

When buying a stock, an investor should act as if he or she is buying the whole company. KHD has received ~$149MM of customer prepayments for future work. If an investor were buying the whole company, he or she would insist on keeping the cash necessary to complete requested work and not give the cash to the old owners. This business has historically generated ~6% profit margins (94% cost), so it will need almost all of the $149MM to service the business customers have prepaid. Adding that $149MM to the $419MM market capitalization while subtracting the $402MM of cash results in an investor buying the business for $166MM. I believe normalized cash flow is ~$34MM per year, and thus the Company is trading at a 20% FCF yield. Below I will explain why I do not find this free cash flow yield appealing enough to invest in KHD.

Increased Competitive Pressures

KDH faces increased competitive pressures from companies with capabilities that it does not currently possess. Companies such as Bechtel or Fluor can manage the entire construction of a cement plant, including the design and equipment supply. Increasingly, cement manufacturers use these companies to act as the primary contractors, relegating companies like KHD to a subcontractor role. Based on my calls to those familiar with the industry, companies like KHD are selected directly by clients only in order to reduce cost. Additionally, as a subcontractor, KHD faces price pressures from the primary contractor, as it does not have the direct client relationship. Despite the seemingly compelling free cash flow yield, this concern over competitive pressures leads me to doubt the long term sustainability of the KHD’s cash flow generating ability.

The author of this article is Matt Darrah, Chief Investment Officer of MD Capital Management and contributor to The Manual of Ideas. Matt describes his background as follows: "I have been investing since 1998 (age 16) when I saved nearly all my money from working on my winter break from high school, and invested it according to the value investing principles I had read about in Warren Buffett’s shareholder letters and books about value investing. After high school, I attended Southern Methodist University (SMU) in Dallas, Texas, where I graduated summa cum laude with a degree in finance. Post graduation, I worked in investment banking for two years (helping companies raise financing, buy other businesses or sell their businesses) before joining a private equity and debt investment firm, where I have worked for three years. My investing philosophy has been developed through my (i) insatiable reading of books written by and about prominent value investors and their investment philosophy, (ii) 11 years of public market investment experience and (iii) three years of private equity experience, where I have invested and/or manage over $625MM of investments in 6 companies."

Beware the costs of financial middlemen. You may think you're only paying 0.5% to 2% to have other people manage your money, but the multiple layers of financial intermediation that is so prevalent in today's investing world – with one money manager subcontracting to another – can lead to as much as 6% in non-performance-related fees being assessed along the way. What's worse is that this proliferation of the middlemen has been accompanied by rising CEO pay but often lukewarm returns for shareholders -- the ultimate owners of the companies.

View the interactive presentation.

Berkshire Hathaway’s 2010 Proxy Statement was released yesterday and much attention has been devoted to the low compensation provided to Warren Buffett and Charlie Munger.  Mr. Buffett’s total compensation remained at $175,000 which included $100,000 of salary and $75,000 in director’s fees from the Washington Post.  In addition, the company paid $344,490 for Mr. Buffett’s personal security during 2009.  Mr. Munger’s salary remained at $100,000.  Marc Hamburg, Berkshire’s Chief Financial Officer, received $874,750 in total compensation. The $100,000 salary for Mr. Buffett and Mr. Munger has remained constant for 29 years, during which time inflation has eroded over 60 percent of the purchasing power of a dollar.

Appropriate Alignment of Incentives Today …

According to Berkshire Hathaway’s Owner’s Manual, Mr. Buffett has over 98 percent of his net worth in Berkshire while Mr. Munger’s family has over 80 percent invested in the company.  Both men wish to set an example by ensuring that their fortunes move in lockstep with the results for investors:

Charlie and I cannot promise you results. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner. We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when our partners do and in exactly the same proportion. Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours.

As a result of this unique management philosophy and heavy ownership interest, it is hard to see how large salaries would do anything to enhance the alignment of incentives between Berkshire management and shareholders.  Mr. Buffett has stated on many occasions that he would happily pay Berkshire in exchange for running the company.  Berkshire shareholders are the big winners in this arrangement.  Mr. Buffett’s salary in 2009 amounted to approximately 11 cents per Class A share.

However, Berkshire’s Policy May Be Flawed …

When a company establishes a policy on executive compensation, the arrangement needs to codify principles that will apply regardless of who holds the top management position.  Policies should not be set up such that they work when applied to unique situations but fail to work in a broader context. Unfortunately, Berkshire’s overall policy on executive compensation may fall into this category.  Here is the policy statement from the proxy:

The Committee has established a policy that: (i) neither the profitability of Berkshire nor the market value of its stock are to be considered in the compensation of any executive officer; and (ii) all compensation paid to executive officers of Berkshire be deductible under Internal Revenue Code Section 162(m). Under the Committee’s compensation policy, Berkshire does not grant stock options to executive officers. The Committee has delegated to Mr. Buffett the responsibility for setting the compensation of Mr. Hamburg, Berkshire’s Senior Vice President/Chief Financial Officer.

Based on the wording of this policy, it seems like it is intended to apply over the long run, which means it will apply to Mr. Buffett’s successor as Chief Executive Officer.  The policy is indicating that the executive officers cannot be paid in a manner that is based on profitability of Berkshire or the market value of the stock.  Accordingly, stock options are not granted to executive officers.

The obvious question is how the Board intends to align the incentives of the next CEO with the interests of shareholders if they will not take into account company profitability or even the long term share price.  What will the overall compensation philosophy look like and what performance metrics will be used to set salary and bonus compensation?  These are legitimate questions that are not adequately answered in the current policy on executive compensation and require clarification.

The next CEO at Berkshire is very likely going to be someone who is motivated by a desire to follow in Mr. Buffett’s footsteps and to continue his legacy.  Money may not be a driving factor since the successor is almost certain to be independently wealthy already.  However, the next CEO is not going to have nearly as much of an ownership interest in Berkshire compared to Mr. Buffett and therefore it is necessary to formalize a compensation system that provides monetary incentives that are aligned with shareholder interests. Furthermore, this should be done while Mr. Buffett is running the company and can provide his “stamp of approval” since any successor who seeks a change is likely to encounter substantial criticism when proposing any changes to policies that applied under Mr. Buffett.

The author of this post 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.

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Yesterday I highlighted an investment strategy I first read about in a Spring 1999 research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy. The premise, simply stated, is to identify undervalued small capitalization stocks where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’m going to explore it in some depth over the next few weeks.

The idea is reminiscent of “Super” Mario J. Gabelli’s Private Market Value with a Catalyst methodology, the premise of which is the value of a company “if it is acquired by an informed wealthy family, or by another private or public corporation, as opposed to the price it is trading at in the stock markets. Simply put, it is the intrinsic value of a company plus the control premium:”

To calculate PMV, Gabelli first takes into account the free cash flow (after allowing for depreciation), deducts debt and net options (stock options) and adds back the cash. To this, he then applies an ‘appropriate’ multiple to arrive at the PMV. It sounds simple enough, but where you can go completely wrong is the multiple. Gabelli says he either looks at recent valuations of similar acquisitions or applies an appropriate historical industry acquisition multiple to arrive at the PMV.

“Some of the factors that we look at while deciding multiples to apply are: what the business is going to be worth in five years from now, what kind of return on equity can we get over time, how much further debt can be put on the company, the tax rate and what the company would be worth if there was no growth or at some particular rate (4 or 8 per cent for instance),” he explains. Of course, the multiple – and the PMV – changes over time, as it is a function of interest rates, the capitalisation structure and taxes, all of which have an indirect impact on the value of the franchise.

Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recall were each called “Endangered Species Update” and discussed the returns from the strategy. It seems that those follow-up reports are now lost to the sands of time. All that seems to remain is the press release of the final report:

For the last few years, Piper Jaffray has been reporting on the difficulties that small public companies face in today’s equity markets. Since the late 1990s many well run, profitable companies with a market capitalization of less than $250 million have watched their share prices underperform the rest of the stock market. With limited analyst coverage and low trading liquidity, many high-quality small companies are “lost in the shuffle” and trade at significantly lower valuation multiples than larger firms. Since our 1999 report “Wall Street’s Endangered Species,” we have held the position that:

This is a secular, not cyclical, trend and the undervaluation will continue. The best strategic move to increase shareholder value is to pursue a change-of-control transaction. Company management and the Board should either sell their company to a large strategic acquirer with the hope of gaining the buyer’s higher trading multiple, or take the company private.

In the last few of years, many small public companies identified this trend and agreed with the implications. Executives responded accordingly, and the number of strategic mergers and going-private transactions for small companies reached all-time highs. Shareholders of these companies were handsomely rewarded. The remaining companies, however, have watched their share prices stagnate.

Since the onset of the recent economic slowdown and the technology market correction, there has been much talk about a return to “value investing.” Many of our clients and industry contacts have even suggested that as investors search for more stable investments, they will uncover previously ignored small cap companies and these shareholders will finally be rewarded. We disagree and the data supports us:

Any recent increase in small-cap indices is misleading. Most of the smallest companies are still experiencing share price weakness and valuations continue to be well below their larger peers. We strongly believe that when the overall market rebounds, small-cap shareholders will experience significant underperformance unless their boards effect a change-of-control transaction.

In this report we review and refresh some of our original analyses from our previous publications. We also follow the actions and performance of companies that we identified over the past two years as some of the most attractive yet undervalued small-cap companies. Our findings confirm that companies that pursued a sale rewarded their shareholders with above-average returns, while the remaining companies continue to be largely ignored by the market. Finally, we conclude with our third annual list of the most attractive small-cap companies: Darwin’s Darlings Class of 2001.

Piper Jaffray did follow up the reports in a 2006 article called Is There a Renewed Prospect of Going-Private Transactions? Their conclusion:

Small-Cap Stocks Outperform

Small-cap stocks have experienced a dramatic resurgence over the past five years. With weak performances from large-cap stocks, small-caps have become more favorable investments with better returns and stronger trading multiples. Here is what we have seen:

• Over the last one-, three- and five-year periods, companies in the Russell 2000 have offered average returns of 21%, 227% and 240%, respectively, compared to S&P 500 companies with average returns of 16%, 89% and 57%, respectively.
• The valuation gap that we saw five years ago between the bottom two deciles of companies in the Russell 2000 and the S&P 500 no longer exists, with the last two deciles in the Russell trading at only a 3% discount to the median EBIT multiple of S&P 500 companies and a 9% premium over the median P/E multiple.

(Click to embiggen)

Despite the rebound in valuations, small-cap stocks continue to face the same capital market challenges:

• For companies with market caps between the $50 million and $250 million range, there are approximately 1.3 analysts covering each stock versus 7.7 analysts for companies with market caps of more than $250 million.
• Trading volumes are slightly higher, with the last three deciles trading an average 202,276, 176,092 and 223,599 shares, respectively, per day, but still significantly below the volume of S&P 500 companies, which trade an average of 4.0 million shares per day.

More to come.

The Role of Warren Buffett and David Sokol

Here are some passages that mention Warren Buffett's contacts with Lehman as it was trying to raise capital:

pp. 613-614: After the near collapse of Bear Stearns, Lehman moved to raise additional capital. Lehman initiated work on an equity offering and restarted efforts to locate candidates willing to make a strategic investment in Lehman. In late March [2008], Lehman undertook discussions with Warren E. Buffett, CEO of Berkshire Hathaway. However, those discussions did not result in any investment by Buffett, Berkshire Hathaway, or any of its affiliates. Instead, at the beginning of April 2008, Lehman completed a $4.0 billion convertible preferred stock offering. Other offerings to bolster Lehman’s capital followed in May and June.

pp. 640-642: The SpinCo idea was a variation on a good bank/bad bank structure. Among
Lehman’s strategic options, SpinCo had a longer time horizon than other options, because substantial advance work would be needed. By early August 2008, Lehman anticipated completing the spin‐off in the first quarter of 2009. Lehman intended SpinCo to accomplish four interrelated purposes. The first and primary purpose of SpinCo was to relieve Lehman’s balance sheet of its “outsized” commercial real estate exposure that had become a source of increasing market concern and pressure. Second, by moving those assets to a separate entity, Lehman hoped to avoid the necessity of having to continue marking down those assets as the market continued to deteriorate. That process had exposed Lehman to criticism in the press and by analysts in what Hugh “Skip” E. McGee, III, the head of Lehman’s Investment Banking Division, referred to as the “are we marked correctly game.” Third, by spinning off those assets, Lehman would avoid a “fire sale for the vultures” that would have locked in its paper losses. Instead, SpinCo would allow Lehman to manage those assets on a value‐maximizing basis for the benefit of Lehman’s shareholders, either by selling the SpinCo assets or holding them to maturity. Fourth, once Lehman had purged its balance sheet of “toxic” commercial real estate assets, it hoped that the post‐spin “clean” or “core” Lehman (a.k.a. “CleanCo”) could achieve returns on equity in the low teens, twelve times net leverage, and maintain an A rating. However, SpinCo faced substantial structural and execution issues that led some observers to question its feasibility. Paulson told the Examiner that he expressed great skepticism about SpinCo to Fuld and advised him to abandon the plan. James L. “Jamie” Dimon, JPMorgan’s CEO, told the Examiner that he did not believe that SpinCo would work, thinking that the proposal was too leveraged, too complex, and involved too much real estate. When the concept was described to Buffett, he dismissed it. Ultimately, Lehman was not able to carry out the SpinCo plan prior to its bankruptcy.

p. 651: In March 2008, Lehman had approached Buffett concerning a private investment. In mid‐July 2008, Lehman again considered approaching Buffett about investing in SpinCo debt. In late August or early September 2008, McGee called MidAmerican Energy Holdings’ President David L. Sokol, hoping to entice Sokol either to have MidAmerican Energy Holdings invest in the SpinCo plan or to advocate the plan to Buffett. McDade and McGee showed Sokol Lehman’s “Gameplan”
presentation, explaining that Lehman was ready to execute the plan if Lehman had an investor. Sokol was not interested in investing, but relayed the basic premise of the SpinCo plan to Buffett. During that discussion, Buffett dismissed the idea as unrealistic.

p. 664-667: In late March 2008, McGee suggested that Lehman reach out to Buffett. McGee had a pre‐existing banking relationship with Sokol of MidAmerican Energy, which is majority‐owned by Buffett’s Berkshire Hathaway. Either McGee or Joseph G. Sauvage, LBI Vice‐Chairman, called Sokol to ask if Buffett would take Fuld’s call. Jerry A. Grundhofer, who was about to join Lehman’s Board, also asked Buffett if he would take Fuld’s call. Buffett agreed. Before calling Buffett, Fuld called Sokol on March 27, 2008. That same day, Lehman prepared a draft of a letter, to be sent by Fuld to Lehman employees, outlining a $3.5 billion investment from Buffett in Lehman’s preferred stock at a $54 per share conversion price. Fuld told the Examiner that he did not know how that letter came to be prepared, and it does not appear that Fuld saw the draft. Fuld also did not recall Buffett indicating a willingness to invest $3.5 billion. Buffett was surprised that Lehman had prepared a draft letter announcing the deal, because he never got close to a deal with Lehman. Fuld and Buffett spoke on Friday, March 28, 2008. They discussed Buffett investing at least $2 billion in Lehman. Two items immediately concerned Buffett during his conversation with Fuld. First, Buffett wanted Lehman executives to buy under the same terms as Buffett. Fuld explained to the Examiner that he was reluctant to require a significant buy‐in from Lehman executives, because they already received much of their compensation in stock. However, Buffett took it as a negative that Fuld suggested that Lehman executives were not willing to participate in a significant way. Second, Buffett did not like that Fuld complained about short sellers. Buffett thought that blaming short sellers was indicative of a failure to admit one’s own problems. Following his conversation with Buffett, Fuld asked Paulson to call Buffett, which Paulson reluctantly did. Buffett told the Examiner that during that call, Paulson signaled that he would like Buffett to invest in Lehman, but Paulson “did not load the dice.” Buffett spent the rest of Friday, March 28, 2008, reviewing Lehman’s 10‐K and noting problems with some of Lehman’s assets. Buffett’s concerns centered around Lehman’s real estate and high yield investments, lending‐related commitments, derivatives and their related credit‐market risk, Level III assets and Lehman’s securitization activity. On Saturday, March 29, 2008, Buffett learned of a $100 million problem in Japan that Fuld had not mentioned during their discussions, and Buffett was concerned that Fuld had not been forthcoming about the issue. The problems Buffett saw in the 10‐K along with Fuld’s failure to alert Buffett to the issue in Japan cemented Buffett’s decision not to invest in Lehman. At some point in their conversations, Fuld and Buffett also discovered that there had been a miscommunication about the conversion price. Buffett was interested only in convertible preferred shares. Buffett told Fuld that he was willing to agree to a $40 conversion price per share, while Fuld thought Buffett was offering to buy in at “up‐40,” or 40% above the current market price, which would have been about $56 per share. On Friday, March 28, 2008, Lehman’s stock closed at $37.87. Fuld spoke to Lehman’s Executive Committee and several Board members about his conversations with Buffett. Lehman recognized that an investment by Buffett would provide a “stamp of approval.” However, Lehman already had better offers for its April capital raise, and Lehman did not think it could give a better deal to Buffett at the same time it gave a less attractive deal to others. On Monday, March 31, 2008, before Buffett could tell Fuld that he was not interested, Fuld called Buffett to say that Lehman could not accept his terms.

p. 667-668: McGee contacted Sokol again in late August or early September 2008 and outlined Lehman’s “Gameplan” for survival, specifically SpinCo. During a subsequent telephone call with Sokol, McGee explained the “good bank/bad bank” scenario and stated that Lehman would need an investor. Sokol believed the e‐mail and call were intended to induce Sokol to pass that information on to Buffett, so Sokol briefed Buffett on SpinCo. Buffett thought the idea would not solve Lehman’s problems. Sometime during the week prior to Lehman’s bankruptcy, McGee again reached out to Sokol with what both Sokol and McGee described to the Examiner as a “Hail Mary” pass. McGee asked, “Do you have any ideas to save us?” Sokol, who was bear hunting in Alaska at the time, told McGee that he did not.

p. 708: On Saturday, September 13, 2008, Barclays reached out to Buffett to ask whether Buffett would guarantee Lehman’s operations until a Lehman‐Barclays deal closed. Barclays and Buffett discussed a scenario in which Buffett would provide $5 billion of protection. Buffett expressed interest in that possibility, but Barclays did not pursue it.

p. 709: Lehman’s management had scheduled a Board meeting for noon on Sunday, September 14, 2008, but delayed the meeting until 5:00 p.m. in order to try to come to some resolution at the FRBNY meetings. At some point on Sunday, Fuld was told that the FSA would not waive the requirement that a guaranty of Lehman’s obligations required the approval of Barclays’ shareholders, and therefore the FSA would not approve the Barclays deal. Fuld asked Paulson to call Prime Minister Gordon Brown, but Paulson said he could not do that. Fuld asked Paulson to ask President Bush to call Brown, but Paulson said he was working on other ideas. From that, Fuld inferred that Paulson was going to call Buffett, although Paulson never mentioned Buffett’s name. Fuld brainstormed about other means to contact and convince the FSA to permit the deal, including having Jeb Bush, a Lehman advisor, ask President Bush to call the Prime Minister.

The Role of David Einhorn

Greenlight Capital's David Einhorn is also mentioned in the report. Here are the excerpts:

p. 205-206: ...David Einhorn of Greenlight Capital, who at the time held short positions in Lehman, stated in an April 8, 2008 speech: "There is good reason to question Lehman’s fair value calculations. . . . Lehman could have taken many billions more in write‐downs than it did. Lehman had large exposure to commercial real estate. . . . Lehman does not provide enough transparency for us to even hazard a guess as to how they have accounted for these items. . . . I suspect that greater transparency on these valuations would not inspire market confidence." Einhorn’s skepticism was also reflected in the financial press. On March 20, 2008, Portfolio.com published an article titled “The Debt Shuffle,” which asked: “What actually happened to Lehman’s balance sheet in the first quarter? Assets rose. Leverage rose. Write‐downs were suspiciously miniscule. And the company fiddled with the way it defines a key measure of the firm’s net worth.” Lehman’s Head of U.S. Global Credit Products, Eric Felder, forwarded this article to Ian Lowitt, Lehman’s Co‐Chief
Administrative Officer, with the note, “bunch of people looking at this article,” to which Lowitt replied, “[d]oesn’t help.” Firms such as Lehman required the confidence of the market to assure its sources of short term financing that they would be repaid; and the market’s confidence in Lehman was publicly questioned.

p. 661: SpinCo was seen by some as validation of their suspicion that Lehman’s assets were not properly valued. David Einhorn, President of Greenlight Capital, told the Examiner that the creation of SpinCo supported his contention that Lehman had not been marking down its commercial assets. Einhorn believes that Lehman’s efforts to spin out its commercial real estate into a company where the assets did not have to be marked to fair value revealed that Lehman had not been marking those assets to fair value. 

p. 713: After Bear Stearns nearly collapsed, short sellers began to focus on Lehman and other banks. On March 20, 2008, Russo contacted Linda Thomsen, the SEC’s Head of Enforcement, regarding rumors of hedge funds “taking another run at Lehman.” On April 1, 2008, at Lehman’s prompting, Erik R. Sirri, head of the SEC’s CSE program, made a statement at an annual conference regarding the SEC’s view of the seriousness of rumors and stock manipulation in the context of short sales. At the April 15, 2008 Board meeting, Lehman’s management discussed Lehman’s concerns regarding short selling. On May 21, 2008, at the Ira Sohn Conference, one day after the comment period for the SEC’s proposed rule concluded, Einhorn gave a presentation on Lehman, analyzing Lehman’s Form 10‐Q, filed April 9, 2008.2767 Einhorn announced that he was shorting Lehman’s stock based on his belief that the stock was over‐valued. Before that presentation, Einhorn had corresponded with Callan in mid‐May 2008, as part of what he described as fact‐checking in advance of his presentation at the Ira Sohn Conference. Einhorn focused on four major issues in his correspondence with Callan and in his May 21, 2008 speech: (1) Lehman’s disclosures regarding CDO exposure and related write‐downs; (2) the difference between the amount of Level III assets disclosed in the Form 10‐Q filed in February 2008 and during Lehman’s first quarter 2008 earnings call; (3) Lehman’s disclosure and valuation of its stake in KSK Energy; and (4) Lehman’s write downs of its CMBS assets. On the day of Einhorn’s speech, Lehman’s stock closed down $2.44, with its highest volume of the entire month of May 2008. Einhorn’s criticism of Lehman and Callan is commonly cited as the reason for Callan’s replacement less than three weeks later. Following the near collapse of Bear Stearns, Einhorn published a book, Fooling Some of the People All of the Time, which focused on Allied Capital. Thomas C. Baxter, Jr., General Counsel to the FRBNY, said that reading Einhorn’s book made him think that the FRBNY should pay more attention to short sellers’ concerns. However, Baxter did not reach that conclusion for the reason that Lehman would have wanted, namely to persuade the Government to regulate short sellers, but rather because it appeared to Baxter that Einhorn may have been shorting Lehman for good cause. Baxter was unable to say, however, whether anyone at the Federal Reserve followed up on Einhorn’s criticism of Lehman in his speech.

The following are links to the Report of the Examiner in the Chapter 11 proceedings of Lehman Brothers:

(click to enlarge)

Click here for more charts from the U.S. Census of 1870.