The Ideas Report For Serious Investors

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The Superinvestor Issue of The Manual of Ideas is out!

Inside you'll find comprehensive coverage of the portfolio moves of more than 50 top investment managers, including idea rankings based on our proprietary Signal Rank methodology. The latter reveals the current top ideas of the world's best investors, as determined by an acclaimed proprietary scoring process of The Manual of Ideas.

The following is our superinvestor coverage list:

Here is a complete table of contents:

Access the full 167-page report -- subscribe today!

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Good article by Atlantic Monthly on how Soros famously "broke" the Bank of England.

(Thanks to Nadav Manham for the link.)

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By Greenbackd

In The value of Seth Klarman (free registration required), Absolute Return has a rare interview with the president and portfolio manager of the 28-year-old Baupost Group. In the interview, Klarman discusses several of Baupost’s positions over the last twelve months, including the fund’s stake in Facet Biotech, which I fumbled last year:

Around the same time the CIT deal was playing out, Klarman took a sizable stake in Facet Biotech—a small biotech company spun off in December 2008 from PDL BioPharma—for an average cost of $9 even though it had $17 per share in net cash at the time of the spinoff. “We liked the discount and pipeline of products,” Klarman recalls. “We knew that when small caps are spun off, they are frequently ignored and become cheap.”

Biogen Idec tried to acquire Facet in a hostile deal for $14.50 per share, raising the offer later to $17.50. When Facet allowed its largest shareholder, Biotech Value Fund, to buy up to 20% of the company, Baupost asked for identical terms, essentially becoming a poison pill. Baupost then told Facet it did not intend to tender its shares in the $17.50 per share offer. Eventually Biogen backed off, and Facet accepted a $27 per share offer from Abbott Laboratories.

Here Klarman discusses his strategy more broadly:

Value investors are typically thought of as stock investors, but Klarman says most of the time he prefers to buy bonds. Bonds are a senior security, offering more safety, and they have a catalyst built into them. Unlike equity, debt pays current principal and interest. If the issuer doesn’t make that timely payment, an investor can take action. “Catalysts can reduce your dependence on the level of the market or action of the market,” he explains. For example, defaults are specific incidents affecting the company regardless of what is going on in the overall market.

Over the past two years, Klarman’s preference for debt has been even more pronounced. After peaking at just $2 billion in June 2008, Baupost’s total equity assets shrank to around $1.2 billion from the fourth quarter of 2008 to the first half of 2009, before turning up slightly at year-end 2009 to nearly $1.6 billion. That puts equities at just a little more than 7% of total assets under management.

And his view on the market

The value pro is still looking at troubled companies, mortgage securities and select equities. But he is not buying much at the moment. Klarman says there are some opportunities in commercial real estate on the private side, but not as much as would be expected, given the depressed levels of the market. “That’s why we want to be patient,” he stresses.

Baupost is 30% in cash now, its long-time average. Klarman stresses that the cash position is residual—the result of a search for opportunity and not the result of a macro view. He says he can find great opportunities to buy at the same time he has a bearish view on the world. “We’re good at finding bargains, good at doing analysis,” he emphasizes. “We’re not good at calling short-term movements in the markets.”

And when the markets started to crumble in mid-May, he mostly stood pat, asserting that the 5% to 8% drop in prices did not unleash a torrent of bargains, mostly because of the market’s surge from its March 2009 bottom. “The market has gone up so much that, based on valuation, it is overvalued again to a meaningful degree where the expected returns logically from here can be as low as the low single digits or zero for the next several years,” he says.

Click here to see the remainder of the interview (free registration required).

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By Greenbackd

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From C-SPAN: "Responding to questioning, Warren Buffett agreed that there are still risks involved in the derivatives market during today’s Financial Crisis Inquiry Commission hearing. The hearing focuses on the role of ratings firms in the financial crisis and is titled, "Credibility of Credit Ratings, the Investment Decisions Made Based on those Ratings and the Financial Crisis.” Executives from Moody’s, including its current CEO, are also among the witnesses. Mr. Buffett's Berkshire Hathaway is Moody's largest shareholder."

FCIC Hearing: Session 1   

FCIC Hearing: Session 2 (incl. Buffett testimony)

FCIC Hearing: Session 3

AP: Congress grills Moody's officials

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It is said that those who fail to study history are doomed to repeat it.  The benefits of a careful study of general history is self evident and the same applies to investors who wish to learn from past events as well as the mistakes of others.  There is no reason to learn painful lessons firsthand when we can learn vicariously through our predecessors.  At the same time, it is important to guard against the tendency to judge those making decisions in the past solely based on events that occur subsequently.  However, it is reasonable to expect that an individual making a decision in the past should have acted logically based on knowledge available at the time.

With this in mind, it is interesting to review Michael Burry’s letter to his investors written in November 2006.  ‘A Primer on Scion Capital’s Subprime Mortgage Short’ is Dr. Burry’s attempt to explain his decision to take a bearish position in credit default swap contracts.  Based on accounts in The Big Short, which we reviewed last week, Dr. Burry’s investors were highly skeptical of his short position and many were threatening to withdraw funds.

Viewed from our perspective in May 2010, Dr. Burry’s investment thesis was obviously correct and the letter makes perfect logical sense.  We have the benefit of hindsight and are fully aware of the wreckage in the mortgage market that took place after mid 2007.  However, the real question is whether the argument was persuasive from the vantage point of late 2006.  It certainly appears persuasive even if one does not base that judgment on what we know today.  Dr. Burry clearly outlines the structure of the securitizations in question, documents the very thin nature of the lower tranches, and shows how a modest level of default could easily hit the higher “investment grade” tranches.

The following excerpt is from the conclusion of Dr. Burry’s letter and nicely illustrates the risk/reward characteristics of the trade.  If the thesis was proven to be incorrect, the annual cost of carrying the position would amount to about six percent of fund assets each year.  The benefits of the thesis being proven correct was massively larger than the actual risk assumed:

The Funds currently carry credit default swaps on subprime mortgage-backed securities amounting to $1.687 billion in notional value. As I selected these, I was not looking to set up a diversified portfolio of shorts. Our shorts will have common characteristics that I deemed to be predictive of foreclosure, and therefore they should be highly correlated with each other in terms of both the timing and the degree of ultimate performance. Again, ultimate performance matters much more than the valuation marks accorded us by our counterparties in the interim. In the worst case, I expect our mortgage short will fully amortize to nil value over the next three years, corresponding to an average annual cost of carry over that time of roughly six percent of current assets under management. Calibrating the more positive outcomes will become easier as 2007 progresses.

It is always risky to retroactively pass judgment on decisions that were made in the past with imperfect information.  It is true that the consensus viewpoint at the time was that nationwide home prices “never” decline, and if this is accepted at face value, the annual six percent cost of carry could seem like a simple speculation.  Dr. Burry’s investors included sophisticated and well respected value investors who today would probably concede that his short thesis was accurate but disagreed strongly at the time. Alan Greenspan still thinks that those who predicted the housing bubble were merely lucky “statistical illusions”.

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.    

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Warren Buffett was highly critical of Kraft’s acquisition of Cadbury throughout the takeover process.  It is therefore not entirely surprising to learn that Berkshire Hathaway cut its stake in Kraft by nearly 23 percent during the first quarter. It is not common for Mr. Buffett to openly criticize managers so it was all the more notable to hear him say that the deal made him feel poorer, particularly due to the “dumb transaction” involving the sale of Kraft’s pizza business to fund part of the acquisition.

In a 13F Filing with the Securities and Exchange Commission this afternoon, Berkshire reported holding 106.7 million shares of Kraft as of March 31, 2010 compared to nearly 138.3 million shares on December 31, 2009.  In addition to the sale of Kraft shares, Berkshire liquidated shares in several other companies and added to positions in three companies.  No new positions were initiated during the quarter.  Let’s take a brief look at the Kraft sale and other transactions revealed in today’s report.

Why Sell if Kraft is Still Undervalued?

The reason we stated that the sale of Kraft shares was not “entirely surprising” is due to Warren Buffett’s longstanding preference for dealing only with managers who can be trusted to exercise good business judgment.  With wholly owned subsidiaries, Mr. Buffett is looking for good operational managers who can run their businesses well but he handles all capital allocation personally.  This is not the case with minority stakes in public companies.  Mr. Buffett quite clearly believes that Kraft CEO Irene Rosenfeld is incompetent in capital allocation, although he has said that she is a capable operational manager.

What makes the size of the reduction somewhat surprising is that Mr. Buffett still believes that Kraft is undervalued on a component part basis.  According to several accounts of notes taken at the Berkshire Hathaway annual meeting (for example, click on this link for The Inoculated Investor’s notes), Mr. Buffett quite clearly stated that Kraft is undervalued.  The implications of a large sale is that the degree of undervaluation may not represent enough of a margin of safety to protect against future incompetence in capital allocation.  Of course, Berkshire continues to own a large stake in Kraft even after the sales during the first quarter.

Other First Quarter Portfolio Changes

During the first quarter, Berkshire eliminated positions in Wellpoint, United Health Group, Travelers, and SunTrust Bank.  Both individually and in aggregate, these were relatively small positions for Berkshire and from the prior 13F report, it appears that the Wellpoint and United Health stakes were most likely positions controlled by GEICO’s Lou Simpson.

In addition to Kraft, positions that were reduced but not entirely eliminated include CarMax (3.4% reduction), Costco (17.5% reduction), Gannett (21% reduction), Johnson & Johnson (11.9% reduction), M&T Bank (17.2% reduction), Moody’s (3.2% reduction), Conoco Philips (9.4% reduction), and Proctor & Gamble (9.6% reduction).

Berkshire added to its position in three companies:  Republic Services (30.6% addition), Iron Mountain (11.4% addition), and Becton Dickinson (16.3% addition).

In addition to the changes noted above, the latest report shows the effect of Berkshire’s acquisition of Burlington Northern Santa Fe.  The 76.8 million shares that were held as of December 31, 2009 no longer appear on the report due to the completion of the acquisition on February 12.

Due to the widespread availability of free high quality resources for viewing Berkshire’s portfolio in real time, we are no longer providing the spreadsheet that was previously posted following the 13F release.  Instead, we suggest using Dataroma’s Berkshire portfolio tracker for basic information or GuruFocus.com for more in depth coverage.

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.

Posted by manualofideas at 04:51 AM | Permalink | Comments (0)

In recent weeks, there has been some speculation that Li Lu may be a potential candidate for Chief Investment Officer at Berkshire Hathaway once Warren Buffett retires.  Berkshire Hathaway’s succession plans call for Warren Buffett’s job to be split into two roles.  The new CEO will have ultimate responsibility for Berkshire Hathaway and one or more investment officers will have oversight responsibility for investment operations and will report to the CEO.

Who is Li Lu?  According to his Wikipedia entry, Li Lu was an organizer of the student protest movement in China and took part in the Tiananmen Square protests of 1989.  After the post-Tiananmen crackdown, Mr. Lu had to flee mainland China and moved to the United States where he became one of the first students in the history of Columbia University to complete three degrees simultaneously:  a B.A. in Economics, a J.D. from Columbia Law School, and a M.B.A. from Columbia Business School.  Mr. Lu founded Himalaya Capital in 1997 and ran the fund until 2004.  In 2004, he founded a long only investment vehicle named LL Investment Partners.

During the Berkshire Hathaway annual meeting, Charlie Munger made a vague reference to a candidate for the CIO position who returned 200 percent in 2009.  At the Wesco meeting the following week, Mr. Munger mentioned Li Lu in the context of the BYD investment.  While no specific reference has been made to Li Lu, it is obvious why there is some speculation regarding the possibilities.

In the following video, Li Lu speaks to Bruce Greenwald’s value investment class at Columbia University. Please click on this link for the video.  Note that registration is not required to view the video.  Simply click on the play button in the center of the display.  Do not select a video quality.  The site will open up an unrelated window but should begin streaming the main presentation.  The actual lecture starts at about the three minute mark.

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.

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By Nadav Manham

In his annual letter to Moore Capital investors, Louis Bacon wrote about his fund's new marketing strategy:

Bacon also said it's looking to attract longer-term investors after its performance was restrained by redemptions during the financial crisis.

Moore Capital has a new marketing team, which "has had very good success in attracting what we hope is sticky capital from more institutional investors," he wrote in the letter.

Bacon is a rock star among hedge fund rock stars. His fund has returned over 20% for over two decades. My understanding is that he charges above-market fees and has a long lock-up. If even he needs stickier capital, imagine how difficult it is for everyone else. And how important.

My working hypothesis about attracting sticky capital is that it is a two-part process. The first part involves, as Bacon notes, attracting more institutional investors with a long-term capital base. This is not easy, but it is simple: everyone knows who these investors are. You might think of this as "structural stickiness": that portion of an LP's propensity to redeem capital from your fund that can be explained by the type of investor it is (pension, endowment, fund of funds, high net worth, etc). The way to increase the aggregate structural stickiness of your capital base is to attract LPs in the right categories. Simple but not easy.

The second part of the process is more amorphous and intangible. It is the effort to increase an LP's "non-structural stickiness," which can be defined as that portion of an LP's propensity to redeem capital that cannot be explained by its category. High non-structural stickiness can overcome low structural stickiness. That is, an investor in a category known for being flighty can sometimes be your most loyal investor. Consider Warren Buffett's father-in-law:

"Doc Thompson was the kind of guy, he gave me every penny he had, basically. I was his boy."

That was in 1956, and it worked out well. Non-structural stickiness is a function of persuasion, positioning, and underwriting.

I've created a new category called "The Search for Sticky Capital" in which I plan to explore these issues further, the search for both structural and non-structural sticky capital. I will explain what I mean by "persuasion, positioning, and underwriting." The presence of sticky capital is a significant source of competitive advantage for a hedge fund, so the ability to attract it and create it is crucial.

I confess I am a novice in this area, so I welcome any thoughts you may have.

P.S. On the flip-side, from the perspective of a prospective investor in a hedge fund, sticky capital is also very important. You want to spend time learning about how a fund goes about increasing the stickiness of its capital, both structural and non-structural.

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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In a warning that was largely ignored at the time but proven correct in subsequent years, Warren Buffett referred to derivatives as “financial weapons of mass destruction” in his 2002 letter to Berkshire Hathaway shareholders.  Critics of Berkshire’s recent involvement in derivatives often like to point out the superficial inconsistency between Mr. Buffett’s earlier warnings and his willingness to enter into derivatives contracts in recent years.  Today’s Wall Street Journal article regarding Berkshire Hathaway’s lobbying efforts related to the financial regulatory reform bill are already raising charges of hypocrisy. Let’s take a brief look at the facts and how the legislation may impact Berkshire Hathaway.

Background

While Warren Buffett has emphasized the dangers of derivatives on many occasions, he entered into a number of derivatives contracts in recent years to take advantage of what he believed were mispriced terms at the inception of each contract.  The derivatives generally fall into two categories:  Equity puts and credit default swaps on individual companies.  The equity puts are long term contracts that require minimal collateral and are not exercisable until contract expiration.  In a previous article, we provided more details regarding the nature of these contracts in an attempt to clear up persistent misunderstandings regarding the issue.  Mr. Buffett’s latest letter to shareholders provides updated information based on developments in 2009

In addition to the derivatives portfolio managed personally by Mr. Buffett, certain Berkshire subsidiaries such as MidAmerican enter into derivatives contracts for hedging purposes.

Derivatives “Float” and Collateral Requirements

At the end of 2009, Berkshire Hathaway held approximately $6.3 billion of “derivatives float” which represents funds received from counterparties that Berkshire can use for investment purposes.  Berkshire’s counterparties are required to make payments at the inception of contracts. According to Note 12 in Berkshire’s 2009 annual report, very minimal collateral requirements exist and even additional credit downgrades would only require a relatively modest increase in collateral:

With limited exceptions, our equity index put option and credit default contracts contain no collateral posting requirements with respect to changes in either the fair value or intrinsic value of the contracts and/or a downgrade of Berkshire’s credit ratings. Under certain conditions, a few contracts require that we post collateral. As of December 31, 2009, our collateral posting requirement under such contracts was $35 million compared to about $550 million at December 31, 2008. As of December 31, 2009, had Berkshire’s credit ratings (currently AA+ from Standard & Poor’s and Aa2 from Moody’s) been downgraded below either A- by Standard & Poor’s or A3 by Moody’s an additional $1.1 billion would have been required to be posted as collateral.

One additional point that is often missed is that Berkshire continues to own the securities posted as collateral and benefits from any returns earned by the collateral.

It is obvious that Berkshire was able to secure very favorable terms from counterparties regarding collateral requirements precisely because the financial strength of Berkshire has never been seriously questioned.

Berkshire Objects to Retroactive Changes to Collateral Requirements

According to the Wall Street Journal article, Berkshire Hathaway is only objecting to efforts in Congress to retroactively apply new collateral requirements to existing contracts:

The provision, sought by Berkshire and pushed by Nebraska Sen. Ben Nelson in the Senate Agriculture Committee, would largely exempt existing derivatives contracts from the proposed rules. Previously, the legislation could have allowed regulators to require that companies such as Nebraska-based Berkshire put aside large sums to cover potential losses. The change thus would aid Berkshire, which has a $63 billion derivatives portfolio, according to Barclays Capital.

Mr. Buffett’s push is especially notable because he has warned of the potential dangers of derivatives, famously branding them “financial weapons of mass destruction.”

The White House has been trying to kill the Berkshire provision on the grounds that it would weaken the government’s ability to regulate the enormous market for derivatives. Berkshire Hathaway argued that it shouldn’t be made to redo existing contracts and that it is already healthy enough to cover its obligations. The battle over the provision shows how lobbying by businesses and lawmakers to insert just a few words into a complex bill can have a major impact on the country’s biggest companies.

The proposed changes to collateral requirements would have widespread impacts and are not targeted specifically to Berkshire.  The current reports regarding Berkshire’s lobbying indicate that the company is seeking a broad based “fix” to prevent the government from forcing retroactive changes to existing contracts rather than a special exemption only for Berkshire.

Bottom Line Impact

While it is impossible to know exactly what the bottom line impact of the proposed legislation would be for Berkshire Hathaway, it is important to note that any additional collateral that Berkshire is forced to post would continue to be owned by Berkshire and would earn income for the company while it is held.  The ultimate gain or loss from the derivatives position would be unchanged with the main difference being that additional collateral would have to be posted for the duration of the contracts, most of which will remain outstanding for many years.

The more significant impact going forward may be to discourage Berkshire from entering into new derivatives contracts if collateral requirements for new contracts become even more onerous.  A reduction in this type of activity may be inevitable in any case because many Berkshire shareholders may only trust Warren Buffett to personally manage these types of risks.  Whether shareholders would be comfortable with a proprietary derivatives strategy run by Mr. Buffett’s successor is far from clear.

From a valuation perspective, it seems most conservative to consider the $6.2 billion proprietary derivatives float to be in “run off” rather than a permanent source of value.  The derivatives positions will likely produce significant profits for Berkshire over the next several years but renewal of such opportunities seems too uncertain to rely on the proprietary derivatives strategy as a source of ongoing value.  In contrast, Berkshire’s much larger $62 billion of insurance float remains a long standing and enduring source of intrinsic value for the company.

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 more information regarding the company including a brief section regarding the derivatives portfolio.

Posted by manualofideas at 01:16 PM | Permalink | Comments (0)

Warren Buffett started his investment partnership in 1956 with $105,100 of capital made up of his own funds and investments from family and close friends.  According to the BLS inflation calculator, initial capital was $840,920 measured in 2010 dollars which would be a very small sum to start a modern day hedge fund.  What is even more remarkable was the fee structure of the Buffett Partnerships.  Mr. Buffett, as the general partner, took 25 percent of all profits in excess of 6 percent.  There was no “2 and 20″ structure in which the general partner received any guaranteed payment.  With nearly all of his net worth invested in the fund and a young family to support, it obviously took a very self confident 25 year old to start this venture.

Mr. Buffett’s early letters to partners have become investment classics and required reading for value investors.   By reading the letters in chronological sequence, one can see how Mr. Buffett’s investment philosophy evolved over the years.  It is particularly interesting to note that many of the same themes that continue to appear in recent Berkshire Hathaway annual letters were regularly appearing in partnership letters during the 1960s.

On an annual compounded basis, the Buffett Partnership returned 23.8 percent/year to limited partners over its history compared to 7.4 percent/year for the Dow Jones Industrial Average.  The limited partners only had one year (1958) in which their results failed to match the Dow Industrials.  (See The Superinvestors of Graham-and-Doddsville for more details)

In his letter to partners in 1969 announcing his “retirement”, Mr. Buffett had the following to say:

“As long as I am “on stage”, publishing a regular record and assuming responsibility for management of what amounts to virtually 100% of the net worth of many partners, I will never be able to put sustained effort into any non-BPL [partnership] activity.  If I am going to participate publicly, I can’t help being competitive.  I know I don’t want to be totally occupied with out-pacing an investment rabbit all my life.  The only way to slow down is to stop.”

Partners who elected to take part of their final partnership distribution in Berkshire Hathaway stock probably did not notice much of a “slow down” in subsequent years.

I was recently contacted by Frank Gifford, a Berkshire Hathaway shareholder who has studied the partnership letters and agreed to share his notes with readers of The Rational Walk.  Mr. Gifford provides a great 20 page introduction to the letters which is very useful for someone looking for a concise summary.

Click on this link to download the partnership letter notes

Disclosure:  The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 12:46 PM | Permalink | Comments (0)

Joel Greenblatt outlined his “magic formula” for stock market investing in The Little Book That Beats the Market. The formula ranks stocks based on two simple and easily calculated figures:  earnings yield and return on capital.  Rather than merely looking for the cheapest companies, the goal is to also find good businesses that achieve high returns on capital.  In the interview shown below, Mr. Greenblatt discusses a new fund that he is introducing which will apply the magic formula to global markets.

Forbes has also published a new interview with Joel Greenblatt with some good background information on the magic formula.

Mr. Greenblatt is also the author of You Can Be a Stock Market Genius which we reviewed last year.  Both books are well worth reading.

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.

Posted by manualofideas at 02:17 PM | Permalink | Comments (0)

Mohnish Pabrai provides some great insights on investing in an interview with Steve Forbes this week. Mr. Pabrai comments on a number of topics including the influence Warren Buffett has had on his investment style and the fee structure of his hedge fund.  One quote has particular resonance for someone who has been involved in technology but has chosen to generally avoid tech investments:

I spent a lot of time in the tech industry. And I like to say that I don’t invest in tech because I spent time in it. And I saw firsthand that the durability of technology moats is many times an oxymoron.

Mr. Pabrai also comments on index funds, the benefits of viewing investing as a “gentleman of leisure activity”, the virtues of an afternoon nap, and the main source of misery for investment managers:

Forbes: So what’s that saying of Pascal that you like about just sitting in a room?

Pabrai: Yeah. “All man’s miseries stem from his inability to sit in a room alone and do nothing.” And all I’d like to do to adapt Pascal is, “All investment managers’ miseries stem from the inability to sit alone in a room and do nothing.”

One suspects that “doing nothing” actually refers to moving funds around by frequent trading.  A prepared mind is required to take action quickly and in size when opportunities arise.  For most investors this requires a tremendous amount of reading and hard work.  To view the entire interview, please click on the image below:

For a list of Mr. Pabrai’s investment holdings as reported in his latest 13-F filing showing positions on December 31, 2009, please click on this link.

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.  

Posted by manualofideas at 06:00 PM | Permalink | Comments (0)

We'll be updating the following list throughout this year's public company annual meeting season:

• Berkshire Hathaway (BRK.A, BRK.B), by Warren Buffett
• Biglari Holdings (BH), by Sardar Biglari
• Coca-Cola (KO), by Muhtar Kent
• Fairfax Financial (FRFHF), by Prem Watsa
• Goldman Sachs (GS), by Lloyd Blankfein
  
• JP Morgan (JPM), by Jamie Dimon
• Leucadia (LUK), by Ian Cumming
• Sears Holdings (SHLD), by Eddie Lampert
  
• Winthrop Realty Trust (FUR), by Michael Ashner

Posted by manualofideas at 09:44 AM | Permalink | Comments (1)

The Rational Walk is pleased to have this opportunity to present an exclusive interview with Prem C. Jain, the author of the recently released book Buffett Beyond Value which we reviewed last week.  Prem Jain is the McDonough Professor of Accounting and Finance at Georgetown University.  He has previously taught at the Wharton School of the University of Pennsylvania and the Freeman School of Business at Tulane University.  His research has been published in many prestigious finance and accounting journals including the Journal of Finance and the Journal of Accounting Research.

Professor Jain generously took the time to provide extensive answers to several questions regarding Warren Buffett, the evolution of behavioral finance in academia, defining an investing circle of competence, approaches for investors who wish to expand their competence over time, and much more.

Please click on this link to read the interview in a formatted pdf file.

Q:  There are many books covering Warren Buffett’s career, particularly over the past few years. What made you decide to write a book about Warren Buffett and how is your book differentiated from Buffett biographies such as Snowball?

Most authors of books on Warren Buffett spend a significant part of their books on narratives about Warren Buffett as a person. They do not analyze his investing philosophy in enough detail to develop a good sense of Buffett-style investing. I have tried to fill that gap. Having taught Buffett’s principles for over twenty years and having personally benefitted from his principles, I have written a book that is primarily about Buffett’s investing principles. My book is even more valuable to those who already have some background on Buffett from reading biographical books such as Snowball.

Q:  Much of your book focuses on how investors can learn from Warren Buffett’s techniques and generate market beating returns. Yet, the usual caveat is that investors must not stray from their circle of competence. Many investors have trouble precisely identifying the boundaries of this circle. How would you suggest that investors go about defining their circle of competence?

An investor should start with analyzing one industry that the investor knows the most about. The investor is in his circle of competence if he is not often surprised by the developments in that industry. Else, he needs to study it more. As a professor, I have benefited from investing in education stocks as I understood the business models of several of those companies. Furthermore, to precisely identify the boundaries of one’s circle of competence, one must also test one’s knowledge in several additional stocks in the same industry.

It is often the case that an investor would invest in one company in an industry (say, Wal-Mart) and would not know much about other companies in the same industry (say, Costco and others). To understand Wal-Mart well, they should study and monitor other similar companies as well. This is how I came across Wal-Mart de Mexico (a Wal-Mart subsidiary in Mexico that trades independently). Only after developing a good understanding of one industry, the investor should start investigating in other industries.

Q:  You identify Warren Buffett as a “renaissance investor” because he was one of the first to blend the “growth” and “value” styles into a model that has produced consistently superior results over many decades. Part of Mr. Buffett’s shift toward “growth + value” was due to the influence of Charlie Munger and others such as Philip Fisher, but part of this was due to size. As Berkshire grew, the small “cigar butt” opportunities were not able to “move the needle” for Berkshire. Portfolio size is not an issue for most small investors. In early 2009, there were many small stocks selling under “net-net current assets” as defined by Graham. Does it make sense for small investors to pursue the “cigar butt” style advocated by Graham or does it make more sense to emulate Buffett’s “growth + value” approach?

Buffett’s investing philosophy has evolved over time. An investor can similarly become a better investor over time. In 1963, Warren Buffett invested in American Express because American Express’s stock price had declined in the wake of the infamous Salad Oil Scandal in which American Express lost money. However, the American Express charge card business was not affected. After a year or two, Buffett sold those shares as the price recovered. In this investing approach which is usually classified as “cigar butt” investing, the focus is on finding stocks when declining stock prices can be attributed more to market psychology than to fundamentals.

The “cigar butt” investing is based on examining numbers such as P/E ratios or other quantitative metrics. However, even as far back as 1967, Buffett wrote in his letter to his partners that really big money tends to be made by investors who are right on qualitative (as opposed to quantitative) decisions. Clearly, Buffett’s investing style was evolving.

An evaluation of Buffett’s writings and decisions over decades suggests that he has maintained the principle of not paying excessively as a value investor (or as a “cigar butt” investor), he is now willing to pay a fair price as a growth investor. If we were to think of him as a pure value investor, it would be difficult to explain him paying about market P/E for several of his stock acquisitions such as BYD and Burlington Northern Santa Fe or even Wal-Mart. He has clearly evolved into a value + growth investor over time and has specifically mentioned that value and growth are two sides of the same coin. An investor should not ignore “cigar butts” but in this day and age when information is ubiquitous, cigar butts are not easily found. However, an investor incorporating the principles of both value investing and growth investing together is more likely to earn large returns.

Q:  Professional familiarity in a field does not necessarily extend to investment competence. For example, many doctors have a reputation as terrible investors because they mistakenly believe that knowledge of technical details of drugs or medical devices makes them qualified to pick investments. The same can be true for many in technology and software fields. But at the same time, it seems natural to invest in areas that professionals know the best. How can a doctor, for example, develop an investment circle of competence that would allow for intelligent investment in companies related to his profession?

This is a good example of an investor not making good returns even when he may have a good understanding of a particular product. The reason is that investment circle of competence requires not only the knowledge of the products but also the ability to understand the financial statements and to project future earnings. Many investors can not translate success of a product into financial success of the company.

I recommend the following to doctors and others who are interested in investing. Investor should think whether the company and not just a product will be successful for a long time. They should forecast sales and earnings in dollar terms and not only evaluate a product’s technical ability. If they are financial-statements-challenged, they should join hands with others who know some accounting and finance. This may prove to be a fruitful partnership.

Q:  Over the past decade, behavioral finance has attracted much more attention than in the past, perhaps due to several events over the past 25 years that could not be easily explained by the Efficient Market Hypothesis. I recall as an undergraduate student majoring in Finance in the early 1990s that there were few mentions of Warren Buffett or other investors who have routinely achieved market beating returns. Most references to Mr. Buffett tended to dismiss his record as an aberration unlikely to be replicated. Do you see this attitude changing in Finance departments today?

Warren Buffett has had tremendous influence on the academia. In 2003, I invited him to Georgetown University to conduct a question-answer session and the response from the students and the faculty was overwhelming. The finance discipline now acknowledges that professors during the 1970s to 1990s overemphasized the market efficiency paradigm. Fortunately, we have people like Buffett who constantly reminded the academia that the professors had much to learn. And professors have learned. For example, in one of the courses at Georgetown, the first class of the course centers on what we may learn from Warren Buffett. Thanks to Buffett that we do not claim that markets are efficient all the time. It is not easy but if investors work hard, they can beat the indexes and possibly earn very high returns.

Q:  How can investors prepare themselves to mentally deal with temporary declines in the market value of their investments? Even if an investor finds undervalued companies, it is obviously possible for market prices to suffer material declines. We have seen this in Berkshire Hathaway, for example, over the past two years. Is the ability to deal with temporary declines a matter of inherent temperament or personality that cannot be changed, or can investors find ways to improve their investment temperament over time?

Knowledge is the best antidote to making bad decisions. For example, if you know about jewelry and diamonds, all that glitters is not gold for you. Your knowledge will allow you to pick diamonds in the rough and hold on to them. In investing, if you know a lot about certain companies and their managers, you will not become nervous and sell the stock at the wrong time or when the market declines. No wonder, Buffett suggests that you should invest only in companies you understand. Both in 2000 and 2009 when Berkshire stock prices went down by about 50%, I added to my Berkshire holdings.

Q:  Most individual investors attempt to pick stocks on a part time basis. How much time per week do you think is required for part time investors to dedicate to this pursuit? It seems like spending a couple of hours each weekend reading Barron’s or The Wall Street Journal simply wouldn’t be sufficient, yet most people do not have 15 to 20 or more hours per week to delve in more deeply. How should investors think about the time investment required to actively pursue undervalued opportunities?

This is related to an earlier question. If a person has a full time day job, he should study only one industry at a time. Only after he understands one industry, he should move to studying other industries. If he does that, he would not need more than a few hours a week. After several years, he should end up with 20 stocks to invest about 5% in each. In the meantime, he can invest partly in an index fund and party in individual stocks. An average investor need not hold more than 20 stocks in a portfolio. Buffett does not invest in a large number of stocks and most of his holdings are for the long term. In Berkshire, five of the top stocks have often constituted 50% of its total stock holdings. Finally, if a person is very busy and does not have any time to find good stocks, he should simply invest in an index fund such as the Vanguard S&P 500 index fund.

Q:  If an investor decides that he has no particular circle of competence or lacks the time to dedicate to the pursuit, does it make more sense to invest in index funds or in mutual funds such as Fairholme that are run by proven value oriented managers? In your book, you recommend against investing in hedge funds due to the asymmetry that is common in the “2 and 20” compensation models. Does the same caveat apply to value oriented mutual funds? Although they are more cost efficient, certainly index funds remain far cheaper.

For a person who has no particular circle of competence but has decided to invest in the stock market, I recommend investing an index fund and not in mutual funds. An investor is less likely to sell an investment in an index fund when the market goes down than if he were to invest in a mutual fund. I am afraid that the investor would blame the manager for not performing well in a down market and sell all his holdings at the wrong time. It may not be the manager’s fault at all but the investor may not be able to see through the effect of the market on an otherwise well run mutual fund. Even the best of managers do not outperform the market in all the years. The only time a busy investor should invest in a mutual fund is when the investor is extremely comfortable with the manager’s style of investing and has examined it in great detail. It is not enough to simply examine a manager’s past performance and invest with the manager.

Q:  One of the most difficult decisions involves when one must sell an investment at a loss. You cover this topic in the book and suggest that investors should be willing to sell at a loss if subsequent events lead the original investment thesis to be invalid. This is perhaps the most difficult aspect of investing for most people because selling at a loss involves admitting a mistake and making it “permanent”. Is this just a matter of inherent “stubbornness” or can investors take any steps to mentally allow them to sell at a loss with more philosophical detachment?

I think we are hard-wired not to admit mistakes. Selling at a loss is indeed difficult. Or, we are optimistic and hope for an improvement in the stock price. I recommend two specific steps. First, one should write detailed notes whenever a purchase decision is made. Periodically, as the company makes earnings announcements or other important announcements, the notes should be updated. I have benefited from this practice a lot. When individuals are forced to write their thoughts on the paper, they can more easily see the right thing to do. For example, if one has a good knowledge of the company’s products, managers and financial statements, a decline in the stock market may be a good time to invest more in the stock market. Second, they should compute a stock’s intrinsic value periodically. I discuss the concept of intrinsic value in detail in my book.  When the intrinsic value is below the current stock price, they may find it easier to sell.

Q:  Berkshire Hathaway is often misunderstood by the media and characterized as Warren Buffett’s “hedge fund”. This leads many investors to worry about succession at Berkshire. Do you have any views regarding who Mr. Buffett’s successor will be and how confident are you that the success will (a) be able to retain Berkshire’s unique culture and (b) continue Mr. Buffett’s capital allocation track record? It seems like the next CEO will have impossible shoes to fill. Could this result in a “shooting for the moon” attitude that could introduce greater risk at Berkshire?

If the Berkshire board decides to have only one person at the top, I think Ajit Jain is the right person. After all, Buffett talks to him every day, insurance is the most important part of Berkshire, and he has been at Berkshire for about 25 years. (This has nothing to do with the fact that I have the same last name. I don’t know him at all.) The two other names often mentioned are those of Tony Nicely of GEICO and David Sokol of MidAmerican and NetJets. It will however not matter much if any one of the three is the CEO. After all, the Berkshire CEO does not interfere with the subsidiary CEOs.

Yes, the culture! What is the culture at Berkshire, I have often asked myself. Once we reflect on some of the unique features of the Berkshire culture, we are less likely to be concerned about the future of Berkshire even if the next CEO is not as good as Warren Buffett. There are at least two important features of the Berkshire culture. First, the subsidiary CEOs (and employees) are compensated according to what is most meaningful. Buffett has often talked about compensation based on return on assets or other appropriate metrics. This creates a sense of fair play resulting in high productivity. Second, subsidiary CEOs are given independence to make all decisions at the subsidiary level. Hence, Berkshire will continue to do well after Buffett because of its decentralized management structure. The capital allocation process may not be as good as it is today under Buffett but there are many people who have been close to Buffett and my guess is that the new CEO will continue to do a good job for a long time to come.

Professor Jain, this has been very insightful.  Thank you very much.

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.

Posted by manualofideas at 06:47 PM | Permalink | Comments (0)

By Greenbackd

Alfred Winslow Jones is generally regarded as the progenitor of the modern “hedge fund.” Jones’s strategy, to construct a portfolio 130% long and 30% short (known as “130/30″), seems pretty prosaic by today’s standards, but it was state-of-the-art when he established the partnership A. W. Jones & Co. in 1949. In the April 1966 Fortune article, The Jones Nobody Keeps Up With (.pdf), by Carol Loomis (the same Carol Loomis who edits Buffett’s Berkshire Hathaway shareholder letters), Loomis described Jones’s strategy thus:

[The] fund’s capital is both leveraged and “hedged.” The leverage arises from the fact that the fund margins itself to the hilt; the hedge is provided by short position – there are always some in the fund’s portfolio.

How did Jones’s “hedge” work?

In effect, the hedge concept puts Jones in a position to make money on both rising and falling stocks, and also partially shelters him if he misjudges the general trend of the market. He assumes that a prudent investor wants to protect part of his capital from such misjudgements. Most investors would build there defenses around cash reserves or bonds, but Jones protects himself by selling short.

And his strategy seemed to perform. Loomis reports that he was up 670 percent for the ten-year period to May 1965. Here’s Jones’s performance chart from the article (performance of a $100,000 investment net of fees):

Particularly interesting was Loomis’s assessment of Jones’s ability to predict the direction of the market:

Jones’s record in forecasting the direction of the market seems to have been only fair. In the early part of 1962 he had his investors in a high risk position of 140 [indicating Jones was unhedged 140% long]. As the market declined, he gradually increased his short position, but not as quickly as he should have. his losses that spring were heavy, and his investors ended up with a small loss for the fiscal year (this is the only losing year in Jones’s history). After the break, furthermore, he turned bearish and so did not at first benefit from the market’s recovery. Last year, as it happens, Jones remain quite bullish through the May-June decline, and then got bearish just about the time the big rally began. As prices rose in August, Jones actually moved to a minus 18 risk – i.e., his short positions exceeded his longs, with the unhedged short position amounting to 18 percent of partnership capital.

A perfect contrary indicator. Regardless, he seems to have generally been right when purchasing individual stocks:

Despite these miscalculations about the direction of the market, Jones’s selections of individual stocks have generally been brilliant.

Loomis credits someone else with the idea for the limited partnership structure and fee calculation adopted by Jones:

The idea is common to all the hedge funds, and the idea was not original with Jones. Benjamin Graham, for one, had once run a limited partnership along the same lines.

It’s hard to find a place in investment where Ben Graham hasn’t gone first.

Posted by manualofideas at 10:30 AM | Permalink | Comments (0)

Click here to listen to an interview with Eric Sprott, dated March 27, 2010, or visit the source page.

"Eric Sprott has over 35 years of experience in the investment industry and manages roughly $5 billion.  Eric has been stunningly accurate in his writings for quite some time and is one of the highly respected industry professionals who foresaw the current crisis and chronicled the dangers of excessive leverage as well as the bubbles the Fed was creating while correctly forecasting the tragic collapse we are all enduring.  In this interview Eric discusses the stock market, bond market, inflation, deflation, gold, silver, gold stocks, consolidation in the gold sector, the economy, the US Dollar, paper currencies globally, tax revenues going down, layoffs in US government jobs in states, oil and much more."

Posted by manualofideas at 10:05 PM | Permalink | Comments (0)

H. Kevin Byun, managing partner of Denali Investors, provides some enlightening commentary in his just-released Q1 letter to investors. Byun argues that the equity market is behaving as irrationally on the upside today as it did on the downside in late 2008 and early 2009. He attributes some of the recently exuberant action to so-called "Mr. Magoo pretenders" who suffered big losses in 2008 and may still be chasing their high watermarks. In a quest to recoup losses and get paid, Messieurs Magoo appear content to gamble with their investors' capital, risking disaster yet again. Byun also discusses his concerns surrounding the recent rise of protectionism.

Download Byun's Q1 letter or keep reading his market commentary here:

The first quarter of 2010 has been marked by a continued upward creep in the markets, in stark contrast to recent fear and dislocation. From the lows reached far back in March, when the S&P broke to 667, we have seen a rally of over 75%.

2010, as it turns out, is a make-or-break year for many funds. The severe drawdown in 2008 and massive run-up in 2009 showed once again that it is better to fail conventionally than to succeed unconventionally. With many funds still below high water marks, their urgency for near-term performance in 2010 is greatly magnified. How can these fund managers properly invest with a long-term view when a short-term sword of Damocles hangs precariously above? Can these Mr. Magoo pretenders make it another year? And so career risk, business risk, and behavioral finance, rather than the best interests of their investors, comes to the fore.

With 2010 shaping up to be another interesting year, my view remains that the potential big-picture range and probability of outcomes have widened considerably, although the expected value or average represented through the market may appear narrow. With all the dislocations, machinations, and interventions, the potential energy in the markets is building once again. Exactly how and when the kinetic shifts occur remain an unknown, but the set up to dramatic changes appears to be in place. Expect the water to be choppy.

One related area that has become a topic of increasing attention, just to pick one out of the hat, is that of exchange rates, namely the call coming from some corners for China to let their currency float. From my perspective, it is not analytically prudent to draw a line in the sand on the issue due to the tricky and ever present law of unintended consequences. There are many interpretations even for concepts far simpler than floating and fixed rate frameworks, but let’s venture through. Regarding these unintended consequences, I would like to humbly present the following words as food for thought.

I often see politicians on the news putting the issue in binary terms, as right versus wrong, as good versus bad, as us versus them. This may prove to be a great disservice. Indeed, our country has outsourced many jobs, and low level ones at that. But this means we have also outsourced our unemployment and social unrest. Can you imagine what our unemployment number would look like if the capital base and employee base that supplies our goods just from China were simply put inside the US? Would it surprise you that this would approach Great Depression numbers? The migrant workers and unemployed masses of the Great Depression actually do exist today. But it simply goes unnoticed here because that too has been outsourced!

Conversely, what I have never seen a politician ever mention in the exchange rate debate is the likely resulting inflation. Why not? The average person is already stretched and living paycheck to paycheck. The group that will be impacted the most, which is that same group to which politicians pander, will find costs for basic items moving further out of range. Does it make sense that twenty pairs of tube socks from China are available for $8 retail? For every dollar prices for these tube socks move up to reflect true domestic and rate adjusted costs, a dollar less is available for other necessities. Such limited financial resources create an increasingly desperate zero sum game. Do I buy food or do I buy school supplies for the kids? If exchange rates do float and there is inflation, what will be the call to action then? Who will be the scapegoat? This may result in further finger pointing and a resurgence of social unrest, trade tariffs, trade barriers, and protectionism. This will be part of a negative reflexive process that may have much more severe and unfortunate consequences. But no one is talking about that.

If you are intellectually honest, you have to admit this is not a simple scenario to figure out for which this discussion barely scratches the surface and does not do justice.

As such, I present the following parable not as an answer, but as a surprisingly liberating approach for the analytical mind. It is a story my father told me a long time ago.

“Seh-Ong Ji Ma”
(Seh-Ong’s Wise Horse)

There was a farmer named Seh-Ong that had a beautiful and strong horse. The neighbors complimented, “You are so lucky to have such a beautiful and strong horse.” The farmer replied, “We’ll see.”

Days later, the horse ran away from the farm and could not be found. The neighbors wailed, “You are so unlucky to have lost such a beautiful and strong horse.” The farmer replied, “We’ll see.”

Days later, the farmer’s horse returned, but had brought back seven other wild horses that were equally beautiful and strong. The neighbors complimented, “You are so lucky to have so many beautiful and strong horses.” The farmer replied, “We’ll see.”

Days later, the farmer’s son was attempting to train one of the wild horses, fell off the horse, and broke his leg. The neighbors wailed, “You are so unlucky to have your son break his leg.” The farmer replied, “We’ll see.”

Days later, the king’s army came through to take all the able-bodied young men for war. The neighbors complimented, “You are so lucky to have your son spared from the war.”

The farmer replied, “We’ll see.”

For me, this is one of the most powerful, simple, and elegant lessons of life and, therefore, investing.

Read Kevin Byun's Q1 2010 Denali Investors letter.

Download Kevin's 2009 presentation at Columbia Business School.

Read an excerpt of our exclusive interview with Kevin.

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

Tariq Ali's Street Capitalist blog has an excellent analysis of Michael Burry's posts on a value investing thread he started in 1996.

Read it here.

Posted by manualofideas at 09:16 AM | Permalink | Comments (0)

By Greenbackd

Dr. Michael Burry has been a very popular topic on Greenbackd recently as a result of Michael Lewis’s The Big Short and the Vanity Fair article Betting on the Blind Side. I have posted a link to Burry’s techstocks.com “Value Investing” thread (now Silicon Investor) and another to Burry’s Scion Capital investor letters, but the thirst for all things Burry remains undiminished. The New York Times now has an article, The Origins of Michael Burry, Online, discussing some of Burry’s early postings on his techstocks.com thread. Here Burry discusses his strategy for shorting:

I mentioned that I pick stocks to short based on valuation, not ratios (I ask you to find the correct free cash flow — I bet most people don’t kow they’re working with negative net working capital, either). But I ENTER based on technical analysis. KO could go up or down. The odds are down, technically, but that’s what buy stops are for. This isn’t a long term short by any means. Research on shorts show that profitable shorts make money with small gains, not by waiting for businesses to bankrupt. The small gains are usually there for the picking. Another indicator – if it’s mentioned in Barron’s as a buy three different times <g> — set me onto Wells Fargo.

What’s there to understand about Coke? The business is a KISS model. This gets to my value/short strategy. When people start claiming a business deserves a special valuation above all reasonable fundamental analysis (because of the “franchise”, because there’s so little institutional ownership for a big cap growth stock, because Buffett’s in it, because global expansion will provide endless opportunity, because ROE is so damned high, because it’s nearly a monopoly, because Buffett’s in it…), that’s a short, IMO.

I just read a bunch of Graham, and he doesn’t deal with shorts (I assume it would be “speculation”), but EMT isn’t all that its panned to be either, IMO.

Just trying to think independently,

Mike

The NYT has also unearthed a Forbes magazine article from 2000:

VALUESTOCKS.NET www.valuestocks.net Supposedly for value investors, though Warren Buffett might not agree with this definition of value. Run by a 28-year-old neurology resident, Dr. Michael Burry, Valuestocks.net showcases Burry’s own $50,000 portfolio, which includes some surprising choices including Pixar, the maker of Toy Story. Has good information on how to identify net-net stocks (trading for less than assets minus all conceivable liabilities). Accompanying all this are Burry’s incisive reports, as good as anything from Wall Street. One of the site’s best features is a list of essential finance texts, including thumbnail reviews and links to Amazon.com (Burry’s only source of revenue, since he doesn’t accept banner ads). BEST: Original analysis, links to great finance sites, and a must-read book list for value investors. WORST: Limited content is sometimes dated.

It seems Greenbackd is rapidly, if unintentionally, becoming Mike Burry’s Of Permanent Value, which is Andrew Kilpatrick’s encyclopedic collection of stories about Warren Buffett. Incidentally, my copy of Of Permanent Value is around ten years old, which means it’s one-third the size of the 2010 edition (I’m not even joking. Mine came in a single volume, and it now seems to be a three-volume extravaganza. Buffett has been busy over the last 10 years).

Posted by manualofideas at 10:04 PM | Permalink | Comments (0)

By Greenbackd

The New York Times has a fantastic profile on Carl Icahn called Does Icahn Still Make Them Tremble?

He is one of Wall Street’s most colorful, controversial and complicated characters.

Wearing slightly rumpled khakis and waving his eyeglasses to punctuate key points, Mr. Icahn is constantly jumping from one topic to another in an endless stream of dialogue. In that respect, he more closely resembles an absent-minded professor than a master of the universe.

Corporate executives visiting his offices walk through hallways adorned with paintings of battle scenes and sculptures of cowboys on bucking broncos. One large painting in the conference room features a lion gazing at the bones of an animal in a desert.

Yet he bristles at being labeled a “raider,” despite the fact that he is widely viewed as a founding member of the clan that roamed Wall Street in the 1980s, occasionally pursuing hostile takeovers with ruthless abandon.

He prefers to paint his role in those years with the same “activist investor” brush he holds today, arguing that he has created tens of billions of dollars of value for shareholders in companies in which he invested. (In conversations, he declares that he has created $30 billion, $40 billion and even $50 billion worth of value for shareholders. What is a few billion among friends?)

This is Icahn’s thesis for his investments in the biotechnology sector:

“The biotechs have been his big winners recently,” particularly investments in ImClone Systems and MedImmune, said Mr. Young at Institutional Shareholder Services. “His thesis, which is no secret, is that biotech firms should be purchased by Big Pharma, which is always in need of new products. In his mind, that’s a match made in heaven.”

I love this story:

Mr. Icahn does not seem to let anything, including a very close friendship, get in the way of protecting his and his investors’ profits. Late in 2008, through his hedge fund, he sued Realogy, a real estate company controlled by Leon Black, the head of the private equity firm Apollo Management. Mr. Black was trying to reduce Realogy’s hefty debt load by offering to exchange some of the debt with bondholders.

Mr. Icahn, a bondholder who has known and been friends with Mr. Black for decades — the two have been longtime tennis partners — objected to some terms of the exchange and sued.

“Carl and I have been good friends for over 25 years,” Mr. Black said in an e-mail message. “Occasionally we skirmish as couples are wont to do, but I believe we both feel that when the chips are down that the friendship is paramount.”

How, exactly, does one sue and still be good friends with someone on Wall Street? Mr. Icahn smiles sagely over his cup of coffee: “The two of us have a saying that we always use whenever there is friction in our business dealings. We always say, ‘there’s only one Maltese Falcon.’ ”

At one point in that classic 1941 film, a character chasing a valuable figurine says to a close associate, “You’ve been like a son to me,” Mr. Icahn explains, paraphrasing from the movie.

Then, lowering his voice with mock intensity, Mr. Icahn adds that the character says that if you lose a son, it’s possible to get another — “but there’s only one Maltese Falcon.’ ”

Click here to see the rest of the article.

Posted by manualofideas at 04:23 PM | Permalink | Comments (0)

From The Wall Street Journal's Deal Journal:

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.”

Posted by manualofideas at 09:44 PM | Permalink | Comments (0)

Another snippet:

Posted by manualofideas at 11:35 AM | Permalink | Comments (0)

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

Posted by manualofideas at 06:55 PM | Permalink | Comments (0)

Respected value investor Aaron Edelheit writes a very interesting piece on his excellent blog:

A very, very strange thing happened to a company I follow called Contango Oil & Gas (AMEX: MCF). This is an extremely well-run company that generates tons of cash from natural gas in the Gulf of Mexico. You couldn’t ask for a more efficient and well run company. Consider that Contango has raised $60.5 million in its life and yet has already bought back $65 million, thus having a negative capital situation due to negative dilution. Quite an astonishing task for a commodity company. Further the company’s costs are the lowest around with their find, develop and acquire costs at a measly $1.36 per mcf (thousand cubic feet).

Mr. Ken Peak, the CEO, is a straight shooter, no-nonsense kind of CEO. In fact, I wish most CEOs were more like him. In their last press release for earnings, Mr. Peak said, “Concerning natural gas prices, the weather is cooperating on the demand side, but natural gas supply continues to hold steady. I wouldn’t be surprised by either $3.00 or $6.00 natural gas over the next year or so, but we have good prospects and are aggressively moving forward to drill.” Now how many CEOs would have the guts to say that $3 mcf natural gas prices could happen? Compare him to Chesapeake Energy’s rather repugnant CEO, Aubrey McClendon, who is a perma-bull who enriches himself at shareholder’s expense and has created no value for shareholders.

For disclosure purposes, I have invested in Contango in the past and wrote a research report on it at $38.30, exclaiming how cheap it was. I have since taken my profits with its move to over $50 per share and reallocated my money elsewhere. I still follow Contango, in case it sells off again, and to see what Mr. Peak is doing.

So imagine my surprise when I see Monday’s press release, which has been getting absolutely zero press or news. Contango, which has been strictly an oil & gas company, announced that they were making an investment of up to $3 million in looking in Alaska for gold!

Here is what Mr. Peak said:

“This investment does not signal, foreshadow or represent a change in our natural gas and oil exploration business model. We recognize that the risks and challenges inherent in gold exploration are quite different from our natural gas and oil exploration business and were attracted to invest in this project solely by what we perceive to be its reward/risk ratio, where a relatively small amount of initial exploration risk capital ($3 to $5 million is envisioned) could potentially lead to a more extensive gold exploration/development project. Our 2009 exploration program found relatively few samples of commercial grade gold ore – generally considered to be 0.5 grams per tonne or more – but we believe our results merit an expanded exploration program for the summer of 2010.”

Mr. Peak continued, “Our planned 2010 exploration program will be directed toward additional rock sampling, trenching and drilling core holes. Shareholders are reminded that at this early exploration stage our investment should be considered as nothing more than an ‘interesting speculation’ and that the odds of our ultimately being successful in finding gold in a volume sufficient to support a commercial gold mining operation are quite low. To put it in oil and gas parlance, this ‘play’ is the rankest of ‘wildcats’ that is currently only at the ‘idea’ stage and we are hoping, based on our 2010 work program, to learn if we can mature it to the ‘prospect’ stage in order to justify committing additional risk exploration capital. After we have taken our core, rock and pan samples, they will be assayed in an independent lab and then evaluated for prospectivity and commercial development potential. This process will likely take until December 2010.” Here is the link to the release: Contango Gold Investment

I think this is a big warning sign. Neither Contango, nor Mr. Peak, as far as I know have any experience looking for gold, and the company has made all of its money on natural gas. This investment raises a host of questions. What also does it say about the natural gas market, or Mr. Peak’s view of it, that he would be willing to spend $3 million on gold instead of drilling for natural gas? What does it say about the value of Contango’s stock, that Mr. Peak would rather search for gold and not buy his own stock back?

But then I pause my this line of questioning and remember that Mr. Peak has been an excellent allocator of capital and has an excellent eye for value. So, I turn the question around and ask, what does it say about Mr. Peak and Contango’s thoughts on gold and the future of gold?

I think this news deserves a lot more attention and analysis. I know Contango is much smaller, but could you imagine if Exxon announced they were looking for gold? Ken Peak and Contango have an excellent reputation and are held in high regard, their decision should be viewed no less important than if a major such as Exxon had announced it.

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By Greenbackd

Seth Klarman’s teachings, which I’ve covered on this site on several occasions (see, for example, Klarman on calculating liquidation value, on identifying catalysts, and on investing in liquidations), are always worth reading. In his most recent investor letter Klarman has provided a list of twenty investment lessons of 2008 (via the always superb Zero Hedge):

Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.

Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

When a government official says a problem has been “contained,” pay no attention.

The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.

Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

See also Klarman’s False Lessons of 2009.

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Warren Buffett includes an “Owner’s Manual” for Berkshire Hathaway shareholders in each annual report which is also available separately on the company’s web site.  The Owner’s Manual does not change very often which is appropriate since it is supposed to communicate basic business principles that are not likely to change each year.  For this reason, it was easy to miss a change that has significant implications for Berkshire Hathaway’s earnings retention policy going forward.

Original Retained Earnings Test

The following statement has been documented as business principle #9 ever since Mr. Buffett published the Owner’s Manual in 1983:

We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.

The basic meaning of this business principle is that earnings retention must, in the long run, deliver at least $1 in market value to shareholders for each $1 that management retains.  It had the virtue of simplicity and was also very easy to measure.  Anyone can calculate Berkshire’s retained earnings for a five year rolling period and then examine whether the retained earnings resulted in a corresponding rise in market value.

Limitations With Original Principle

While the principle is simple and measurable, there are clearly problems with the way it is formulated.  It is obvious that over the past decade, valuation extremes were common for companies both on the upside and downside.  As Mr. Buffett noted in his latest shareholder letter, Microsoft CEO Steve Ballmer and General Electric CEO Jeff Immelt both had the misfortune of taking over as CEO near the peak of a bubble in their company’s stock valuation.  Just as it is difficult to evaluate the performance of these CEOs over the past decade based on share price performance alone, it is difficult to evaluate the wisdom of earnings retention using the same standard.

Berkshire’s Modified Earnings Retention Test

The updated version of Berkshire Hathaway’s earnings test reads as follows:

I should have written the “five-year rolling basis” sentence differently, an error I didn’t realize until I received a question about this subject at the 2009 annual meeting.  When the stock market has declined sharply over a five-year stretch, our market-price premium to book value has sometimes shrunk. And when that happens, we fail the test as I improperly formulated it. In fact, we fell far short as early as 1971-75, well before I wrote this principle in 1983.

The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.

It must be noted that any modification of a long standing test that recently failed should be treated with a healthy dose of skepticism.  Is management changing the test due to a legitimate problem in the formulation of the original wording or is the goal line simply being moved?  The fact that the CEO is Warren Buffett does not mean that this question should not be asked.

Mr. Buffett’s argument is that the original test was improperly formulated because markets can remain extreme for a long period of time, which is certainly true.  During such times, Berkshire’s price to book value often falls.  This is certainly the case as we noted in The Rational Walk’s Berkshire Hathaway Briefing Book. As Mr. Buffett notes, this also happened during the early 1970s far before he formulated the Owner’s Manual principles.

Allowing Mr. Market to dictate earnings retention policy even over a five year period can cause unintended consequences.  For example, Berkshire Hathaway failed to meet the test at the market lows in 2009.  A strict interpretation of the original rule would have forced a dividend in February or March 2009 and would have limited the capital available to Mr. Buffett to take advantage of opportunities caused by the market crash.  This would not have served shareholder interests.

Does the New Rule Make Sense?

The new retention principle says that the litmus test should be whether Berkshire’s book value gain exceeded the performance of the S&P 500 and whether the stock consistently sells at a premium to book – meaning a price to book ratio of at least 1.  Based on this formulation, Berkshire would have passed the earnings retention test even at the 2009 lows.

One obvious problem with the new rule is that book value is only a rough proxy of changes in Berkshire’s intrinsic value, as Mr. Buffett himself tells us in his shareholder letters.  In addition, Mr. Buffett has told us that intrinsic value far exceeds book value.  From a directional standpoint, changes in book value are likely to signal changes in intrinsic value, but a price to book ratio of 1.0 or 1.1 is almost sure to signal an undervaluation of Berkshire shares.

Under the new rule, future managements at Berkshire could argue that earnings should be retained under the new test even if the price to book value is only slightly above 1.0 provided that the change in book value over a five year period at least exceeds the S&P 500 change.

One other objection is that looking at Berkshire’s overall price to book value ratio does not measure the wisdom of retention of incremental capital.  It is perfectly possible to have value destroying earnings retention coincide with maintenance of a price to book value ratio well in excess of 1.0 because of the cumulative effect of decades of good decisions that have created the bulk of the intrinsic value.  At the margin, earnings retention could still destroy value while the price to book ratio remains above 1.0, although below what it otherwise might have been without earnings retention.

No Substitute for Management Judgment

The bottom line is that few shareholders would have wanted Mr. Buffett to declare a dividend in March 2009.  Shareholders trust his judgment based on his cumulative history at Berkshire and are willing to grant a huge amount of latitude based simply on the track record.

The problem with attempting to define this type of rule is that some element of management judgment is always going to be required when deciding on earnings retention policy.  Only after a period of time passes will shareholders be able to evaluate whether the retained earnings created value or not.  Future CEOs at Berkshire Hathaway will find it impossible to alter any of the business principles in any way whatsoever because they will be accused of trying to modify the company culture.  Therefore, Berkshire shareholders must be comfortable with these principles as they apply to the next CEO, not just Mr. Buffett.

The fact that Berkshire Hathaway has an Owner’s Manual with clear principles is a great example for other companies to follow but the recent revision to the earnings retention test demonstrates the inherent limitations associated with static principles that meet the irrational behavior of Mr. Market.

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.

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.

If you receive Portfolio Manager's Review in the mail each month, you are eligible to receive Ravi Nagarajan's newly published 70-page Berkshire Hathaway 2010 Briefing Book and Excel model for FREE. Click here to buy the briefing book, then email your purchase confirmation to support at manualofideas dot com. We will promptly refund the $19.96 purchase price to you via PayPal.

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By Ravi Nagarajan

Despite a snowstorm that caused the absence of several speakers, the Columbia Investment Management Conference in New York today included many interesting presentations and panel discussions.  The highlight of the day was the conversation between Columbia Professor Bruce Greenwald and Martin Whitman, Founder and Portfolio Manager of Third Avenue Management.

Mr. Whitman has a sixty year history in the investment management field and represents a distinguished voice of experience we can all learn from.  This article includes several topics that were included in the discussion between Prof. Greenwald and Mr. Whitman but it is not a complete transcript and, unless otherwise noted, is based on the authors notes and recollection of the conversation rather than a presentation of direct quotes.

The Evolution of a Value Investor

Most investors who have arrived at a “value oriented” strategy moved toward the approach over a period of time.  Many of us know the story of Warren Buffett reading every book on investing in the Omaha library but not reaching the conclusion that value investing represents the best strategy until reading Ben Graham’s The Intelligent Investor in 1950.  A similar “evolution” was the case for Mr. Whitman who entered the business as a security analyst at Shearson, Hammil in 1950.  For the first four years, Mr. Whitman focused on many of the traditional benchmarks that security analysts today still concentrate on such as earnings per share growth and predicting near term price movements.

In 1955, Mr. Whitman read Between the Sheets by William J. Hudson which is a book (currently out of print) regarding the importance of paying particular attention to the balance sheet.  This book combined with several real life examples at the time convinced Mr. Whitman that emphasizing balance sheet quality should be more heavily considered in the field of security analysis.  Mr. Whitman also gained a great deal of experience working as a portfolio analyst for William Rosenwald starting in 1956. Experience in stockholder litigation and bankruptcy, fields that were shunned at the time, also provided important lessons regarding analyzing the capital structure of distressed firms.

“Cheap is Not Sufficient”

At several points in the discussion with Prof. Greenwald, Mr. Whitman came back to a central theme:  It is not sufficient for a security to be “cheap”.  It must also possess a margin of safety as demonstrated by a strong balance sheet and overall credit worthiness.   In other words, there are many securities that may appear cheap statistically based on a number of common criteria investors use to judge “cheapness”.  This might include current year earnings compared to the stock price, current year cash flow, and many others.  However, if the business does not have a durable balance sheet, adverse situations that are either of the company’s own making or due to macroeconomic factors can determine the ultimate fate of the company.  A durable balance sheet demonstrates the credit worthiness a business needs to manage through periodic adversity.

A New Take on Graham’s “Net-Nets”

Mr. Whitman believes that it is a “myth” that there are no “net-net” opportunities available in the market today.  We discussed Graham’s concept of net-nets in a prior article and came up with some examples of such opportunities over the past year (for example, see the articles on Hurco and George Risk Industries).  However, such opportunities are very rare and often exist only in the most thinly traded stocks and therefore are rarely actionable.

Rather than adhering to Ben Graham’s original concept of “net-nets”, Mr. Whitman has made a few modifications.  Instead of using current assets as the store of value, he looks at “readily ascertainable asset value” and tries to buy at a large discount to that value.  Assets that can be readily convertible to cash may include high quality real estate, for example.  In certain situations, assets such as real estate may be more valuable in a liquidation than inventories which are part of current assets but often highly impaired in distressed situations.

One other point that Mr. Whitman made while discussing corporate governance also applies to many net-net situations.  The true value of a company may never come out if there is no threat of a change in control.  This obviously makes intuitive sense because the presence of a very cheap company alone will not result in realization of value unless management is willing to act in the interests of shareholders either by liquidating a business that has no future prospects but a very liquid balance sheet or taking steps to improve the business.

When asked if the management of a typical public company is overpaid, Mr. Whitman said “you’d better believe it” due partly to the fact that most Boards of Directors are “a bunch of wimps, including me.”  This serves as a reminder that there is one other characteristic that many value investors share:  Humility and a willingness to admit errors.

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.  

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Edward Lampert, Founder of ESL Investments and Chairman of Sears Holdings Corporation, has released his annual letter to shareholders.  Mr. Lampert’s investment style has often been compared to Warren Buffett’s approach particularly when it comes to capital allocation.  While many companies fail to adhere to disciplined capital allocation practices, Sears has taken a more intelligent approach.

Maintenance vs. Expansion Capital Expenditures

Mr. Lampert has been criticized for failing to make the necessary investments to keep Sears and K-Mart stores competitive.  Personal experience and anecdotal evidence does suggest that Sears Holdings retail properties are not necessarily the most modern facilities in many locations.  However, this fact alone does not automatically justify blindly committing funds to expansion or improvements beyond “maintenance” levels of capital expenditures:

I have written previously about what I believed was the reckless expansion of retail space leading to lower profitability for many retailers and to low or negative returns on the investment required to expand space. In other industries, consolidation rather than expansion has led to a more sensible competitive environment and better returns for shareholders. If you examine the level of capital expenditures over the past decade at many large retailers and compare that expenditure to value created, it would not paint a pretty picture.

Additionally, the dramatic declines in capital expenditures over the past couple of years at most large retailers are strong evidence that the level of maintenance capital expenditures for a big box retailer is materially below what many analysts and experts previously believed. Most of the capital spent over the past decade has been largely for store expansion, with some lesser amount required for maintaining existing stores.

The cost of updating or expanding properties must be weighed against the best possible alternative uses for the funds such as improving Sears’ strongest brands like Kenmore and Craftsman or authorizing share repurchases:

While we continued to repurchase shares during the economic crisis because the value was attractive and because we had significantly lower leverage than others in our industry, many of our competitors suspended their repurchase programs to appease credit rating agencies only to resume them again after their share prices recovered significantly.

Mr. Lampert also criticizes ratings agencies for simplistic analyses that automatically favor capital investment to share repurchases ignoring the fact that capital investment at negative rates of return can end up harming bondholders as well as stockholders.

Owner Orientation

While many executives only pay lip service to “shareholder value” and “management alignment with shareholder interests”, Mr. Lampert’s record and ownership interest in Sears Holdings serves to back up his claims.

We do some things differently than others, and we have certain beliefs that differ from theirs. Our culture is owner-oriented, because we have owners who serve on the board that governs the company. We believe that ownership makes a difference, especially when owners have significant financial interests in the company and a long-term perspective. Instead of this raising concern, rating agencies should welcome and value owners with a demonstrated track record of long-term value creation and conservative capital policies, even when some of the capital allocation preferences differ from those that others believe lead to higher long-term credit performance.

This is the type of owner orientation that makes it preferable to repurchase shares rather than plowing funds into capital expenditures at negative rates of return even though doing the latter is more popular within any organization in the short run and also will win the praises of local community leaders at ribbon cutting events.  The problem with companies that pursue popularity rather than intelligent capital allocation is that eventually the day of reckoning will arrive and the music will stop.

Regulation and Politics

Wading into more controversial topics, Mr. Lampert is critical of policies that may over-regulate the economy by placing government bureaucrats in place of private sector capital allocators when it comes to sustaining an economic recovery.  In terms of financial regulation, Mr. Lampert advocates the removal of the implicit “too big to fail” guarantee which would level the playing field.  However, it is unclear how the government can remove the “too big to fail” perception without some form of regulation to constrain financial institutions from reaching the size and interconnectedness that makes government bailouts inevitable.

Capital can quickly reorganize and provide financing for businesses and projects that create value for our society, without the heavy hand of government planning and policy. I disagree with most people calling for a gigantic overhaul of our financial system led by new and “improved” regulations. Instead, begin the process of allowing more competition in financial services and begin the removal of implicit and explicit government guarantees that provide the perception that some are “too big to fail.” While there are those that claim that their institutions are not too big to fail, they surely recognize the significant competitive advantages that come from this perception. Of course they will accept regulations as long as these regulations do not permit additional competition from entities and institutions that do not take insured deposits, do not have access to Federal Reserve funding, and do not have government guarantees associated with their debt offerings. Regulatory capture comes when there is little competition allowed outside regulated entities and a “freezing” of competitors and innovation in an industry.

Mr. Lampert also protest the special treatment given to Amazon.com and other online retailers that are not required to collect sales and use tax in locations where they do not have a physical presence.  It is difficult to argue with the logic behind treating traditional retailers and online retailers in a uniform manner and the observation that current practices will prove unsustainable as more commerce shifts online.

The real story here is that it is not the payment of taxes or the charging of taxes that is at issue. It is the collection of taxes on behalf of local governments from purchasers of goods and services from stores in a locality or for use in such locality. It is the latter fact that is often ignored. A person who buys products from Amazon.com is required by law to pay sales or use tax to their local jurisdiction. In practice, almost nobody does so. The cost and unpopularity of enforcing such laws has allowed customers to avoid paying sales or use taxes, even though they are required in many states and localities. If you buy a work of art or piece of jewelry in NYC, for example, and have it shipped to New Jersey or California, the seller does not collect sales tax on that purchase but the buyer would be required to pay sales or use tax on the purchase where they receive the merchandise and use the merchandise. So, a piece of jewelry shipped to California would require the buyer to pay California sales or use tax.

Mr. Lampert recommends Thomas Sowell’s latest book Intellectuals and Society.  Although I have not kept up with Mr. Sowell’s work in recent years, I consider one of his previous books, The Vision of the Anointed, to be one of the best essays on the mentality that often drives the decisions of those in high positions of power.

Click on this link to read Edward Lampert’s full letter to Shareholders.

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 does not own shares of Sears Holdings.

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By Ravi Nagarajan

Note to Readers:  The following essay is part of an introductory section of an upcoming analysis of Berkshire Hathaway to be published by The Rational Walk shortly after the 2009 Berkshire Hathaway Annual Report is released at the end of February.  The full analysis will be available for purchase as premium content with certain excerpts to be provided on The Rational Walk blog free of charge.

For a formatted PDF File of the following essay, please click on this link.

From Cigar Butts to Business Supermodels

There are numerous books and publications that provide detailed accounts of the history of Berkshire Hathaway as well as Warren Buffett’s life and career.  It is also impossible to fully understand Berkshire without studying the life and career of Vice Chairman Charles T. Munger.  A list of resources for those interested in a comprehensive history of the company and its leaders is provided as an appendix to this document (available in the forthcoming full analysis).  This section merely attempts to provide some context regarding the remarkable history of Berkshire Hathaway and Warren Buffett’s investment approach.

Warren Buffett’s Early Investment Philosophy

Warren Buffett’s early investment philosophy was largely based on the principles developed by Benjamin Graham.  Mr. Buffett has stated on many occasions[1] that his view of investing changed dramatically when he first read Mr. Graham’s book, The Intelligent Investor, in early 1950.  Up to that point, Mr. Buffett had read every book on investing available at the Omaha public library but none were as compelling as Mr. Graham’s straight forward approach summarized in the phrase: “Margin of Safety”.

Benjamin Graham’s approach is more fully documented in Security Analysis which, in contrast to The Intelligent Investor, is more targeted toward professional investors.  Mr. Graham’s approach involved examining securities from a quantitative perspective and making purchases only when downside risks are minimized.  This approach rarely involved speaking to management since doing so could adversely influence the analyst’s impartial view of the data.  In particular, Mr. Graham was a proponent of purchasing stocks selling well under “net-net current asset value” arrived at by taking a company’s current assets and subtracting all liabilities.  In such cases, the buyer was paying nothing for the business as a going concern and had some downside protection due to liquid assets far in excess of all liabilities.

Mr. Buffett was able to leverage the “deep value” approach advocated by Benjamin Graham throughout the 1950s.  In the five year period ending in 1961, the Buffett Partnerships trounced the Dow Jones Industrial average with a cumulative return of 251 percent compared to 74.3 percent for the Dow[2].  While Mr. Buffett employed multiple strategies, one approach involved finding companies that fit the “cigar butt” mold, meaning that they had “one puff left” and could be purchased at a deep bargain price.  This approach led Mr. Buffett to begin acquiring shares of Berkshire Hathaway, a struggling New England textile manufacturer, in late 1962. While Berkshire Hathaway was trading well under book value at the time, Mr. Buffett would later say that book value “considerably overstated” intrinsic value[3].

From Cigar Butts to Insurance

Berkshire Hathaway, as it existed in 1963 when the Buffett Partnership became the company’s largest shareholder, was a cheap company from a quantitative perspective but it was not a good company in terms of offering a business that had durable competitive advantages.  In fact, over the next two decades, Berkshire Hathaway continued to invest in the textile mills but would never gain sufficient traction to complete with overseas competitors with lower cost structures.  Textiles are a commodity business and the low price producer has the advantage.  In retrospect, Mr. Buffett’s purchase of Berkshire Hathaway was a mistake[4].

While Berkshire’s textile mills were doomed to eventual failure, a period of profitability[5] appeared in the mid to late 1960s that presented Mr. Buffett with a choice:  He could either reinvest the profits in the textile business or redeploy the funds elsewhere.  Above all else, Mr. Buffett is a master capital allocator.  He could see the troubles brewing in textiles and, despite attempts by Berkshire’s textile managers to obtain capital for new investments, Mr. Buffett chose to deploy the funds elsewhere.

Berkshire’s entry into the insurance business with the purchase of National Indemnity in 1967[6] was a transformational event for the company.  The textile business, despite a temporary period of profitability, required significant capital investments to continue to remain competitive.  In contrast, insurance operations that are well run generate significant cash in the form of “float”.  Float represents funds that are held by an insurance business between the time when policyholders submit payment and when funds are eventually paid out to settle claims.  As long as underwriting practices are sound, float represents a low cost means of funding investments.  By purchasing National Indemnity, Berkshire was on its way to transforming from a textile manufacturer consuming large amounts of capital at low to negative rates of return into an insurance powerhouse generating large amounts of float for investment in other businesses offering better prospects of high returns.

See’s Candies:  The Turning Point

Few Californians can recall a holiday season where See’s Candies were not a prominent part of the festivities.  The brand is so powerful in California and other western states that many consumers would never think of buying a competing product.  See’s Candies is a textbook example of a company with a formidable “moat”.  Such companies have built up brand identity that cannot be replicated by new entrants even with significant capital investments[7].

Berkshire Hathaway Vice Chairman Charles Munger has been widely credited with convincing Warren Buffett that there are certain situations where deviating from Benjamin Graham’s “deep value” approach can be justified.  Mr. Munger has rebutted[8] the notion that his influence was a deciding factor in Mr. Buffett’s overall record, but many accounts[9] of the events surrounding the See’s Candies purchase supports the conclusion that Charlie Munger deserves much credit for shifting Berkshire’s bias from cigar butts selling at a “bargain price” to excellent businesses selling at a “fair price”.

See’s Candies is the perfect example of a business that produces an excellent return on equity year after year but requires very little capital investment in order to sustain the “moat” that makes such returns possible.  When Berkshire purchased See’s Candies for $25 million in 1972, the company only had $8 million of net tangible assets.  However, See’s was earning approximately $2 million after tax at the time[10].   $17 million of the $25 million purchase price could not be accounted for by assets on See’s balance sheet but represented the value represented by intangible “brand equity”.

Over the first twenty years of Berkshire’s ownership of See’s Candies, sales increased from $29 million to $196 million while pre-tax profits grew from $4.2 million to $42.4 million.  However, that is not even the most amazing part of the story.  What is more remarkable is that Berkshire Hathaway only had to reinvest $18 million of retained earnings over that twenty year period while $410 million of cumulative pre-tax earnings were sent back to Berkshire for redeployment in other investments[11].

There have been many other key turning points in the history of Berkshire Hathaway but the decision to pay a “premium price” for See Candies in 1972 may best symbolize the transformation of Mr. Buffett’s approach toward investing.  This is perfectly summarized in Mr. Buffett’s 1992 Letter to Shareholders:

In my early days as a manager I, too, dated a few toads.  They were cheap dates – I’ve never been much of a sport – but my results matched those of acquirers who courted higher-priced toads.  I kissed and they croaked.

After several failures of this type, I finally remembered some useful advice I once got from a golf pro (who, like all pros who have had anything to do with my game, wishes to remain anonymous).  Said the pro:  “Practice doesn’t make perfect; practice makes permanent.”  And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.

Berkshire Hathaway is the company it is today because Mr. Buffett stopped kissing toads like the original Berkshire textile business and started aggressively pursuing supermodels like See’s Candies instead even if they were more “expensive dates”.  As we shall see, Berkshire has no shortage of supermodels today.

[1] For example, see Mr. Buffett’s preface to any recent edition of The Intelligent Investor.
[2] The Buffett Partnership track record is available in many publications.  See, for example, Roger Lowenstein’s Buffett: The Making of an American Capitalist, 1995 Hardcover Edition, Page 69.
[3] See comment in Berkshire Hathaway Owner’s Manual, Page 5.
[4] Mr. Buffett directly stated that buying Berkshire was a mistake in his 1989 letter to shareholders.
[5] See Lowenstein, Page 133.
[6] For a good history of the National Indemnity purchase, see Lowenstein, pages 133 to 135.
[7] For an excellent brief history of See’s Candies, see Max Olson’s paper entitled Quality without Compromise.
[8] See Mr. Munger’s statement in Poor Charlie’s Almanack, Third Edition, “Rebuttal:  Munger on Buffett”
[9] For example, see Alice Schroeder’s account of the See’s Candies purchase in Snowball:  Warren Buffett and the Business of Life, Chapter 34.
[10] See the appendix to Warren Buffett’s 1983 Letter to Shareholders.
[11] See Warren Buffett’s 1991 Letter to Shareholders.

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.

Posted by manualofideas at 11:18 AM | Permalink | Comments (0)

The Manual of Ideas: Are there any books on value investing, particularly globally oriented investing, that you have found valuable but investors may not be broadly familiar with?

Ori Eyal: Reading voraciously is a characteristic that all great investors share in common. There is simply no better way to gain wisdom and learn about the world than to read great books.

For international investing, Jim Rogers’s earlier books, Investment Biker, Adventure Capitalist, and Hot Commodities are good. The Economist is a great weekly magazine to read and learn about the world. I also think Mohnish Pabrai’s The Dhandho Investor and Joel Greenblatt’s You Can Be a Stock Market Genius are great investing books.

Economics is a key investing skill so I think everyone should read Milton Friedman, especially his books Capitalism and Freedom and Free to Choose.

Trying to forecast what the future will look like is an important investing skill. To this end I recommend books by Ray Kurzweil, Fantastic Voyage and The Singularity Is Near. Bill Gates has called Ray Kurzweil “the best person I know at predicting the future of artificial intelligence.”

To broaden your latticework of mental models, I highly recommend books by Richard Dawkins, Jared Diamond, Richard Feynman, Michael Pollan and John Brockman. I also think Buzzmarketing by Mark Hughes and Influence by Robert Cialdini are must read books.

Finally, I highly recommend the fantastic publications by The Manual of Ideas: Downside Protection Report, Portfolio Manager’s Review, etc. I also think that Value Investor Insight is great.

Read a sample issue of Downside Protection Report.

Read a sample issue of Portfolio Manager's Review.

Posted by manualofideas at 03:45 PM | Permalink | Comments (0)

Respected value investor Aaron Edelheit of Sabre Value recently discussed his investment approach and current investment opportunities in an exclusive interview with Portfolio Manager's Review. The full interview will be published in the forthcoming monthly issue of the Review. Here is a quick excerpt for those looking to pick up a good book:

The Manual of Ideas: Are there any “off-the-beaten path” books that have made you a better investor?

Aaron Edelheit: I just read a fantastic book called “The First Tycoon,” by T.J. Stiles, about Cornelius Vanderbilt. There were many lessons and ideas I drew from the book about what made him so successful, and I think there is a lot to learn about history as well.

Read the full interview with Edelheit as soon as it is published -- subscribe to Portfolio Manager's Review today.

Posted by manualofideas at 04:26 PM | Permalink | Comments (0)

Those of our readers who have followed the evolution of Steak n Shake (SNS) over the past couple of years know that the company has made huge strides in terms of stabilizing operations and creating value for shareholders. Whereas the previous management team almost ran Steak n Shake into the ground, new chairman Sardar Biglari quickly restored the company's fiscal health, ensuring that Steak n Shake will be around for a long time to come. Not least, Steak n Shake's stock price has enjoyed a renaissance of sorts after languishing for years under the old management.

Despite all the positives that Sardar Biglari's involvement has brought to Steak n Shake, the Indianapolis Business Journal (IBJ) has published an article that can hardly be described as anything other than a hatchet job. In the article, Cory Schouten writes:

"Biglari in June persuaded the board to transform Steak n Shake into a holding company for a diverse range of investments and give Biglari sole discretion over asset allocation. The board’s vote essentially allowed the hedge-fund owner to use the publicly traded company as a personal investment vehicle."

"The unanimous vote came after Biglari, the board chairman, managed to push out every board member unwilling to give him dictatorial authority over Steak n Shake despite his relatively modest ownership stake."

"Personal investment vehicle"? "Dictatorial authority"? This language might be more appropriately used to describe the state of Steak n Shake under previous management. Biglari's words -- and, more importantly, actions -- have made it clear that his paramount goal is maximizing long-term value for all Steak n Shake shareholders. Biglari's authority could be described as "dictatorial," but so could every CEO's authority. The question is whether such authority is used for the benefit or detriment of shareholders. In Biglari's case, the business results and stock price of Steak n Shake speak volumes.

The IBJ article also stokes fears about Steak n Shake relocating to Biglari's hometown of San Antonio, Texas, implying that jobs and capital investment might be lost in Indianapolis. We have no problem with a hometown paper looking out for its town, but in this case the IBJ is far off-base. Steak n Shake "The Restaurant Company" will continue to be based in Indianapolis. Meanwhile, Steak n Shake "The Holding Company" will operate out of San Antonio, Texas, likely with a very lean holding company staff.

The inability of organizations such as the IBJ to distinguish between Steak n Shake "The Restaurant Company" and Steak n Shake "The Holding Company" is precisely why Steak n Shake "The Holding Company" will be renamed Biglari Holdings. Listen up, confused IBJ readers: The restaurant business will continue to be called Steak n Shake.

The reader comments posted on the IBJ website show just how destructive it can be in the fast-paced online age when misleading or outright wrong information is spread by a supposedly authoritative voice. Writes IBJ reader Mike,

"This is an unexpected turn of events. I frequent Steak n Shake for many reasons, but mostly b/c of the local headquarters. I for one will not go as often (or ever) if most of the local corporate jobs are moved."

Adds IBJ reader Joe,

"when did we...decide to let sleazeball Iranian refugees (from the Shah's regime no less)purchase/own good 'ol 'Merkan companies and run 'em into the ground...my guess is his family has millions in Swiss bank accounts they've been living off of for years (used to work with one of these Iranian ex-pats years ago and had he was the sleaziest 'businessman' I ever met!)"

Another IBJ reader who calls himself Indy Observer takes a more lighthearted approach to spreading baseless rumors:

"Any truth to the rumor that the Steakburger is being renamed the Big Lari Burger?"

On second thought, that last one could actually catch on. Give it a few decades, by which time Biglari Holdings may well be another stock with a six-figure price tag and tens of thousands of happy shareholders attending each annual meeting. At that time, "Big Lari Burger" just may become a no-brainer name for a burger that will be enjoyed by droves of happy shareholders.

Disclosure: No position.

Posted by manualofideas at 09:04 PM | Permalink | Comments (0)

The following are links to hedge fund manager interviews posted on the website Hedgefundnews.com. The interviews were conducted between 1995 and 2004.

• John B. Kleinheinz, Kleinheinz Capital Partners - January 2004
  
• John Paulson, Paulson & Co. - July 2003
  
• Russell Abrams, Titan Capital Group - April 2003
  
• John Muresianu, Lyceum Capital - January 2003
  
• Robert P. Rotella, Rotella Capital Management - June 2002
  
• Alexander J. Roepers, Atlantic Investment Management - April 2002
  
• Ernst von Olnhausen, Robert Vicas, Double V - October 2001
  
• Raj Gupta, Epoch Funds - July 2001
  
• Michael Rome, Lazard Frères - April 2001
  
• Brian Stark, Michael Roth, Staro Asset Management - January 2001
  
• Thomas M. O'Neill, Navigator Asset Management - October 2000
  
• Gregg D. Groechel, American Express - July 2000
  
• Marc J. Gabelli, Gabelli Asset Management - April 2000
  
• Fabien Pictet, Fabien Pictet & Partners Ltd. - January 2000
  
• Errol M. Rudman, Rudman Partners, L.P.-October 1999
  
• Morris Mark, Mark Asset Management-July 1999
  
• Stephen Edwards, Magus Capital Management Ltd.-April 1999
  
• Sanford Grossman, Quantitative Financial Strategies-Jan. 1999
  
• George Hall, Clinton Group-July 1998
  
• Charles Schaffran, Alliance-April 1998
  
• Wayne Cooperman, Ricky Sandler, Fusion Partners-January 1998
  
• Stacy Ruchlamer, The Consumer Fund, L.P.- October 1997
  
• Geoffrey L Symonds, Trace Global Opportunities Fund-July 1997
  
• Raj Rajaratnam, The Galleon Group-April 1997
  
• Charles Davidson, Joseph Jacobs and Shaiy Pilpel, Wexford Management LLC-January 1997
  
• John Armitage and William Bollinger, Egerton Capital Limited-November 1995
  
• Gerald R. Jordan, Jr., Hellman, Jordan Management-July 1995
  
• Michael Sofaer, Sofaer Capital Inc. -May 1995
  

Posted by manualofideas at 08:15 PM | Permalink | Comments (0)

Canadian value investor Vito Maida, founder of Patient Capital Management and former Prem Watsa protege, discusses his strategy and market outlook in this interview with the Financial Post.

If video fails to load, click here to watch.

If video fails to load, click here to watch.

Here is how Patient Capital describes the firm's investment philosophy:

PCM's investment philosophy is based on long-term absolute value. The objective of the investment philosophy is to focus on the preservation of capital while earning superior rates of return. PCM attempts to meet these objectives by purchasing only those securities that meet very strict criteria for value and quality. PCM's mandates allow for substantial cash balances to accumulate if securities cannot be found that meet its very high standards. Investments are only considered in companies that have a long history of operation and are in stable businesses that PCM can analyze and understand with a high degree of certainty.

PCM’s portfolios are constructed entirely on a bottom up basis. Each investment is analyzed through a very independent and rigorous analytical approach. Reliance on external research is minimal. Historical annual reports are analyzed to determine balance sheet strength, sustainability of cash flows and profitability. A very important component of the analytical process is an assessment of the company’s accounting policies. In depth interviews are often conducted with company management in order to assess future strategy and competitive position. In addition, a considerable amount of time is spent attempting to estimate “intrinsic value” through the use of discounted cash flow models and traditional valuation measures such as price/earnings ratios and price/book ratios.

New investments are only purchased if PCM’s criteria for high quality fundamental characteristics such as superior returns on capital, substantial free cash flow and low debt are present as well as a security price that is trading at a substantial discount to PCM’s estimated intrinsic value.

Although PCM’s investment horizon is five to ten years we will exit an investment for any one or more of the following reasons:

• The security price reaches our targeted sale price;
• Significant management changes occur;
• A dramatic change in strategic direction is undertaken;
• Increased debt levels are incurred;
• Adverse changes in accounting policies are implemented.

We believe that our investment philosophy is very different from virtually every other Canadian value manager. Because our clients do not require us to be fully invested we do not have to compromise our standards for quality and price in order to meet a fully invested mandate. Other value mangers that must remain fully invested must by definition practice “relative value investing.” In addition, PCM portfolios are concentrated and will hold a maximum of twenty securities.

(Thanks to Corner of Berkshire and Fairfax for the interview link.)

Posted by manualofideas at 03:47 PM | Permalink | Comments (0)

Here are some recent letters that you may find worthwhile:

• Chuck Akre: Akre Capital Management Q4 letter
• Christopher Begg, Ben Favazza: East Coast Q4 letter 
• Bruce Berkowitz: Fairholme annual letter
  
• Sardar Biglari: 2009 Steak n Shake chairman's letter
  
• John Burbank: Writeup on gold investment thesis 
• Kevin Byun: Denali Investors Q4 letter
• Carr, Coates and Phillips: Oak Value Fund Q4 letter
• McLane Cover: Mistral Capital Partners December letter
  
• David Einhorn: Greenlight Capital Q4 letter 
• Ori Eyal: Emerging Value Capital Management letter
  
• Bill Gates:2010 Bill & Melinda Gates Foundation 2010 letter
• Jeremy Grantham: GMO Q4 letter
• Bill Gross: February commentary, "The Ring of Fire" 
• Robert Hagstrom: "Who's afraid of a sideways market?"
• John Hussman: Latest weekly comment
• Tomas Jelf: Prologue Capital December 2009 letter
  
• Jonathan Lourie: Cheyne Capital 2010 newsletter
  
• Howard Marks: Latest memo, "Tell Me I'm Wrong"
• Angus Murray: 2010 market outlook for precious metals
• Richard Perry: 2009 annual letter 
• Jay Petschek: Corsair Capital Q4 letter 
• Eric Sprott: December letter, "Is it all just a ponzi scheme?"
  
• Whitney Tilson: T2 Partners annual letter
• Pruitt, Miller and Koster: Chanticleer Advisors annual letter
  

Posted by manualofideas at 12:00 AM | Permalink | Comments (0)

The blog My Investing Notebook has posted Bill Ackman's presentation on Kraft (KFT), dated February 3rd. The slides provide a good overview of the businesses of Kraft and Cadbury. Ackman also shares a valuation analysis of the combined company, not surprisingly suggesting that the stock should earn a strong return over the next couple of years.

While we like the presentation, we would take some of the assertions with a grain of salt, particularly Ackman's claims regarding merger synergies, potential margin expansion, and a "good" price paid for Cadbury.

Somehow investors always seem to believe there is room for margin expansion. Needless to say, margins don't always expand.

The following classic Buffett quotation may ultimately prove prescient with regard to Kraft/Cadbury: "In some mergers there truly are synergies - though often times the acquirer pays too much for them - but at other times the cost and revenue benefits that are projected prove illusory. Of one thing, however, be certain: if a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked."

Posted by manualofideas at 05:49 PM | Permalink | Comments (0)

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In the following interview, Bruce Berkowitz of The Fairholme Fund discusses his recent sale of Pfizer, which had been Fairholme's largest holding through most of 2009.

Berkowitz also opines on the issue of tax rates in the pharmaceutical industry and says that effective tax rates have been too low for too long. The implication is that this could change, potentially depressing earnings -- or at least slowing earnings growth -- across the industry.

Finally, Berkowitz suggests that Fairholme is moving away from a defensive posture toward a more offensive stance in terms of picking investments. Underlying the more aggressive posture is Berkowitz's view that the financial crisis is essentially over and that we are now in recovery mode.

Posted by manualofideas at 05:54 PM | Permalink | Comments (0)

Posted by manualofideas at 05:52 PM | Permalink | Comments (0)

Bruce Berkowitz's Fairholme Fund (FAIRX) disclosed a new position in Citigroup in the annual report of The Fairholme Fund for the fiscal year ended November 30, 2009.

Bruce Berkowitz is one of more than 20 superinvestors regularly covered in Portfolio Manager's Review.

Posted by manualofideas at 05:52 PM | Permalink | Comments (0)

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Posted by manualofideas at 08:58 PM | Permalink | Comments (0)

We recently had the pleasure of interviewing Mary Buffett, author of Buffettology, The New Buffettology and the newly published Warren Buffett Management Secrets: Proven Tools for Personal and Business Success. We will be bringing you various portions of the wide-ranging exclusive interview in the next few days.

We start this series of posts with Mary Buffett's description of Warren Buffett's approach to "winning an argument," which is also discussed in Chapter 17 of Warren Buffett Management Secrets: Proven Tools for Personal and Business Success.

Click here to listen to or download the MP3 audio.

Posted by manualofideas at 12:32 AM | Permalink | Comments (0)

Wilbur Ross, chairman and CEO of WL Ross & Co., discusses his interest in New York's Stuyvesant Town:

Posted by manualofideas at 11:49 AM | Permalink | Comments (0)

By Nadav Manham

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Bill Ackman of Pershing Square went on the air right before Warren Buffett this morning. Quite interesting that Ackman appears to have misread Buffett's views on the Kraft deal for Cadbury. Watch Ackman's comments first and then scroll down to the Buffett interview in our next article. The juxtaposition is fascinating.

Part One of Bill Ackman Interview:

Part Two of Bill Ackman Interview:

Posted by manualofideas at 03:36 PM | Permalink | Comments (0)

If Kraft CEO Irene Rosenfeld was hoping for a public vote of confidence from Warren Buffett, she is surely disappointed this morning.  Perhaps not surprisingly based on his unusual public criticism of Kraft on January 5, Mr. Buffett says that he “feels poorer” in light of Kraft’s richer bid for Cadbury and he disagrees with the decision to shed a highly profitable frozen pizza business to provide funding for the deal.

The statement today in a CNBC interview prior the special meeting of Berkshire Hathaway shareholders clearly refutes yesterday’s Wall Street Journal article which cited an unnamed source within Kraft who indicated that Mr. Buffett was “totally supportive” of the new terms.

Mr. Buffett also comments on a number of topics including the Obama Administration’s proposed bank tax, stating that he does not believe that banks are making “obscene profits” and companies that have already repaid TARP funds should not be forced to effectively pay for bailouts at Fannie Mae and Freddie Mac.

Other topics covered include the Berkshire Hathaway Class B stock split, Wells Fargo’s results, executive compensation, and Ben Bernanke’s prospects for a second term as Federal Reserve Chairman.  In addition, Mr. Buffett is not planning to increase Berkshire’s stake in Posco at this time and indicated that reports yesterday to the contrary may have been due to a misunderstanding with Posco’s CEO due to language translation.

CNBC Interview: Part One

CNBC Interview:  Part Two

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. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 02:08 PM | Permalink | Comments (0)

Longtime shareholders of Berkshire Hathaway know that Warren Buffett hardly ever comments directly on his assessment of the company’s intrinsic value.  In an interview with Bloomberg at today’s special meeting of shareholders, Mr. Buffett made an exception to his usual silence on the matter when he was asked about issuing shares of Berkshire to pay for part of the Burlington Northern transaction.

The question of whether the bid for Burlington sends any signals regarding Mr. Buffett’s views on Berkshire’s intrinsic value has been discussed here shortly after the transaction announcement in November and again after the proxy statement was released in December.

Here are excerpts from the interview:

You have no problem issuing shares if your stock is fully valued.  I think our stock actually, measured against book value which many people do and is not a crazy way to measure it, it’s at the low end … so I hate issuing shares.  And if I’m paying $100 a share to Burlington shareholders, it’s costing our shareholders more than $100 which I will explain to them in the annual report, because we’re using shares I don’t want to use.

Now, this deal still makes sense in our view.  I mean, we talk about this extensively at the Board.  But we value Berkshire [shares] that we’re giving out at what we think Berkshire is worth.  Unfortunately the Burlington shareholder is going to value it at the market, so we have to give them $100 worth.  Weighing all of that, we like the deal.  But we don’t salivate over it.  I mean, it was close.  We wouldn’t have issued any more shares than we’re doing.

To view the interview, click on the image displayed below or on this link.

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. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 01:23 PM | Permalink | Comments (0)

According to a Bloomberg article, Warren Buffett may be interested in increasing Berkshire Hathaway’s stake in Posco, a South Korean steelmaker. Posco cited Mr. Buffett as saying that he “should have bought more Posco shares when the stock price dropped during the economic crisis.”  According to Bloomberg, Mr. Buffett met with Posco CEO Chung Joon Yang in Omaha yesterday.  Mr. Buffett has not commented on the meeting.

Here is a brief except from the article regarding prospects for Posco this year:

World steel demand will rise 10 percent this year, Posco said last week when it announced a 77 percent jump in fourth- quarter profit and plans to push ahead with $30 billion of overseas expansion. Buffett, 79, may have a paper profit of more than $1.3 billion in his Posco holding, first disclosed in 2007.

“From the point of view of Buffett, there may be few steel stocks to buy in Asia,” said Chang In Whan, president of KTB Asset Management Co. in Seoul, which manages the equivalent of $8.9 billion in assets. “I’m sure Posco will acquire companies this year, which will help it secure growth in size as well as in efficiency.”

Berkshire held 3,947,554 shares of Posco on December 31, 2008 which represented a 5.2% stake in the company.  Berkshire did not report updates on positions in securities traded on foreign exchanges in quarterly 10-Q reports or in 13-F filings during 2009.

The price of Posco stock has increased from 380,000 Won on 12/31/2008 to 604,000 today while the U.S. Dollar has weakened from 1262 Won/USD on 12/31/2008 to 1124.61 Won/USD as of yesterday.  This would indicate that the value of Berkshire’s holdings in Posco has appreciated from $1.191 billion on 12/31/08 to approximately $2.12 billion today.

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. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 06:58 PM | Permalink | Comments (0)

By Greenbackd

Recently I’ve been laying the groundwork for a quantitative approach to value investment. The rational is as follows: simple quantitative or statistical models outperform experts in a variety of disciplines, so why not investing in general, and why not value investing in specific? Well, it seems that they do. A new research paper argues that quantitative funds outperform their qualitative brethren. In A Comparison of Quantitative and Qualitative Hedge Funds (via CXO Advisory Group blog) Ludwig Chincarini has compared the performance characteristics of quantitative and qualitative hedge funds. Chincarini finds that “both quantitative and qualitative hedge funds have positive risk-adjusted returns,” but, ”overall, quantitative hedge funds as a group have higher [alpha] than qualitative hedge funds.”

Definition of quantitative and qualitative

Chincarini distinguished between quantitative and qualitative equity-focussed funds thus:

Our main method used to classify was to look for the term quantitative or a description of a similar nature to place a fund in the quantative category. We also looked for words like discretionary to classify qualitative funds and systematic to classify quantitative funds. Of the four main hedge fund categories, we only found two of them reliable enough to classify. Thus, in the Equity Hedge category, we classified Equity Market Neutral and Quantitative Directional as quantitative hedge funds and Fundamental Growth and Fundamental Value as qualitative categories.

…

We did not classify any of the Event Driven funds since these funds vary too substantially within the category and it was not clear from the descriptions how to separate quantitative and qualitative funds. We also did not classify any of the Relative Value funds, even though many of these funds use quantitative techniques, because the broader descriptions left us no clear cut way to divide them.

…

We classified a fund as quantitative if the following words appeared in the fund description: quantitative, mathematical, model, algorithm, econometric, statistic, or automate. Also, the fund description could not contain the word qualitative. We classified a fund as qualitative if it contained the word qualitative in its description or had none of the words mentioned for the quantitative category.

Performance

Using return data from 6,354 hedge funds from January 1970 through June 2009, Cincarini concludes, based on the raw performance data:

Generally, quantitative funds have a higher average return and a lower average standard deviation than qual funds. Amongst the quant funds, the highest average return comes from the Quantitative Directional strategy. The correlations of the fund categories with the S&P 500 are quite low at 0.17 and 0.38 for quant and qual respectively. The risk-adjusted return measures provide mixed evidence, but overall seems in favor of quant funds.

…

The qual funds perform significantly better than quant funds in up markets (25% and 15% respectively). However, the quant funds do significantly better in down markets (-2% versus -16%). This is mainly driven by the presence of Equity Market Neutral funds. In the 1990s, the average qual fund return was higher than the average quant fund return. They were roughly the same from 2000 – 2009. During the financial crisis (which we measure from January 2007 - March 2009), quant funds did better than qual funds (3.29% versus -4.77%).

Table 9 below shows performance summary statistics for the various funds:

Advantages and disadvantages of quantitative vs qualitative

Chincarini identifies several advantages quant funds hold over qualitative funds:

…the breadth of selections, the elimination of behavioral errors (which might be particularly important during the financial crisis of 2008 – 2009), and the potential lower administration costs (after hedge fund fees).

And several disadvantages:

The disadvantages for quantitative hedge funds include the reduced use of qualitative types of data, the reliance on historical data, the ability to quickly react to new economic paradigms. These three might have been especially crippling during the financial crisis of 2007 and 2009.

Finally, there is the potential of data mining, which will lead to strategies that aren’t as effective once implemented. In this paper, we will only focus on the return differences rather than attempting to detail which of the advantages or disadvantages in central in the return differences.

Hat tip Abnormal Returns.

Posted by manualofideas at 06:05 PM | Permalink | Comments (0)

Value investor Amit Chokshi of Kinnaras Capital Management levels criticism at Bill Miller in a recent blog post, arguing that Miller has been overpaid given his lackluster long-term track record. Writes Chokshi:

It appears that Legg Mason is rolling out its public relations machine and finding amicable partners in the media to help bolster its reputation along with that of its most recognized fund manager Bill Miller.  This Bloomberg article attempts to repair Miller's deservedly tattered reputation but the authors missed a few key points that potential Value Trust investors should consider.

The Bloomberg article points out that Miller's Value Trust fund rose 43% through December 23rd, beating 93% of its peers.  This performance has led to some self-congratulatory comments with Miller stating "Even when things were really bad last fall, it was pretty clear that there would be a cyclical bullish phase to the market" and “It is too early to pat ourselves on the back...we’re just one year off of a very bad period, so we can’t get complacent."

This mentality of feeling like "you're back" after one good year despite prior years of destroying your investors capital through incompetent stock selection compounded by high fees is sickening, particularly to younger investment managers like myself.  Rather than even consider complacency, Miller should feel shame in his long-term performance and disregard for any risk management.  Miller should also show some level of concern for his investors as those that placed capital in Value Trust as far back as 1997 are underwater.  Even worse, Miller and his team were highly compensated for this incompetence.

LEGG MASON VALUE TRUST ("LMVTX") HISTORICAL PERFORMANCE

Read the full article by Amit Chokshi.

Posted by manualofideas at 06:25 PM | Permalink | Comments (0)

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In a recently published letter to shareholders, the managers of Oak Value Fund explain their investment strategy, results for 2009, as well as the investment case for several current holdings.  In addition, the managers comment on Berkshire Hathaway’s proposed acquisition of Burlington Northern Santa Fe.  Oak Value has a solid long term track record despite a relatively high expense ratio demonstrating the benefits of a rigorous value-oriented approach.  Two brief excerpts from the letter appear below.

Investment Philosophy

In our work we are neither interested in the value nor the price of “everything.” We focus our efforts on understanding a collection of growing, advantaged businesses and having an informed opinion of what we believe they are worth. For this group of companies, we are very interested in price, but only in relation to our estimate of their value. Determining price requires a buyer and a seller. Assessing value requires knowledge, insight and judgment. Price is a reaction to the present. Value is a function of the future – growth, predictability and quality. As another great investor once said, “price is what you pay, value is what you get.”

Berkshire Hathaway and Burlington Northern

Berkshire Hathaway made headlines during the quarter with the announcement that it would acquire the remaining 77% of the Burlington Northern Santa Fe railroad company. This is a large acquisition, even for Berkshire, but we believe it is consistent with Mr. Buffett’s longstanding position that it is better to pay a fair price for a good business than a good price for a fair business. The long-term economics of the railroad industry should remain quite attractive, and Burlington’s geographic footprint in the West, where long-term growth prospects appear to be above average, could make it especially compelling. The Burlington network is positioned to benefit from increased volume of imports from China, increased intra-country transport of coal out of the Rockies, and increased movement of grain out of America’s heartland. After a quarter century of consolidation and reorganization, the railroad industry today operates much more efficiently and rationally. As one of the industry’s largest players, Burlington should benefit from structural and competitive advantages for years, if not decades.

Meanwhile, shares of Berkshire Hathaway remained little changed during the quarter as the investment community seemed preoccupied with the task of interpreting some “hidden message” in the timing and/or structure of the Burlington transaction. In our opinion, the most important message for observers to glean from this transaction is the sheer economic power of the Berkshire Hathaway business model to accomplish such a transaction at this point in time.

Click on this link to read Oak Value Fund’s Letter to Shareholders (pdf)

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: No position in Oak Value Fund. Long Berkshire Hathaway.

Posted by manualofideas at 08:11 PM | Permalink | Comments (0)

In a new quarterly letter, up-and-coming special situation investor Kevin Byun describes his fund's success in 2009 and the fund's investment framework. Byun writes on the latter:

Based on the recent and continuing upheaval in the markets, it becomes worthwhile to revisit the fundamentals of our investment framework and to reevaluate the manner in which they hold us in good stead through current and future turbulent times. Although our partners already adhere to our investment mindset and believe in the validity of the tenets (which we consider sensible and logical), we know that most managed capital does not align with our framework.

Our basic structure (the allocation groupings and the incentive structure) is based on the Buffett partnerships from the 1950’s. Today, most people associate Buffett with a buy-and-hold-forever philosophy. However, most people do not know how he first created wealth for his investors and himself. What the popular view discounts is that Buffett began his career managing a hedge fund that was value-based and heavily involved in special situations. Basically falling into two categories, his “Generals” were undervalued stocks (still studied by many today) and his “Workouts” were special situations investments (unstudied by almost all).

Generals & Workouts: The Generals tend to produce returns that are more greatly affected by the overall market performance, as with rising or falling tides. The Workouts tend to provide market agnostic returns and tend to have more attractive risk-reward profiles in downturns. Much of Buffett’s consistency in outperformance even during years in which the markets declined is attributable to his special situation investments. Critically, the combination of the two is much more powerful than either one alone in producing absolute returns over an extended time frame.

The validity of this portfolio structure strikes me as powerful, simple, and elegant. In my view, those that focus only on one category at the exclusion of the other are at a fundamental disadvantage. The inherent balance in the combined structure is why Buffett himself said he expected, although could not guarantee, to outperform in bear markets and underperform in bull markets. By having a balanced tool kit, a portfolio remains flexible in allocating to the most promising opportunity set that presents itself.

Flexible mandate: We have a flexible mandate that allows us to look at any opportunities that may be attractive. Certain funds that are designed to fit into a ‘style box’ remain captive to a certain sector, geography or asset class. The problem for such fund managers is that capital can flood out as easily as it floods in (i.e. technology sector funds in 1999 versus 2000 or energy specific funds in 2008 versus 2009). Also, they become captive to a slice of the market when it is no longer attractive and are simultaneously prevented from areas that are attractive. Whether bargains are available or not is immaterial. The order of the day is to sell. As a generalist, our flexible mandate allows us to look at opportunities across the spectrum.

Concentration: Another advantage is our concentration of investments into our best five to ten investment ideas. Our opportunistic style of investing allows us to wait for investments with highly favorable risk-reward profiles and requisite margins of safety. Allocating more capital to really good ideas, which do not come around too often, simply makes sense. This builds a portfolio one idea at a time, such that performance over time correlates to the outcome of those ideas rather than to the market. On the flip side, the typical mutual fund holds about 80 positions, which practically guarantees below average performance and explains why 80% of them underperform the market simply due to frictional costs.

Cash: Another advantage is the ability to maintain net cash in the absence of other opportunities. Many funds must be fully invested according to the fund’s mandate. A fund manager must then perhaps buy at a time that may not be prudent or sell at a time that is even less prudent. Our ability to hold cash is a great advantage, especially as the current market dislocation unfolds. The use of leverage can be extremely dangerous. As has become apparent, investments that were mediocre at best were made to look superior in cooperative markets through the use of easy borrowing.

Alignment of Interests: We eat our own cooking. I have the lion’s share of my net worth in the fund and I will continue to keep my assets in the fund. The idea is if we do well, we all do well together. I can assure you that my focus is on judiciously growing partners’ capital. The fund manager, whose responsibility is to protect and shepherd capital, should not be exempt from the downside risk. One should cast a very skeptical eye at managers who consistently pull their fees out of the funds they
manage.

Read Kevin Byun's Q4 2009 letter to investors.

View Kevin Byun's recent presentation on special situation investing.

Posted by manualofideas at 04:58 PM | Permalink | Comments (1)

Robert Huebscher of Advisor Perspectives has published an engaging interview with Bruce Berkowitz, manager of the $11 billion Fairholme Fund and one of the most successful value investors of the past decade. Here is an interesting exchange from the interview:

My last question is an unusual one: Since you are obviously in a very competitive business, why do you do interviews with people like me?

We have no marketing. Our shareholders are wired for wealth creation. They are well-informed by using channels such as yours. Whatever I say here becomes public. It’s a great way to communicate with existing shareholders.

I can make points to you that I would be uncomfortable making to shareholders, because what you do is in the public domain. We don’t talk to that many people. You are an extremely efficient channel for our existing shareholders. It’s not cheap to reach 80,000 readers.

It’s also important for Fairholme to attract the right shareholders. For example, if someone called me up for the five-minute timing digest, we are not going to have a chat. The same would be true with the technical analysis channel.

If I can communicate with our shareholders and with other great potential shareholders, then it is very effective, because there is a natural ebb and flow. People leave us during difficult times. We want to keep in touch with our shareholders and keep a high-quality shareholder base.

This is why we charge a flat 1% fee with no loads and have never used a 12(b)1 fee and actually abolished the ability for us to use such a fee.

Last year, there were outstanding managers who had significant amounts of capital withdrawn, who were unable to execute their strategies. Fairholme did not have significant net outflows. It’s hard for me to remember if we had even a month of net outflows. That is a huge weapon and a big advantage – having the right shareholders who will stick with us while others are running for shelter. Without that we couldn’t execute.

I have to find ways to talk to smart people who can present our concepts to the kinds of people we would like to have as shareholders. That’s why we do it. I’m not giving anything away. I would never talk to you about what I am going to do today, what we plan for the future or what is not in our public reports.

The real service is for our shareholders, to let them know who we are, how we behave, how we maintain our level of integrity, how we perform during difficult times and whether we eat our own cooking. That is what’s important.Now that we’ve finished our tenth year, it’s good that people can look back and see what we had to say every six months and how we behaved during very difficult periods. They can stress test us.

At the end of the day, however, I know talk is cheap. You’ll know in three to five years whether I had anything interesting to say today.

Read the full interview with Bruce Berkowitz.

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Here is a video interview with HBS alumnus Seth Klarman "regarding his experience at HBS and his views on leadership and success and the priority of giving back to one's community."

(Thanks to Corner of Berkshire and Fairfax for the link.)

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Contrarian investor James Chanos of Kynikos Associates gained fame by predicting corporate failures such as Enron and Tyco. Now, Mr. Chanos believes China could be headed for demise. As quoted in a recent New York Times article, Mr. Chanos says that China looks like "Dubai times 1,000 - or worse." Accordingly, the hyperstimulated economy, including unsustainable growth in the real estate market, is headed for a crash.

Mr. Chanos' views on China differ not only from accepted conventional wisdom, but also run against the opinion of such informed and successful investors as Jim Rogers. For more on this debate, please read the recent New York Times story.

Michael Auslin of the American Enterprise Institute also had insightful recent remarks on China, echoing the views expressed by Mr. Chanos. Please click here for further reading.

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Via Bloomberg. Excerpt:

Shares of banks such as Citigroup Inc. and Bank of America Corp. were collapsing [in early 2009] on rumors they would be nationalized. On Feb. 25, the U.S. Treasury put out a white paper and a term sheet on its Web site for the government’s Capital Assistance Program. They said the preferred stock the government was buying in the banks would be convertible to common shares at prices far above where they were trading -- 37 percent higher in the case of Citigroup and 21 percent for Bank of America, Bloomberg Markets reported in its February 2010 issue.

For Tepper, 52, that meant it was time to buy. “If the federal government was putting out this paper, they weren’t going to nationalize the banks,” he says.

Second, the conversion price of the preferred shares meant the bank stocks were seriously underpriced.

“It was crazy,” says Tepper, a Pittsburgh native. “In February and early March, people were in a panic.” 

(Thanks to Nadav Manham for the article link.)

Posted by manualofideas at 09:59 PM | Permalink | Comments (0)

Miguel Barbosa of the multi-disciplinary Simoleon Sense blog recently interviewed fellow blogger and value investor Tariq Ali, founder of Street Capitalist. Ali sheds light on his investment approach and talks about some of his best and worst investments. Says Ali,

My worst investment was a small position in Mosaic, I definitely took a top down approach with that one, something I will never do again.

Ticketmaster was an investment I really liked. I entered into the position around $3.99 and sold out in the mid $11-range. It was a spinoff that I had watched since the summer when it began trading at $27. I had actually been excited about the business ever since the deal was announced, just because Ticketmaster is such a monopolistic business.

Fairfax financial was purchased at $210 in 2007 and now trades around around $400. Here was a business that has an amazing jockey, Prem Watsa, was bought at about 1/2 book value and had a great portfolio of credit default swaps to hedge against the financial crisis.

Read the full interview with Tariq Ali.

Posted by manualofideas at 05:33 PM | Permalink | Comments (0)

Max Olson of Max Capital Corporation and FutureBlind.com recently published an excellent article on the story of Steak n Shake and Sardar Biglari, the early-30s investor whom some are already calling the next Warren Buffett. We certainly agree that Biglari is someone to watch very closely as he sets out to transform Steak n Shake into a Berkshire Hathaway-like investment vehicle.

Read Max Olson's article.

Read Sardar Biglari's letter to Steak n Shake shareholders.

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By Nadav Manham

The WSJ profiles hedge fund manager David Tepper of Appaloosa, whose fund was up 120% in 2009.

Tepper's success this year is a testament not only to his gutsy bets, but to successful positioning.  After the annoying experience of having been unduly influenced by his investors not to short the Nasdaq in 2000, he resolved more or less to ignore his LPs.  By the time I got to Wall Street a few years later, Appaloosa was well-known as a fund that made bold bets, which would produce very great years but also some very stressful years.

If even I knew this, then Appaloosa's investor base knew it too, which reduced the fund's asset/liability mismatch in terms of risk tolerance.  A bold portfolio required bold capital providers, and over time that is what the fund has attracted,

Ultimately, this "everyone on the same page" state allowed Tepper to make his 2009 moves relatively unmolested (Alan Shealy of Boise does not count as a molester).

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.

Posted by manualofideas at 09:15 AM | Permalink | Comments (0)

Warren Buffett has often said that there are no called strikes in the field of investing.  Investors are presented with a series of “pitches” every business day by the market but there are no penalties for failing to swing other than the potential to miss out on interesting opportunities.

Of course, Warren Buffett gets many more “pitches” than ordinary investors.  Berkshire Hathaway’s huge cash balance in 2008 created many situations where Mr. Buffett  was offered unique investment opportunities but he passed on the vast majority of them.  The Wall Street Journal has published a detailed account of the many offers made to Mr. Buffett  in 2008 including some details that were previously not known.

One of the early “pitches” came from the CEO of Lehman Brothers on March 28, 2008.  According to the article, Mr. Buffett spent the evening of March 28 reviewing Lehman’s latest 10-K  report and jotted down the number of pages where he found troubling information.  By the time he finished the report, there were too many problems and he passed.  Click on this link for a copy of the 10-K cover provided by the  Wall Street Journal.

In the video below, the author of the Wall Street Journal article provides some additional background information and commentary:

The Wall Street Journal also made available a letter that Mr. Buffett sent to Treasury Secretary Hank Paulson on October 6, 2008 proposing a public-private investment fund.

When Mr. Buffett finally swung on the Goldman Sachs and General Electric pitches in October 2008, he was able to secure investments that have already proven to be very profitable for Berkshire Hathaway.  While he could have achieved even better results by waiting for the March 2009 lows, there was no realistic way to forecast the exact low or to time the market to produce an “optimal” result.

The author of this post, 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.  

The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 10:40 AM | Permalink | Comments (0)

Prem Watsa, the chief executive of Canada-based insurer Fairfax Financial (FFH), was a favorite target of short sellers only a few years ago. The shorts attacked Fairfax after the company's M&A strategy hit a major snag, but the shorts overplayed their hand, leveling ridiculous accusations at Fairfax and using (near-)criminal tactics to get their way (Fairfax's lawsuit against the short sellers is still pending). Watsa, who has had the strong loyalty of many value-oriented investors throughout the ordeal, has redeemed himself in the eyes of the marketplace as well. Fairfax investment strategy paid off handsomely during the recent financial collapse, with Fairfax making billions on credit default swaps and other bearish investments. Wasta turned bullish earlier this year, cementing his position as one of the all-time investing greats.

In a recent interview with Diane Francis of The Financial Post, Watsa comments on a wide range of topics, including what's next for stock market investors. Here are some highlights:

Q Are we at the bottom?

A It is difficult to say but the economy is still in a great deal of trouble. Do you think anybody is going to speculate in houses for the foreseeable future? People may do something else irrational, but not houses; a housing bubble is no longer in the cards. This goes to your point about international regulation: You don't have to worry about new rules and regulations, the free market is sorting itself out.

Q You began shorting, hedging with credit default swaps in 2003 before the bubble ended. Were you criticized for that?

A It was painful because we did not have a lot of income, the stock went down in 2006. Our $300-million worth of credit default swaps purchased in 2003 were worth only $75-million or so in 2006 before things turned. We were made fun of in Forbes magazine. We had to withstand some pain. But that is OK, we have a long-term philosophy.

Q Do you worry about concentration of economic power between Wall Street and Washington?

A There are other players coming up as we speak. They said IBM was too big, then came Microsoft, then came along Google, then IBM found a new path to success. The point is, big entities lose talent and they start their own firms. This is already happening at Goldman Sachs and other large institutions. Transparent and free markets and capitalism work in the long run.

Q The market's corrected but is the worst over?

A 80% of the economy [the private sector] is de-leveraging. 20% is government stimulus. Companies are operating at 65% of capacity or utilization rate. Unemployment is rising. If in six to 12 months' time, the stimulus and bailouts don't work, and we are at zero interest rates, what then? We had 20 years of good, meaning no recession to speak of, and only one year of bad. We are not worried about inflation, just the opposite. If wages start to go up, there will be inflation. But there is lack of demand. That's the problem.

Read the entire interview with Prem Watsa.

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Famed macro investor Jim Rogers offers a contrarian view on the dollar, predicting a rally in the greenback due to short-covering. Mr. Rogers is still negative on the longer term prospects for the dollar, however, and remains bullish on gold and other real assets. He also offers a frank assessment of Moody's AAA rating for the U.S., which leads to an awkward interchange with the reporter.

Follow this link to watch the interview with Mr. Rogers.

Posted by manualofideas4 at 01:11 PM | Permalink | Comments (0)

Robert Huebscher of Advisor Perspectives recently interviewed well-known Columbia Business School professor and author of Value Investing, Bruce Greenwald. In the wide-ranging, two-part interview (part one, part two), Greenwald dropped a bombshell when asked about Berkshire Hathaway's (BRK) stock deal for Burlington Northern (BNI). Here's the exchange from the interview:

I know you own Berkshire Hathaway, so I have to ask you what you think about Buffett’s purchase of Burlington Northern.

It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex. So they are under-depreciating, and their profit numbers are lower than the true profit numbers – and in a bad way, because the tax shield for the depreciation is undergone too. Their profitability is much lower than it looks.

Buffett’s paying 18-times [at $100/share] and at $75 he was paying 16-times. Our calculation is he was paying 21-times.

Secondly, there are two kinds of assets. There are the rights-of-way, which you can’t get rid of. So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-ofway. If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value. We didn’t see a lot franchise value or hidden asset value.

The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up. There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad. If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive.

There is nothing special about the railroads. It’s entirely an energy play.

If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that. So you don’t have a good aggressive management over these five years producing outsized returns.

We looked back at when they did the merger with Santa Fe, because then they did increase margins. But they got bored with it, and margins started to come down. The same thing happened recently. We don’t see a lot of hidden profitability in the culture of the company.

It looked to us like an oil play. He has a history of making bad oil play decisions. And that was at $75/share, we thought there were better oil plays. At $100/share we think he has lost his mind.

Greenwald's criticism of Buffett triggered a firestorm of disagreement, with some value investors suggesting that it was Greenwald who had lost his mind, not Buffett. One of the more lucid responses to Greenwald's criticism was published as a letter to the editor on the Advisor Perspectives website:

I read with some amusement professor Greenwald’s discussion of Berkshire Hathaway’s purchase of Burlington Northern (BNI), I could not disagree with his analysis more.  One of my Native American friends says that one must be careful not to view things with “old eyes” and I fear that is what is happening to the professor’s view of Burlington Northern.

When I first began to look at railroads in the 1980’s, they were the very epitome of capital-intensive, labor-intensive companies consistently earning less than their cost of capital and that was during a period when they all  had millions of acres low cost land holdings with attached mineral rights.  At that time, the one true measure of a railroad’s operating success, its operating ratio, was rarely below 90%.  Union work rules were killing them.

Since that time, a reduction in government regulation, mergers and disposals of surplus lines, changing crew consist rules, technology and improved motive power efficiency have combined to make railroads productive and highly profitable companies.  They have created huge cash flows which have funded debt reduction and capital spending, making them much more profitable. Today, any railroad with a operating ratio in excess of 75% is considered to be poorly managed.  They have not accomplished this by diversifying their business; their resource land grants are long gone they are almost pure rails now.  They have not done it with increased leverage as they carry less debt and preferred than they did 10 years ago.  They have done it by sticking to their knitting, serving the customer, driving down costs, capital discipline, technology investments and just hardnosed business practice.

An example of increased efficiency: changes in engine design have reduced the number of motive units needed per train, reducing costs in terms of both fuel and crew.   Recently, GE introduced a new line of motive units with 16 cylinder higher horsepower diesel engines that, at sustained speeds, turn off four cylinders and maintain their speed on the remaining 12.  The fuel savings are in the area of 30% for comparable runs.

The other issue unique to BNI is that the nature of its traffic has allowed it to replace many of its previously fixed costs with variable costs, giving it greater financial flexibility and the ability to change in an instant to accommodate business conditions.   This in turn allows greater capital discipline and better returns.

While Buffett’s purchase of BNI does not seem to satisfy Berkshire’s traditional pattern of purchasing irreplaceable franchises, it does meet a more basic precept of being a toll-taker by offering a product an economy cannot do without.   Most of the traffic on today’s railroads cannot be moved by any other modality. If we are going to continue to import goods from lower cost developing world countries, then the BNI route structure from the west coast ports  to the mid west will be one of the few (two actually) to move that traffic.

Did he overpay? Maybe.  Does it revalue all the rails? No.  Will it work out for Buffett and his shareholders? Probably and better than most viewing it with “old eyes” can see at this point.

Dennis Gibb
President
Sweetwater Investments
Redmond, WA

Visit Advisor Perspectives and sign up for their excellent free weekly email newsletter.

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An exclusive interview with European value investor Don Fitzgerald of Tocqueville Finance was published in a recent issue of Portfolio Manager's Review. The interview should be of interest to value-oriented investors anywhere. Excerpts:

MOI: Describe your investment process at Tocqueville Finance?

Don Fitzgerald: We focus on stock picking without consideration of benchmark, sector or country allocation and look for companies that are undervalued by the market relative to their fundamentals. Given our long term investment horizon naturally we keep our portfolio turnover relatively low and avoid overconcentration—for example, more than 5% in a single position. We avoid derivatives with the exception of very limited use of covered calls. In times of limited investment opportunities we can hold up to 25% in cash or equivalents.

MOI: What companies draw your attention? How do you generate stock ideas?

Fitzgerald: Investment ideas come from a number of sources, such as regular quantitative screenings, tracking of Tocqueville investments which have been portfolio holdings in the past, monitoring of the financial press, management meetings and conferences.

Opportunities caused by disappointments of short-term market expectations are good targets. Also spin-offs and de-mergers where existing investors often sell without doing their homework on the new company’s real value or situations where you have a forced seller pushing down the stock price are good hunting grounds for fundamental investors.

MOI: Do you have any favorite valuation methods? Are there any analytical approaches you avoid?

Fitzgerald: In the financial analysis we place strong emphasis on margins and returns stability, through-the-cycle profitability, free cash flow generation and balance sheet strength in order to generate our best estimate of intrinsic value. Valuation is judged in absolute terms, relative to the peer group, industry transaction multiples and relative to the company’s own valuation history. We often use sum-of-the-parts valuations for multi-business groups.

Regarding ratios I am wary of valuation ratios like P/Es and price to sales, which often understate the importance of creditor claims on company assets and cash flow. Likewise EV to EBITDA ratios forget that companies need to replace equipment one day and that profitable companies actually pay taxes. I think EV / NOPAT is a nice ratio that in theory corrects for a lot of these faults. However, don’t forget that ratios are just tools or marker points.

MOI: What European markets have you invested in the most and why? Do you invest in Eastern European markets? If so, are there any differences in the valuation approach you apply there compared to investments in more developed Western European stock markets?

Fitzgerald: We invest all across Western Europe and, given our bottom-up approach, there are no countries we avoid or focus on. We have limited experience investing in Eastern European markets and due to lower transparency, corporate governance concerns and issues with the protection of minority shareholders, we are not likely to change our stance in the short to medium term.

MOI: Have you favored or avoided any particular industry as a result of recent financial market dislocation and macro-economic turmoil?

Fitzgerald: For the last three years or so we have had limited exposure to financials, not necessarily because we foresaw all of the problems in the sector but merely because the profitability achieved in the sector from 2003 to 2006 did not appear sustainable and we had concerns about transparency.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Fitzgerald: The biggest mistake investors probably make is following the herd and ignoring common sense. The herding instinct is part of the way our brains are wired and we must try to discipline our minds to avoid this default. The worst buying points in any asset occur due to bubbles caused by mass crowds pushing assets prices too far – like the Internet bubble at turn of millennium or house prices in many countries in recent years. Thankfully, value investing helps one to avoid bubbles by focusing on the difference between price and value. Other mistakes investors make is not having a proper strategy, philosophy or discipline to guide their investment decisions.

MOI: When you review your past investment successes, what key common traits do you observe?

Fitzgerald: Probably the best investments were made in companies where I had a very good understanding developed over time on the fundamentals of the company in terms of strategy, management and competitive positioning. This rigorous homework allows you to generate a fair view on the company’s intrinsic value so that you can pounce when Mr. Market offers an attractive entry price.

Read the full Manual of Ideas interview with Don Fitzgerald.

Posted by manualofideas at 07:49 PM | Permalink | Comments (0)

The Financial Times recently featured an interview with investor Jim Rogers. Here are some of the highlights:

What is the secret of your success?

As I was not smarter than most people, I was willing to work harder than most. I was prepared to examine conventional wisdom. If everyone thinks one way, it is likely to be wrong. If you can figure out that it is wrong, you are likely to make a lot of money.

What is your basic investment strategy?

Buy low and sell high. I try to find something that is very cheap, where a positive change is taking place. Then I do enough homework to make sure I am right. It has got to be cheap so that, if I am wrong, I don’t lose much money. Every time I make a mistake, it is usually because I did not do enough homework.

Do not underestimate the value of due diligence. In the 1960s, General Motors was the world’s most successful company. One day, a GM analyst went to the board of directors with the message: “The Japanese are coming.” They ignored him. Investors who did their homework sold their GM stock – and bought Toyota instead.

I’m not buying any stocks at the moment. If anything is undervalued now it is commodities and some currencies.

Where should people put their money in the recession?

Invest only in things you know something about. The mistake most people make is that they listen to hot tips, or act on something they read in magazines.

Most people know a lot about something, so they should just stick to what they know and buy an investment in that area. That is how you get rich.

You don’t get rich investing in things you know nothing about.

Read the full interview.

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Zeke Ashton of the top-performing Tilson Dividend Fund (TILDX) recently spoke with Ticker Magazine, outlining his fund's investment strategy, discussing why some investors get tripped by "value traps," and more. Here is a highlight:

Q:  What kind of value are you seeking and how do you judge that?

A: Value can come in many forms, but we are generally most comfortable with those ideas that offer one of two highly visible forms of value. The first form of value is cash flow. We focus on high quality, well-capitalized companies that are already achieving high cash flow levels, and we try to buy those cash flows at reasonably low multiples. Given our emphasis on dividends, it is important to us to buy securities of companies that produce reliable cash flow, because cash flow is what ultimately funds the dividends. The second form of value is asset value, whether it be in the value of hard assets, such as land, natural resources, or investments. Either way, we do our best to make sure that our valuation efforts on each security in the portfolio are underpinned by demonstrated cash flow generation ability and/or asset value. This provides the margin of safety against significant losses that every value investor tries to achieve.

Our belief is that it is more judicious to pay up a little bit more for a company that does have good growth potential versus a comparable business that is not growing as much but which might appear to be cheaper on a conventional price-to-earnings or price-to-book value basis.

When we looked at eBay‘s business, we felt the auction and fixed price merchandise listing businesses is still growing but at a very slow pace. But the PayPal business is growing at a faster pace and is quite profitable. So, we did not see a business that was going to fall off a cliff. Clearly, we saw a business that might have the possibility of future growth, but we certainly weren’t paying for any future growth.

We highlight eBay only because it’s a good example of a high-quality business that was cheap because it was suffering from near-term issues that made it unpopular and therefore available at a very reasonable price. We are still holding some of it in the portfolio though it’s now a very modest size position. Also, eBay doesn’t pay dividends because they prefer to buy back shares instead. So in order to generate some income on it, we sold call options on some of our position at prices that we believed represented a reasonable fair value for eBay stock. Had it taken longer for our eBay idea to work out, we would have continued to sell call options on the position and thus would have earned a nice income on the position over time.

Read the full interview with Zeke Ashton.

Read the full interview with Zeke Ashton.

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Berkshire Hathaway has released a new 13-F filing today which reveals the composition of the company’s equity portfolio as of September 30, 2009.  In addition, the company released an amended 13-F filing for Q2 which shows a position in Exxon Mobil as of June 30, 2009.  This was previously not disclosed due to Berkshire’s request for confidential treatment for the position.

Highlights

During the third quarter, Berkshire made further purchases of Exxon Mobil and also initiated positions in Nestle, Republic Services, and The Travelers Companies.  Berkshire closed out positions in the Eaton Corporation and Wabco Holdings while reducing its stake in Conoco Phillips, Moody’s, NRG Energy, Sun Trust Bank, and WellPoint.

Please note that the 13F report only covers holdings that trade in the United States. The report includes shares of foreign issuers only if those shares are held as ADRs that trade on a United States stock exchange. Shares that trade on foreign exchanges are not reported on this form. Therefore positions such as POSCO, Swiss Re, Tesco plc, and BYD are not covered in this analysis.

Let’s take a closer look at Berkshire Hathaway’s portfolio changes during the third quarter as well as examine the likely performance of the portfolio during the first half of the fourth quarter.

New Positions

As noted above, Berkshire amended its 13-F filing for Q2 and revealed a stake in Exxon Mobil.  The company held 854,490 shares on June 30 and increased the stake to 1,276,290 shares worth $87.6 million as of September 30.  Based on the size of the purchase, it is possible that GEICO’s Lou Simpson initiated this position rather than Warren Buffett.

The Nestle position acquired during the third quarter was worth $144.7 million on September 30 and, assuming that the same number of shares are held as of today, the value of the investment is now $161.5 million.  This is an interesting purchase given Berkshire’s large existing investment in Kraft and the ongoing drama associated with Kraft’s hostile bid for Cadbury.

Berkshire also added a position in Republic Services worth $96.3 million on September 30.  Republic Services is a provider of services in the solid waste industry operating in 40 states.  In addition, a small position in The Travelers Companies was added to the portfolio.

Increased Positions in Wal-Mart and Wells Fargo

Berkshire nearly doubled the size of its position in Wal-Mart during the third quarter.  As of September 30, Berkshire owned 37,836,642 shares of Wal-Mart worth $1.86 billion.  The Wal-Mart position is valued at slightly over $2 billion today assuming the same number of shares are held.

Berkshire added 10.7 million shares to the already massive position in Wells Fargo.  As of September 30, the Wells Fargo position was worth $8.8 billion, and has been nearly unchanged so far this quarter.

Reduced Positions in Conoco Phillips and Moody’s

Berkshire reduced its position in Conoco Phillips by 7.1 million shares.  This is a continuation of the gradual liquidation of the position following a large impairment charge that was taken in the first quarter.  Please refer to the review of Q1 results for a more detailed discussion of the Conoco impairment.

The position in Moody’s continues to be slowly liquidated with 8.8 million shares sold during the third quarter.  So far, Berkshire has sold an additional 1.15 million shares in the fourth quarter.  Berkshire still holds over 38 million shares of Moody’s based on a recent Form 4 SEC filing.  It appears that Warren Buffett is trying to slowly liquidate this position after making some lukewarm statements about the economic moat of the credit rating firms during Berkshire’s 2009 annual meeting.  For coverage of Mr. Buffett’s comments on Moody’s at the annual meeting, please click on this link.

Strong Results in Q4

Berkshire’s portfolio appears to be posting strong results close to the mid-point of the fourth quarter.  We  know that Berkshire has sold shares of Moody’s during the quarter based on the Form 4 filing referred to above.  In addition, based on Warren Buffett’s recent interview with Charlie Rose, we know that Berkshire’s shares in Union Pacific and Norfolk Southern have already been sold.

Adjusting for the proceeds of the Moody’s sale and estimating the proceeds of the Union Pacific and Norfolk Southern sales, we can estimate that Berkshire’s equity portfolio is up 8.6% for the quarter so far assuming no other changes were made to the positions reported on September 30.  The increase in the value of the portfolio plus value of the liquidated shares of Moody’s, Union Pacific, and Norfolk Southern should account for approximately $4.8 billion.  Adjusting for deferred taxes owed on the gains, this would account for approximately a $2,000 increase in book value per A share since the figures reported on November 6 in Berkshire’s Q3 report.

For a more detailed look at Berkshire’s portfolio holdings, we have prepared an Excel workbook.  The first worksheet shows Berkshire’s portfolio changes for the third quarter.  The second worksheet attempts to estimate Berkshire’s portfolio value as of November 16. The Excel file is available under the resources listing shown below.

Resources:

Excel workbook with Q3 13-F Analysis and Q4 Estimates (Source: The Rational Walk)
PDF File with Q3 13-F Analysis and Q4 Estimates – Same Data as Excel File above
Berkshire Hathaway’s Q3 13-F Filing (Source: SEC)
Berkshire Hathaway’s Q2 13-F Amended Filing (Source: SEC)
Berkshire Hathaway’s Q2 13-F Original Filing (Source: SEC)
Berkshire Hathaway Form 4 Filing – 10/28-29 Moody’s Sale (Source: SEC)

The author of this post, 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.

Disclosure:  The author owns shares of Berkshire Hathaway.

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Here is a CNBC video of the complete event with Bill Gates and Warren Buffett at Columbia University on November 12, 2009. Read the transcript.

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One of the most successful investors of the past several decades, Paul Tudor Jones, was the subject of a PBS documentary shot in the 1980s. The video provides a fascinating view into Jones in the early years of his investment firm. Jones's competitive drive and evident love for trading may have been some of the most important qualities behind his huge success.

Watch the 1987 PBS documentary on Paul Tudor Jones.

Read Paul Tudor Jones's latest letter to investors, in which he makes a bullish case for gold.

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Charlie Rose spoke with Berkshire Hathaway chairman Warren Buffett in New York last Friday. Buffett was in town with his friend Bill Gates for a meeting with Columbia Business School the previous day.

Watch an excerpt of the televised interview (don't miss another clip labeled "Web Exclusive").

Watch past Charlie Rose interviews with Warren Buffett.

Michael Corkery of The Wall Street Journal provides the following takeaways from Buffett's latest conversation with Rose:

“I am not for shooting them….but…I want to make it painful for them.”

That is Warren Buffet speaking about how he would like to punish Wall Street executives for their missteps that led to the financial crisis. Buffet told interviewer Charlie Rose that not just executives, but the banks’ directors should be subject to severe curbs on compensation, such as clawbacks and limits on payouts for up to five years after they leave a firm. [...]

On the economic stimulus:

“There should have been more infrastructure in there, and they hung a Christmas tree on it — as I said, it’s sort of like mixing a tablet of Viagra with candy. I mean, it would have been better to leave out the candy and have the full Viagra.”

On leverage and greed:

“….Being greedy can be fun for awhile, you know. Leverage can be fun when it works. Leverage is one of those things that works 99 times out of 100, and when it doesn’t, you know, it’s all over.”

On being “wired” to make money:

“A prosperous country should not just be prosperous for the people like me who are wired a particular way at birth — no credit to me — but I happen to know something about capital allocation and that wasn’t — you know, instead I could have been wired, you know, so I was — I don’t know; a great ukulele player. But there’s no money in that.

On redistributing wealth:

…The market system is not perfect in any kind of distribution of wealth, and taxation is a way you get to the excesses of what the market system produces and where you take care of the people that get the short straws. In a country as prosperous as we are, nobody should get a really short straw.

On breaking up the big banks:

“In 1998, though, it was a firm Long Term Capital Management that actually threatened the system and they had 200 employees in Sanford, Connecticut, and nobody had ever heard of them. So it isn’t just sheer size. It’s creation of huge leverage positions.…If you’ve got a $2 trillion bank, you know, you’ve got to do a lot of things, and I’ll let you do a lot of things, but — I don’t want them at the racetrack; let’s put it that way.”

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Up-and-coming value investor Kevin Byun of Denali Investors spoke to students at Columbia Business School last Thursday. Kevin discussed his brand of special situation investing, revealing a unique and highly successful investment approach.

View Kevin Byun's presentation on special situation investing.

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Warren Buffett and Bill Gates appeared at Columbia Business School yesterday and answered questions from students for over an hour.  The full video is provided below and a transcript has been posted documenting the full session.  I found Mr. Buffett’s response to one question to be particularly important for individuals who are interested in being an active investor:

QUESTION: Hi, I’m Brian Seedabalker. I’m a second-year student. Mr. Buffett, it’s great to see you again. I was on the trip to Omaha last month. Thank you for hosting us. My question is, how would you recommend an individual investor who follows the Graham and Dodd philosophy to allocate their capital today?

BUFFETT: Well, it depends whether they are going to be an active investor. Graham distinguished between the defensive and the enterprising and that. So if you are going to spend a lot of time on investment, you know I just advise looking at as many things as possible and you will find some bargains. And when you find them, you have to act. It doesn’t — it hasn’t changed at all since I was here in 1950, 1951. And it won’t change the rest of my life. You start turning pages. When I got out of school, I turned every page in Moody’s 10,000-some pages twice, looking for companies. And you have to find them yourself. The world isn’t going to tell you about great deals. You have to find them yourself. And that takes a fair amount of time. So if you are not going to do that, if you are just going to be a passive investor, then I just advise an index fund more consistently over a long period of time.

The worst investment mistakes tend be those made by individuals who buy stocks on hot tips or cursory research such as reading a one page Value Line report or a newspaper article.  Intelligent investing takes a great deal of time, and if you think about it, why would this be a surprise?  Mr. Buffett’s advice to buy an index fund if you do not intend to invest the time in research is exactly correct.

The author of this post, 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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Once again, Oaktree Capital Management's Howard Marks has some lucid commentary on achieving investment success in an imperfect world:

In the two-plus years since the onset of the financial crisis, it’s been a regular theme of mine that we should look back, identify the causes and learn from them. I’ve tackled this assignment in a number of memos and a variety of ways. Now, despite the fact that you’ve heard much of this from me before, I’m going to try to pull it all together, using the quotations, adages and images that I feel best capture the essence of what we’ve been through. When I think back, these are the ones that stand out.

"Greed Is Good"

There’s no debating which line from the film Wall Street is the most memorable. It’s hard to forget the image of slicked-back takeover artist Gordon Gekko urging on his troops, invoking the positive power of self-interest. What he meant by “greed is good,” of course, was that greed – or self-interest, or the profit motive – is what drives people and companies operating in a freemarket setting to strive for more and better, and thus to work hard and optimally allocate resources. It’s the force that motivates Adam  Smith’s “invisible hand” and carries economies to increased output and higher standards of living.

Among the many pendulum-like phenomena we occasionally witness is the swing in people’s willingness to rely on the free market. First they trust the market to come up with solutions. Then the shortcomings of those solutions are laid bare and there’s a call for regulation. Then the folly of government involvement becomes evident and people want the free market back, and so forth. Because neither extreme is perfect, the oscillation between them goes on. Governments can’t run economies or companies. But it’s equally true that in a free market, the rules will occasionally be stretched and participants harmed.

In a free market, things will inevitably go past the optimal to the extreme. When they swing back, the retreat can be painful. Thus, if we’re going to rely on the market to settle things, we have to be willing to accept the consequences.

Read the complete memo by Howard Marks.

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Introduction: "Carl Icahn, a prominent activist investor in corporate America, talks about his career and how he became interested in finance and involved in shareholder activism. He discusses his thoughts about today's economy and American businesses and their inherent threats and opportunities. He believes that the biggest challenge facing corporate America is weak management and that today's CEOs, with exceptions, might not be the most capable of leading global companies. He sees opportunities for current, intelligent college students to succeed in the corporate world if they work hard and can identify valuable business pursuits."

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Here is a preview -- we will bring you more coverage later this evening.

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Click here for notes from the meeting of University of Akron students with Warren Buffett, chairman of Berkshire Hathaway.

Paula Schleis's article in the Akron Beacon Journal offers a glimpse into Buffett The Man:

"He's the nicest guy in the world," [business professor Todd] Finkle said. "Very down to earth. Very humble, and he doesn't put himself above anybody."

Kim Baitz, 26, said when she first learned Finkle was asking students to apply for a chance to go on the trip, she had just lost her job.

"I thought this was the perfect opportunity to meet the most intelligent man in the world in finances, and I thought it would be a good time to seek some guidance," said Baitz, who is pursuing her master's in business administration.

She took copious notes of advice from Buffett, but one thing that resounded with her was his belief in finding a career that brings out your passion.

"He goes to work happy every day, and so many of us go to work looking forward to the weekend," she said. Loving what you do is so much more important than making money, he advised.

Finkle said many comments made a deep impression on him as well, but one he'll never forget was in response to Finkle's own question about the most influential people in Buffett's life.

Among those Buffett named was a friend who was a Polish Jew, taken to a World War II concentration camp after an acquaintance reported the friend's hiding place to the Germans.

Buffett said ever since hearing that story, "when he would begin friendships, he would ask the question: Would this person hide me from the Nazis?"

"He then went on to say that one of the most important things [if not the most important] was unconditional love. If you can find two or three people who love you unconditionally, you are a lucky person."

Read the full article. Read the meeting notes.

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The Motley Fool's Chris Hill recently interviewed Buffett biographer Alice Schroeder, author of The Snowball: Warren Buffett and the Business of Life. Here is a highlight:

Hill: You spent a lot of time with him. What most surprised you about him as you were writing this book?

Schroeder: The big surprise was to see how he turns the women around him into these maternal figures -- that a man who was 26 years older than me would be relating to me like a kid. It was really interesting. And this is true with all the women around him. I had to really resist it as an author because (a) I am not his mother, and (b) I was there to report and to be objective. But he didn't have a great childhood, and he didn't have the kind of mother that you would want, so he is sort of always looking for that. He is quite vulnerable. That was a big surprise.

Hill: Do you think that is the biggest misconception about him? His vulnerability?

Schroeder: I think in the personal side, yes. On the business side, I think the biggest misconception about him is that he is a "buy and hold forever investor." He has never said that, but people take little snippets and slices of things that he said, and they turn them into mantras or slogans. I think that people have made a mistake of pulling a few words or a sentence or two here and there and treating that as an all-weather investing technique. It doesn't really work because Warren himself is quite opportunistic, and he does trade and he does adapt. So anybody who thought that you could buy four or five big-cap growth stocks at a fair price and then you could just sit back and just go to sleep -- that has not worked out very well, and he would be the first to say so.

Read the full interview with Alice Schroeder.

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Robert Huebscher of Advisor Perspectives recently spoke with Columbia Business School professor Bruce Greenwald, author of Value Investing and Globalization.

Read Huebscher's interview with Greenwald.

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Do you receive Portfolio Manager's Review in the mail each month? Then you are eligible for a FREE copy of Jeff Benedict's book on R. C. Willey. Email us to request it.

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Transcript:

CATHY BARON TAMRAZ: Greetings from San Diego, where we have just completed the Fortune Most Powerful Women’s Summit. I am Cathy Baron Tamraz, CEO of Business Wire, and I am here with the only male that is allowed into this conference and that is Warren Buffett, Chairman of Berkshire Hathaway, which is also the parent company of Business Wire. Warren has graciously agreed to answer some questions today, and kick off a conference that Business Wire and Market Platform Dynamics are holding in New York City, to launch a new Web site about the payment industry callexd PYMNTS.com. We are really excited about this new portal, which will be a primary source of news for the payments industry. It will havebreaking news and regulatory news in the payment industry, new technology and new products.

Because the payment industry is so vital to the economy, we thought it would be relevant to talk to Warren and hear his views on the state of the economy and what we can do to revitalize it. So thank you, Warren, for speaking with us today and agreeing to be interviewed by me.

WARREN BUFFETT: You are my favorite interviewer!

CBT: Thank you very much. That’s on tape, by the way. So, the first question I have for you is about the near-term future of our economy. The last 12 months feels like a really bad dream. This year has been the year that shook the world. It’s been a year since the bankruptcy of Lehman Brothers and it almost sent the economy over a cliff. We had the Bear Stearns fallout, Merrill Lynch sold to Bank of America, the AIG crisis, Fannie and Freddie falling under government control. It’s been a really difficult year. So, what do you think is going to happen now in the fourth quarter of 2009 and also in 2010?

WB: I am not sure about exact quarters or anything of the sort. Who knows about next week or next month? We made enormous progress since a year ago. We had a real panic. And if you didn’t panic, you didn’t understand what was going on. What happened in September and October of 2008 will particularly be remembered for a long, long time. And while the governmental authorities malign things sometimes, they fortunately did some very right things, very important things. They did them properly, and they kept us from going over the cliff. The fallout from that financial panic hit the regular economy in the fourth quarter like a ton of bricks. We are coming back from that. The patient really went into the emergency room and it won’t come out of the hospital entirely for a while.

There are things that have to be cured in the system, but this system works. If you look at this country, we have gone through the Great Depression, we have gone through world wars, we have gone through civil war, and we have progressed like no country in the world. We have the right system. It doesn’t avoid all the problems, but it overcomes all the problems.

CBT: Do you see consumer-spending increasing in the near term?

WB: No, and not for a while. I think people had an experience a year ago that they are not going to get over quickly. But the factories are there, the human potential is there, the system is there. It works over time. Your kids will live better than you and I live, and our grandchildren will live better than they do. This country moves forward.

If you take the 20th century, we had a Great Depression, world wars, a nuclear bomb, a flu epidemic. We had all these things, and at the end of the 20th century, the average American was living seven times better than at the start of the century. It’s amazing. The Dow Jones Average had gone from 66 to 11,400. So the country works, you don’t have to worry about that.

CBT: This latest debacle has also been called a “crisis of confidence.” Five trillion dollars of American wealth has vanished. If confidence is what’s needed to stimulate the economy, how do we put trust back into the financial system? Does the government need to retain a stronger hand?

WB: Well, people became afraid a year ago, and confidence is not going to exist when fear exists. Fear is very contagious. It spreads very quickly, and that’s what happened in the start of the fourth quarter last year. The confidence doesn’t come back as fast as it’s lost, but it does come back. It’s come back a long way already, but it has a ways to go. As people see and really get re‑affirmed about the fact that this system works. We are still tossing out 14 trillion worth of product a year. It will return. It’s already returned with most people in most ways, but it’s not back 100%. It’ll get there.

CBT: Do you have any comment on the unemployment rate?

WB: Well, the unemployment rate will turn around late. It always lags. People who have gone through a period like this are slow to rehire until they really have to. On the other hand, the time will come when they have to. There will be more people working in housing a year or two from now. We have a brick company. We have companies in the carpet business. We have had to let people go in those businesses in the last year, year and a half. We will be adding people at some point, but we won’t do it until we see the demand come back. It’ll be a little slow because we don’t want to go through what we did before. Although, I will guarantee you that three years from now, our brick companies, our carpet company, and our insulation company will all be employing far more people than now.

CBT: That’s good to hear. The next question is about the government. Congress and the administration have been working on reforming financial regulation. Do you think they are on the right track? And will reforms and new rules to protect consumers help restore confidence?

WB: Well, the new rules won out, so the things they have done during the last year fell pretty short of confidence. Not everything is done perfectly, but nobody can do them perfectly. The important thing is that they got things done and people do believe in them, and they’ll believe in them more and more as it goes along. Government has a real role to play and it will not prevent bubbles forever. Human beings do crazy things from time to time, and the real question is how they recover from it. You and I have done things in our life, and the truth is that we came back from them. That’s the important thing.

You can’t rule out human emotions. When people get greedy as a pack, strange things happen. When they get fearful as a pack, strange things happen. That isn’t the way they exist most of the time, but they do give into that. So rules will help us avoid some of the problems. They’ll help us modify some of the problems, but they won’t eliminate all future problems.

CBT: I was watching a little TV this week and I was listening to William Cohen, who is the author of “The House of Cards.” He said that if you don’t change compensation and how Wall Street is incented, the same thing is going happen all over again. And yet, I recently heard that Wall Street is hiring, and they are also guaranteeing big bonuses and compensation packages, which is a little bit alarming if you ask me. What’s your view is on that?

WB: Well, Wall Street is about trying to make a lot of money. It’s the nature of the system. You get a huge capitalist system, and it raises lots of money and it makes lots of big deals and people – some people get paid very well for it. What you have to change in Wall Street is you have to make sure that in addition to carrots, there are sticks. And it can’t be a one‑way street where they are making ungodly amounts of money when things are good and then they move on to someplace else for a while when things are bad. You have to create a downside. I hope there are some practices put into place – and I’ll have a few thoughts on them myself – but Congress undoubtedly will have a few thoughts too. You have to put in something where there is downside to people who really mess up large institutions and we need some new help in that. Too many people have walked away from the troubles they have created for society, not just for their own institution, and they have walked away rich. They may not be as rich as they were before, but they have walked away better than they should have. There have to be incentives – not only to get rich, but to behave well.

CBT: President Obama said this week that the financial firms “owe a debt to the American people.” And I wasn’t exactly sure how, how they could pay that back to the American people.

WB: It’s interesting. Exactly a year ago when I was at this conference, I had a proposal for the so‑called “toxic assets.” I called three people in the financial world who were going to write Secretary Paulson about it. I wrote them on October 6th. I called three people to help out on this, and it would have required a lot of effort on their part and some commitment of money and time and energy. I asked all three of them if this went forward to do it absolutely pro‑bono. I asked them not to make one dime out of it. And they all said yes to me. So, they are good people. Many are motivated by greed. None of us are perfect, you know? I always say that, “Every saint has a past, every sinner has a future.” We have got some sinners back there, but they are not all bad. They went along with a bubble that they helped create – but the whole American public did. You still have to have the right rewards and penalties for behavior. That’s how you get decent behavior. So, I don’t look at Wall Street as “evil.” I look at Wall Street as given to huge excess sometimes. I don’t want to get rid of it. We need something to allocate capital and distribute securities and all of that throughout the system. We have got a big capitalist system and we have to have a big capital market – but there is plenty of room for improvement.

CBT: Looking into your crystal ball, what will the stock market look like a year from now?

WB: Well, I don’t know about a year from now. Five years from now, it’ll be higher, yeah. Ten years from now, it’ll be higher. One year from now, I don’t know.

CBT: Fair enough. Moving a little bit more closely to the payment and card system. On September 3rd, the The Wall Street Journal had an articled titled “Wal‑Mart to Pay via Check Cards.” Wal‑Mart isn’t going to issue paychecks anymore. So it’s all going to be through a card system, which is actually good for the payment industry and the card industry. And it seems to be a growing movement to use cards to dispense payments. I noticed that on some airlines, if you don’t have a card – a credit card of some kind – you can’t eat or drink anything if you are sitting in economy because they don’t take cash anymore. So that, that’s kind of interesting…

WB: Some restaurant just announced that in New York too, that they weren’t going to take cash.

CBT: That brings us to the next question: Do you think cash is ever going to disappear as a form of payment?

WB: It won’t disappear, but in the end – and that’s the genius of the American system – we do give the consumer what they want. If people want to use the convenience of cards, they will do it. Now there will be enough people that want to use cash, so consumers won’t turn their back on it entirely. They haven’t given up landline phones entirely for cell phones. The American consumer – in the end – is king. You can push them around for a week or a month maybe, but you either figure out what’s in your customers’ mind and decide you are going to serve them; or you are not going to be in business. They are right, and you are wrong. It’s what made this country, to some extent, what it is. Our market system where the customer – 300 million Americans – tell people what to make, where to serve them, and how to do business. Compare that to some totalitarian system, where somebody decides what people are going eat for lunch and we win.

CBT: Well, we are certainly not used to that…

WB: Oh yeah. Mm‑hmm.

CBT: The credit card industry is about 50 years old, and it’s pretty safe to say that it’s going to transform in the next 10 or 15 years. Sometimes I think we’ll have chips in our hands to scan and pay for things. All kinds of things will be transacted electronically.

WB: Cathy, I met Ralph Schneider who was the founder of the Diners Club back in the 1950s. He had just designed an IRA, and they are just using it around New York. They used to charge the merchants 10 percent and the card was very low priced then. American Express went into the business originally defensively. They had the Travelers Check and they were worried about what the credit card would do to it. In 1964, when American Express had what they called the great Salad Oil Scandal, we became this little outfit in Omaha and became the largest shareholders of the American Express Company. I went around to restaurants and service stations, and asked people about whether the Card was losing its appeal because of the scandal that was going around. They said the Card wasn’t losing it but that it was growing in appeal. So, I watched the credit card industry almost from the beginning in that respect. We got in early. I could see it was a powerful tool. First Data was in Omaha, and I have watched them all. Carte Blanche, the Hilton Card – some of those have disappeared over the years. Of course, Visa and MasterCard have been successful. There have been all kinds of developments, but the truth is, the American public likes to be able to go into their pocket and pull out a card.

CBT: Well, that was a really great lead into a question I had about American Express. Everyone knows here that Berkshire Hathaway has an investment in American Express, as you just said. So, you obviously know a lot about the payment industry and that company in particular. Can you tell us what attracted you to that company?

WB: Well, what originally attracted me back in 1964 was that Diners Club got the jump. They were way ahead of American Express. American Express came in with a very interesting market and concept. People already were carrying Diners Club, and American Express wanted to enter the field. They charged more than Diners Club did for their product. Diners Club had this card that had a bunch of flashy little symbols and everything on it. American Express brought out that centurion, and originally it was the green card with the guy that looked like Mr. Integrity. If you went into a restaurant, and you were buying dinner for somebody, and you had a choice of pulling out this Diners Club card that looked like you were giving a check from your mother or pulling out this centurion that made it look you were J.P. Morgan or something – you went with Mr. Integrity. They actually took over the field by establishing themselves not as the low‑priced competitor but, but as the class competitor. It was a great marketing arrangement. Then it swept the country. The card I carry in my pocket says, “Member Since 1964.”

CBT: Mine says “Member Since 1983.”

WB: Well, that was the year you were born, I was 40 years old or something when I did this.

CBT: Last question. We would like you to impart a little bit of advice and tell us what is the one lesson that we should take away from this economic Pearl Harbor?

WB: Well, I think that it goes back what I have told my manager to do: Just keep taking care of the customer. We have got a lot of customers in this country. Since 1886, Coca‑Cola has been selling a product that people like, and they just keep taking care of them. It’s what you have done at Business Wire. In the end, nobody that’s ever taken good care of the customer has ever lost; I mean, that, that is the name of the game.

CBT: That is great advice. I want to thank you for your time, Warren, it’s been a pleasure talking to you, and allowing me to interview you.

WB: It's been fun. Thanks, Cathy.

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We are always interested in listening to the views of Bruce Berkowitz of The Fairholme Funds.  In this interview recorded this evening for the PBS Nightly Business Report, Mr. Berkowitz comments on a number of his holdings, including Berkshire Hathaway.  He appears to be very positive on Berkshire’s acquisition of Burlington Northern Santa Fe.

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Diane Francis of Canada's Financial Post recently spoke with Prem Watsa, chairman and CEO of Canadian insurer Fairfax Financial (FFH). Watsa is one of the savviest long-term investors in Canada (and beyond); those who know him well compare him to Warren Buffett. Over a period of more than two decades, Watsa has amassed an impressive investment and value creation track record at Fairfax. Here are highlights of his interview with the Financial Post:

Q: One commentator noted that Fairfax’s stock has declined by 3.4% this year, why?

A: “We are long-term investors and our company is a long-term investment. Short term fluctuations are market driven and not value driven. We began in 1985, 24 years ago, with US$30 million in assets and about US$7.5 million of shareholders’ capital. Today, coincidentally, we have US$30 billion in assets and US$7.5 billion in shareholders’ equity. That’s up 1,000 times. Our per share book value has grown from US$1.50 to US$372. Our stock price has gone from C$3.25 to between C$375 and $390 a share. These are all long-term results.”

“We are thankful for our track record. More recently our book value in 2006 was US$150 a share and now, as of end of September, it is US$372 a share, more than double and the stock price has naturally followed suit. Over time the book value and the stock price tend to go together.”

Q: You are in India today, and were born there, how is it doing?

A: “The Indian economy has come back up in spades. This country has recently built the interstate road system which took forever because of their bureaucracies. Now, however,economic development is spreading out of the biggest cities like it did in the United States one hundred years ago. India is looking at growth of 8% - potentially even 10% - next year. Our Indian company, ICICI Lombard, was started from nothing less than ten years agowe have 26% ownership of it, and today it is underwriting almost US$1 billion. It is the largest property and casualty insurer in India and the potential is huge. Only 1% of all homes are insured.”

Q: Bubbles are developing in a lot of asset classes, so what do you continue to bet long-term on?

A: “We like the stocks that we have such as Johnson & Johnson, Wells Fargo. Our thinking is that the stronger get stronger and good management will prevail. Look at the commercial/industrial mortgage problem. There are 100 regional banks in this and say they all go bankrupt. That means there’s opportunities for strong banks like Wells Fargo who can buy regional or smaller banks for cheap.”

Read the full interview with Prem Watsa.

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Click here to watch all the Soros lectures.

Introduction

In his recent lecture series at Central European University in Budapest, Hungary, George Soros unveiled his latest thinking on economics and politics in five separate lectures. They are the culmination of a lifetime of practical and philosophical reflection. In his first two lectures he discussed his general theory of reflexivity and its application to financial markets, providing insights into the recent financial crisis. The third and fourth lectures examined the concept of open society, which has guided Soros’s global philanthropy, as well as the potential for conflict between capitalism and open society. The closing lecture focused on the way ahead, closely examining the increasingly important economic and political role that China would play in the future.

Lecture 1: General Theory of Reflexivity -- Link to video here.

George Soros presents the fundamentals of his guiding philosophy, laying the foundation for his four subsequent lectures. This session discusses historical understandings of objective reality, scientific inquiry, and the limits of human perception. It discusses the gap between perceptions and reality, illustrating how actions based on these flawed perceptions then reshape reality in a reflexive system.

Lecture 2: Financial Markets -- Link to video here.

This lecture applies the general theory of reflexivity to financial markets, challenging the prevailing paradigm of the efficient market hypothesis. George Soros discusses bubbles and the recent financial crisis in detail, testing his theory against major financial events.

Lecture 3: Open Society -- Link to video here.

In this session, George Soros discusses the concept of open society, which guides his philanthropy and is central to his political and social thinking. Over the past quarter century, Soros has devoted over seven billion dollars to promoting the underpinnings of this concept—from equal access to justice to freedom of expression—around the world, from South Africa to Poland to the United States. Here, he describes the historical and philosophical roots of open society. George Soros builds on Karl Popper’s thinking while stressing the central importance of fallibility, relating this to reflexivity, and applying these concepts to political and social reality. The lecture concludes by discussing the balance between individual freedom and regulation to protect the common good.

Lecture 4: Capitalism Versus Open Society -- Link to video here.

In this lecture, George Soros explores the conflict between capitalism and open society, market values and social values. Focusing on the principal-agent problem, he will use contemporary economic and political examples to challenge market fundamentalism while presenting ideas for protecting the public good more effectively.

Lecture 5: The Way Ahead -- Link to video here.

Turning his attention to the future, George Soros focuses on the increasingly important role that China is likely to play on the world stage. He will outline key global trends and discuss their major economic and political implications for the years ahead.

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Charlie Munger was interviewed by the BBC and comments on a variety of topics.  As always, Mr. Munger pulls few punches when it comes to providing his candid assessment on investing, economics, politics, and all varieties of “human follies”.

One sure to be classic Munger quote from the interview was in response to a question regarding how concerned shareholders should be when they experience temporary impairments in the market value of their holdings:

You can argue that if you’re not willing to react with equanimity to a market price decline of fifty percent two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result that you’re going to get.

And on politics:

Both parties have wings that are full of idiots.  That is the nature of the game.  And the reason it has worked as well as it has is that the people in the middle have sort of over time tuned out the idiots on both sides.  But every once in a while, the idiots get in control.  And, of course, that has terrible consequences.  That’s the nature of the system.

To view the video, please click on the image below.

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Warren Buffett's daughter Susie Buffett provides some interesting insights into Warren's personal life.

Susie Buffett is one of Warren Buffett's three children with his first wife, Susie Thompson Buffett. Like her two brothers, she runs a charitable foundation funded by her father. The Sherwood Foundation is based in the same building in Omaha in which her father has worked for almost fifty years.

Watch Susie Buffett talk about Warren Buffett.

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Don Graham, son of the late Katherine Graham and current chairman and CEO of The Washington Post, discusses his and his mother's experiences with Warren Buffett in a new BBC interview.

Watch Don Graham talk about Warren Buffett.

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First Manhattan's David 'Sandy' Gottesman, a long-time friend and business associate of Berkshire chairman Warren Buffett, discusses some of the things that make Buffett a truly unique investor.

Watch Sandy Gottesman talk about Warren Buffett.

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Microsoft founder Bill Gates discusses his friendship with Warren Buffett in a new BBC interview.

Three years ago, Buffett announced he was giving the bulk of his fortune - currently estimated at $40 billion - to charity, with most of it going to the Bill and Melinda Gates Foundation.

Watch Bill Gates talk about Warren Buffett.

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Warren Buffett talked to Evan Davis at the headquarters of his company, Berkshire Hathaway, in Buffett's native Omaha.

Buffett shares his ideas about the current financial crisis, his investment philosophy, and his one indulgence - his private jet.

Watch the interview.

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Elizabeth Ody of Kiplinger.com shares the following advice and insights in a recent article:

Warren Buffett, chairman of Berkshire Hathaway: I have no idea what the stock market's going to do tomorrow, or next week, or next month or next year. But over a 10-year period you will do considerably better owning a group of equities than you will owning Treasuries. In fighting the economic war, we've taken action that sows the seeds of substantial inflation down the road. Not in the next six months or year, but 10 years from now the dollar will buy a lot less than it buys today.

Robert L. Rodriguez, chief executive of First Pacific Advisors: Don't run with the herd. Being surrounded by people who are doing the same thing as you offers a false sense of protection. Today, being a loner means owning short-maturity, high-quality debt on the bond side. And if the U.S. government continues to blow up the nation's balance sheet through massive deficits, you should probably move at least 20 to 40 percent of your assets out of the United States.

Jeremy Grantham, chief investment strategist at Grantham, Mayo, Van Otterloo: The recent rally has been very speculative, favoring risky assets over the past few months. I'm sorry if you missed investing at the market's March lows, but don't compound the damage to your portfolio by chasing gains in risky assets. We're at the beginning of a seven-year period of lean returns. You should only be buying the highest-quality blue-chip companies, where valuations are most attractive.

Bill Gross, co-chief investment officer at Pacific Investment Management: The biggest danger right now is that you'll earn zero percent on mattress money, or virtually zero percent in a money-market account or at the bank. Yes, that money is safe, but the economy and inflation may come roaring past you at higher levels. You also have to consider diversifying outside of the United States. The dollar is a weak currency, and as it devalues against other currencies, our standard of living will suffer. Higher returns relative to risk lie in Asia and Brazil.

Martin J. Whitman, co-chief investment officer at Third Avenue Management: Do what we do -- find extremely well-financed companies that do not rely on continuous access to the bond or stock markets for refinancing, that are run by competent management teams and that have favorable prospects for growth. Buy these companies' stocks when they are available at a meaningful discount. All other systems of investing are concerned with predicting stocks' near-term price movements.

Jim Rogers, chairman of Rogers Holdings: Diversification is garbage -- it's something brokers invented to avoid getting sued. You only need four or five good ideas in your life to get really rich if you avoid mistakes. And the one way to avoid mistakes is to stick with what you know. Then, when you see a major development in your area of expertise, you'll know better than Wall Street when to buy or sell.

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Pensions & Investments has an interview with Daniel Och, founder and head of Och-Ziff Capital Management (OZM). Here is an excerpt:

Where do you see interesting investment opportunities?

Several of our businesses are secularly more attractive than they were three years ago. For example, convertible arbitrage, where many participants were using large amounts of leverage, we believe is a much more attractive business than it had been. Long/short equity also continues to be appealing to us.

We're constantly thinking about where we can expand into new opportunities. Structured credit is a good example of that, consisting of residential mortgage-backed securities, commercial mortgage-backed securities and structured products with corporate assets as the underlying collateral. These are areas we were not involved in three years ago given the significant leverage and embedded leverage and the fact that virtually all of the risk management was based on what the rating was.

We built very deep and strong capabilities in structured credit. Now that the sector has dislocated, (we are able to) take advantage of opportunities. Number one, we think that banks and financial institutions will begin to be more aggressive in selling assets off their balance sheets. Number two, on the commercial side, we think that deteriorating fundamentals will impact the structured side, creating literally hundreds of billions of dollars' worth of distressed product.

Our expectation is that the opportunities are beginning now and will continue into 2010, although having said that ... it may take longer to emerge. I think another of the mantras of our firm applies here: Have capabilities everywhere and obligations nowhere. 

Read full interview with Daniel Och.

(Thanks to Simoleon Sense for the link.)

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In his latest commentary, Legg Mason's Bill Miller challenges the view that the U.S. economy will revert to a "new normal" once the current crisis has ebbed. Writes Miller,

In my colleague Michael Mauboussin’s terrific new
book, Think Twice, the opening chapter tells the story of Big Brown, the super looking colt who’d won such impressive victories in the Kentucky Derby and the Preakness, the first two legs of racing’s Triple Crown. This is a story with a lesson that directly relates to investing, and to understanding the kind of recovery that appears to be getting underway in the U.S. economy.

After winning all 5 of his starts by a combined total of almost 40 lengths, Big Brown was a 3-10 favorite to win the Belmont Stakes and become the first horse in 30 years to win the Triple Crown. Those odds indicated the “wisdom of crowds” putting a 77% probability on Big Brown’s winning the race and making horse racing history. Part of that was right: he did make horse racing history —
by being the only horse to win the first two legs of the Triple Crown and finish last in the Belmont.

That so many were so sure of Big Brown’s success was due to a common analytical error that manifests itself in investing as well as horse racing. That error is the neglect of base rates. Psychologists call it the “inside” view, in contrast to the “outside” view. As Michael explains in his book:

The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view…asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.

In the case of Big Brown, taking the outside view would be to see how many horses in the past had won the first two legs of the Triple Crown and then went on to win the third. The inside view focused on Big Brown, his history, the competition he faced, the tracks he ran on and their condition, his time between races, and so on.

The outside view revealed that 29 horses had won the first two races of the Triple Crown in the 130 years it had been run, with 11 of those horses going on to win the third race. Parsing the data a little more finely showed a remarkable divergence in winning percentages. Before 1950, 8 of the 9 horses that had a shot at the Triple Crown won it. After 1950, only 3 of 20 were successful. Moreover, when Big Brown’s speed ratings were compared to the most recent 6 Triple Crown contenders (and not just to his competition in the race), he was the slowest by a wide margin. If those who were betting on the Belmont had used the outside view instead of the inside view, no one would have believed what everyone did believe, that Big Brown had a nearly 80% chance to win the Belmont.

Investors are faced with these sorts of problems constantly: if I put my money in bonds now, what rate of return should I expect over the next 5 or 10 years? What is the outlook for stocks over the next 12 months? What are the chances of a significant rise in inflation over the next few years? What kind of economic recovery will we have? Should I fire my active money manager and replace him with a passive index product? What are the chances we have a “double-dip” recession? And on and on.

Faced with these sorts of questions, most people default to the inside view, and then augment its flaws with the usual assortment of behavioral biases long known to psychologists: they anchor on the most recent experience, they assume instances are representative of deeper patterns, they give more weight to vivid examples or dramatic outcomes, they place twice the weight on a dollar lost as on a dollar gained, etc.

The financial crisis that is now abating has created a near perfect environment for the admixture of all of the above, and that is perhaps why what Nobel winning economist Ken Arrow called the “clouds of vagueness” seem particularly thick and forbidding just now. Taking the outside view on some of the issues facing investors won’t make an inherently unknowable future predictable, but it can improve the odds of getting things right, or getting fewer things wrong.

The difference between the inside and the outside view is well on display in the different and in some cases strongly held views about what kind of recovery is now unfolding in the U.S. PIMCO’s Mohamed El-Erian is the most prominent advocate of the “new normal”, a term he coined to describe a recovery with real growth of 1-2%, persistently high unemployment, and much greater government involvement in the economy. He has recently warned of a big letdown from the “sugar high” we are now experiencing in the market and the economy as the effects of the abatement of the credit crisis and massive government stimuli, both fiscal and monetary, begin to wear off.

He may be the most prominent, but he is not alone. In fact, it looks like he is the leader of a not so silent majority. The current consensus growth rate for the U.S. economy in 2010 is 2.4%. This is way below “normal” for the first year of a recovery, yet even it is well above what most thought only 6 months ago. In April the IMF projected negative growth in world output of 1.3% this year, and only 1.9% growth in 2010. That included a projection of zero growth in 2010 for developed
countries.

Projections such as these follow the classic inside view pattern: they look at current conditions, current trends, anchor on the most recent data, and adjust from there. Since the economy bottomed in March, almost all time series forecasts of economic improvement have been adjusted higher as the year wore on. They are still well below “normal.”

Continue reading Bill Miller's commentary.

Read Bloomberg's coverage of the debate on the "new normal".

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Jonathan Heller of the highly recommended Cheap Stocks blog has posted notes from the Value Investing Congress in New York. You will not want to miss these notes, as they include some of the most important takeaways from the Congress in an easy-to-read format.

Jonathan Heller's notes from Day 1.

Jonathan Heller's notes from Day 2.

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Here is an excerpt from Vivek Kaul's recent interview with value investor Mohnish Pabrai:

How much of Warren Buffett's success can be attributed to his investment prowess and how much to the fact that he is Warren Bufett?

Well the thing is you could have invested even after Buffett had invested and you could have made six times the money out of it.

In fact there are a couple of professors in Ohio, who studied any stock that Warren Buffett bought, if you bought on the last day of the month, when it was public that he owned that stock, and you sold it after it was public that he had started selling it, you would have generated north of 20% annual rate of return.

I would say that we will never see another Warren Buffett. Just like we will never see any Albert Einstein or another Mahatma Gandhi. Buffett is a very unique individual. His skillsets outside of investment are phenomenal but they get dwarfed by his investing skills. The main thing that makes Warren Buffett Warren Buffett is that he is a learning machine who has worked really hard for, let's us say seventy years, and is continuously learning every day.

So the thing is if you want to be like Buffett, there is no short cut. First of all, you have to be deeply interested in investing and you have to be very willing spending tens of hours, hundreds of hours, reading the minutiae. There is a very famous value investor called Seth Klarman. He is into horse racing. And his famous horse is called Read the Footnotes.

Read Vivek Kaul's interview with Mohnish Pabrai.

(Thanks to Value Investing World for this link.)

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Joel Greenblatt, founder of Gotham Capital, shared his thoughts on a number of investing topics in a rare interview on CNBC this morning.  The focus of much of the discussion was related to Mr. Greenblatt’s “magic formula” strategy that he outlined in The Little Book That Beats the Market.

This strategy is also discussed in more detail on the Magic Formula Investing website.  Additionally, The Manual of Ideas 10×45 Bargain Hunter newsletter includes screens using the “magic formula” based on trailing earnings, current earnings, and next year’s projected earnings.  Click on this link to read a review of Mr. Greenblatt’s earlier book: You Can Be a Stock Market Genius.

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We recently interviewed one of Canada's most well-respected value investors, Tim McElvaine of McElvaine Investment Management. As always, he is insightful and to the point.

Read exclusive interview with Tim McElvaine, published in a special edition of Downside Protection Report.

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In a Q2 letter to investors, dated July 13th, respected value investor David Einhorn of Greenlight Capital states that at the end of the second quarter, "the five largest disclosed long positions in the [Greenlight] Partnerships are Arkema, Criteria Caixa, Ford Motor Company debt, gold, and Pfizer."

Einhorn has owned French chemicals company Arkema (Paris: AKE) and Spanish investment group Criteria Caixa (Madrid: CRI) for some time. Greenlight has also owned other Europe-domiciled companies in the past, including French auto maker Renault and Austrian Post, which was named a top monthly stock pick in the recent issue of European Value Report.

While it is impossible to divine Einhorn's strong interest in European equities, we note the following attractive investment attributes offered by many European markets:

• Western Europe has a history of transparency and rule of law. Disclosure and corporate governance standards are high in most European countries, especially European Union member states.
  
• The continued breaking down of economic and political barriers within the EU, as well as the relentless enlargement of the Union via the admission of new states, provides fertile ground for market share gains by well-managed corporations. For example, as pointed out by the Manual of Ideas research team in a recent issue of European Value Report, Austrian Post has expanded beyond the borders of its native Austria, pursuing growth opportunities in several emerging economies of Eastern Europe.
  
• Finally, we believe David Einhorn may have found an interest in European equities as a result of his search for investments that may provide a hedge versus a declining dollar.

Here is a quick overview of the top two European holdings of Greenlight:

Criteria Caixa (Madrid: CRI)

Criteria Caixa is an investment group with holdings in financial and industrial companies. The company’s core shareholder is “la Caixa”; it has been listed on the continuous market of the Spanish stock exchange since October 2007. Criteria has a firm commitment to international growth, active management of its portfolio within a framework of controlled risk, and boosting the growth, development and returns of the companies it invests in. Criteria CaixaCorp holds the largest corporate investment portfolio in Spain by net asset volume with a value of €14,823 million at June 30, 2009. [view investor presentation] [read annual report]

(click to enlarge)

Arkema (Paris: AKE)

Arkema is a global chemical company and France’s leading chemicals producer that operates in three businesses: Vinyl Products, Industrial Chemicals, and Performance Products. Arkema reported revenue of 5.6 billion euros in its most recent fiscal year. The company has 15,000 employees in over 40 countries and six research centers located in France, the United States and Japan. With internationally recognized brands, Arkema holds leadership positions in its principal markets. [view investor presentation] [annual report]

Disclosure: No positions.

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Bruce Berkowitz of The Fairholme Fund held a call with investors on September 30th [listen to call; read transcript]. As always, we found Berkowitz's commentary lucid and helpful in understanding his approach to investing. Here are a few highlights from the call:

On The History of The Fairholme Fund

"In our first letter to shareholders, in May of 2000, we stated our goal of providing shareholders with superior investment performance, without risking permanent loss of capital. We accomplish our goal when we purchase securities at a significant discount to our estimate of their true worth; that is the cash generated over the life of the investment. In the case of common stocks, we estimate the cash a business will generate for owners over the life of the business. In 2000, the Fairholme Fund had over half its net assets in companies primarily involved in property and casualty insurance. At the time, these companies earned about 20 percent returns on book value, and we paid near book value for them. They were the ugly ducklings of their day that the crowd ignored."

"Since then, we have concentrated in areas such as telecommunications, with the junk bonds of WilTel, eventually acquired by Leucadia, and then Level Three Communications; and WorldCom, which became MCI, and then acquired by Verizon. Today, the fund has about 30 percent of its assets in pharma and managed healthcare. Despite the loud noise of the crowd and the administration's rhetoric, we believe our health-related companies are for essential services and products to an aging population, have few substitutes, and have strong free cash flows relative to market prices."

"While the securities in the portfolio have changed over the years, our adherence to a strategy of counting cash has only become more resolute. By focusing on free cash flows, we steered clear or the dotcom era debacles, as well as the recent financial services meltdown, which brought many once unassailable banks and financial companies to their knees. None of those failed companies could ever show us the money. While we can not predict the future with any high degree of success, we're confident that we can properly respond to whatever the future may bring, by adhering to our basic principles of vigilance, focus, commitment, and value. And by having the necessary cash to quickly act, in size, when the opportunities exist. Cash proves especially useful whenever the cashless are forced to sell without regard to price."

On The Investment Process

"In order to protect your capital, we will continually challenge ourselves by asking how might our investments fail. To help answer this question, we retain outside experts ... devil's advocates, if you will ... who have decades of hands-on operational experience in their respective fields, because knowing what you don't know and tapping those who do is one of the critical skills of investing."

"We're not asking our consultants to sell anything for us. We just really need to pick their brains and make sure we understand what we're getting into. And, by the way, this isn't new. Okay? This is not new. Other companies we've studied, with very long, successful records, have used the same process. So, again, we hire experts to corroborate our ideas, our assumptions; and, more importantly, try and disprove what we think is correct."

"When we commit your capital to an idea, it's because we've exercised vigilance in researching both the upside and especially the downsides of a given investment."

"When researching companies, we start with past SEC reports, conference calls, and investor presentations. We then focus on every business element that requires management to exercise judgment, and every element of accounting that may not reflect reality. For example, we check reserves for insurance claims, bad debts, lawsuits, healthcare liabilities, pension obligations, and Uncle Sam. We assume every estimate is too liberal, too light. We look for kitchen-sinking of real expenses, hidden for periods of time, which, in the aggregate, can reverse years of so-called profits.
Management is considered guilty until proven innocent."

"Then it's time to consider which way the winds are blowing. Is the underlying company facing economic, demographic, technological, political competitive headwinds? Is the business growing? Which way are interest rates heading? We then consider where our security lies within the capital structure of the company, and then assess the entire capital structure of the underlying entity. We look at leverage, return on assets versus the return on equity, tangible equity; we want to weigh the heft of the balance sheet, and review and search for all off-balance-sheet items. Can the business work without leverage? To what extent is the business dependent on the kindness of strangers? And by that I mean the capital providers. We also examine good will, which may or may not be a gift that can keep giving. Then it's on to reviewing customers, suppliers, competitors, substitutes, and think of the industry's concentrations of power. Then it's to review, consider, and think about all the different stakeholders in the company. Who are the owners? The regulators? Taxing authorities? Creditors? Retirees? Unions? How powerful are the employees?"

"And, of course, management must be carefully studied. How much does management take in total compensation? Do they under-promise and overdeliver? Do they respect owners? Are they true owners and not just option-holders? Do they allow a level playing field with owners? How good is the paper trail of key executives? Do they play in the center of the court? Do they have a deep understanding of the business? How have they allocated capital over time? It's awfully hard to make a good investment with bad people."

"We then consider illogical extremes. For example, we considered the U.S. Government's past desire for every family to own a home, and evaluated the effect on relevant financial institutions. We consider the worst case. Are there too many variables to monitor or estimate? What are the correlations with other investments? We try and understand the unknowns. Of course, we want to know how can we die with this investment. For example, we did not know how to quantify monumental derivatives risk."

"Then we return back to the price that we're willing to pay for the security. And while easy to say, it's near impossible to be exact with common stocks. And so we use a price range. Does the range reflect an average past environment and normal risk-free rates? Does it allow bad luck? Stress? And a margin of safety? Can we achieve a double-digit, growing, free cash yield, without risking principal? Are we playing Russian roulette? Are we picking up pennies in front of a steamroller? If we haven't killed the investment idea yet, we then compare it to our other investments. How does the investment compare to an investment in other securities of the underlying entities? How does it compare to our current portfolio investments?"

On The Importance of Cash Flow

"At the end of the day, the only thing that we can spend is cash. We can't spend a click, or an eyeball, or a metric. I mean, we can spend cash to benefit our families. So we count cash. And the best way to understand how we try to count cash is to use the analogy of the corner grocery store ... 7-11, or before the time of credits cards, when there was one cash register, and purchases were made, and cash went into the register, and supplies came in, cash came out to pay for all the supplies, and for salaries, and insurance, and to keep the place looking good. And that's it. And then, at the end of a period, what was left in that cash register was for the owners. And then the owners had to decide how to allocate that cash, whether to spend it, whether to reinvest it back in the business to grow it, or rather to invest it in another business. So all we're trying to do with ... we say it a whole bunch of different ways, all we're trying to do is just to measure that cash and understand how it's reallocated, and understand how it eventually gets into our pockets, the owners of the company."

On Stocks versus Bonds

"At Fairholme, we treat common stock as the most junior bond in a company's capital structure, where the true earnings, the free cash flow of a company, are akin to a coupon without a maturity date. We get really excited when we can find more senior and secure bonds that yield better than average equity-like returns. We then compare market prices to our estimates of free cash flows, to determine
an expected return on investment. Price matters, and buying right is half the battle. Getting a reasonable estimate of expected free cash flow is the other half."

On Whether Large Fund Size Hurts Performance

"Basically, by having most of my family's money in the fund, I try to create the balance necessary for such decisions. Personally, I don't wish to sacrifice that which I have worked hard for and may need for that which I will not need. For now, size has helped. Having cash, when few do, has helped. Having heft makes a positive difference, and one of the few advantages against the unknown. Size also allows us to keep focused on the fund, while keeping fees relatively low for what we do. With scale, we can meet the ever-increasing costs of doing business. The bottom line, we have smart shareholders and directors, who are not afraid to voice their opinion on how our size is affecting our performance."

On Protecting The Portfolio From Inflation

"The best way we can protect against inflation is by finding companies that generate large amounts of free cash, which then can either be profitably reallocated into the company or paid to shareholders. And to find companies with that free cash flow, that coupon is growing. And studying history, it's my belief that that's the best we could possibly do. But, also, real, tangible assets will become more valuable, as it will take more dollars to buy those assets; hence, our recent focus on companies such as St. Joe [JOE]."

On Investing In Emerging Markets

"It's hard enough when you're the home team, investing in your own backyard. I don't want to play an away game, where I don't know all the rules. So the answer is no. There's plenty to do here."

On Sears Holdings (SHLD) (price was $65 on the date of the call)

"...the value of all the pieces, in death, is worth more than the current market price. And if Eddie Lampert turns around Sears and KMart, then it's going to be worth considerably more. In another area, if the stock price goes down, the company continues to buy back stock, great, we win. If the stock price just goes up, we win. I don't see ... this is a good example of how we invert the investment process. I can't see how we're going to lose."

Listen to Bruce Berkowitz's conference call on September 30, 2009.

Read the transcript.

Follow Bruce Berkowitz's top ideas—and get acclaimed analysis by the Manual of Ideas research team—in Portfolio Manager's Review.

Posted by manualofideas at 10:04 AM | Permalink | Comments (0)

Easily the best quantitative investor on Wall Street, James Simons of Renaissance Technologies, looks set to retire in the near future. This will certainly mark the end of an era for quantitative investing, as Simons has long been regarded as the most brilliant of a crop of mathematically-driven investment managers.

Learn more about James Simons.

Posted by manualofideas at 09:18 AM | Permalink | Comments (0)

Download the Fall 2009 Issue

An excerpt from the Fall 2009 issue:

Feature Interview: Howard Marks, Co-Founder and Chairman, Oaktree Capital Management

"Do An Excellent Job at a Few Things"

G&D: It seems that most investors focus more on the return side of the equation than on risk, whereas you take the opposite perspective.

Howard Marks: That is important, and that is one of the reasons we are still around. Sun Tzu said if you sit by the river long enough, you’ll see the bodies of your enemies float by. The key is “long enough.” If you live long enough, you have to be the survivor. When I was a kid, we didn’t have the video games you have today, so we used to listen to comedy records. One of the greatest ones was Mel Brooks doing the 2000 year old man. Carl Reiner says to him, “how did you get to be the world’s oldest man?”  And he says, “Simple. Don’t die.” How do you get to be the world’s oldest investor?  The answer is don’t crap out.

Founded in 1995,Oaktree manages over $60 billion of investments in a variety of less efficient arenas, including High Yield Debt, Distressed Debt, and Private Equity, among other asset classes. Oaktree’s excellent long-term track record and Mr. Marks’ unique investment philosophy have resulted in a loyal following of investment professionals.  Since starting his career in 1969, Mr. Marks has seen a range of ups and downs in the financial markets, from the growth of the high yield bond market to the current leverage meltdown.

Posted by manualofideas at 12:11 PM | Permalink | Comments (0)

We are pleased to bring you an exclusive 115-minute audio program on the strategy and tactics behind the business achievements of Henry Earl Singleton (1916-99), founder of Teledyne. The program is presented by John Mihaljevic, CFA, managing editor of The Manual of Ideas. John walks the listener through key passages of Dr. George A. Roberts's biography of Henry Singleton, entitled Distant Force, and opines on the keys to Singleton's success. Author John Train has credited Berkshire Hathaway chairman Warren Buffett as saying that Singleton has "the best operating and capital deployment record in American business."

Select an audio format:
MP3   Windows Media (WMA)   Wave (WAV)

Additional resources on Henry Singleton:

• Henry Singleton biography by long-time business associate Dr. George A. Roberts, entitled Distant Force, available on Amazon.com and directly from the author
  
• Forbes article, entitled "The singular Henry Singleton," July 9, 1979.
• Wikipedia profile
• New York Observer article, entitled "The Brain Behind Teledyne, A Great American Capitalist," April 6, 2003.
• Time Magazine article, entitled "Teledyne's Takeoff," October 6, 1967.
• Article by Chris Mayer, entitled "Why Singleton's Buyback Strategy Has Brought in Millions."
  
• Warren Buffett mentions Henry Singleton in 1981 letter to Berkshire Hathaway shareholders.
• Bill Nygren mentions Henry Singleton in 2002 letter to Oakmark Fund investors.
• New York Times obituary on Henry Singleton, September 3, 1999.
• New York Times article, entitled "Wall St. Eyes Are On Teledyne," July 9, 1987.
• New York Times article, entitled "Teledyne Founder Eases Up," April 28, 1989.
• Harvard Business Review article by Arthur Rock entitled, "Strategy vs. tactics from a venture capitalist," November-December 1987.
  

Posted by manualofideas at 08:05 PM | Permalink | Comments (0)

Up-and-coming value investors Kevin Byun continued his record of outperformance in the third quarter. In a letter to investors, Byun writes, among other things:

"As we consider our opportunity set, one of the most important factors remains investor psychology/behavior. The investment fishbowl that we inhabit contains limited examples of behavior to emulate but many more of what to avoid. Current market stress has revealed more than investors realize about their true temperament. With many burned quite badly in 2008, they are hoping against hope that a healing process will result in full recovery of assets, despite lingering emotional damage from broken promises and misplaced trust. These once trusting investors are looking for answers, solutions, and peace of mind. Not without irony, they are seeking ever more certainty in an increasingly uncertain world (rather than trying to understand and manage the uncertainty that is inherent in it)."

"So while the market gyrations and machinations have rendered many market participants unable to think and act clearly, we must maintain a stable internal compass, and make full use of our practical sensibilities. It is critical, regardless of our recent performance or legacy positions, that we maintain a steady temperament, consistent research process, and clear thinking about the current opportunity set before us."

"Given the erratic nature of the market, I have become increasingly optimistic about our opportunity set. The uncertainty and dislocation are a blessing to value investors, not because we enjoy uncertainty or dislocation, but because of the opportunities they create. Our strategy has remained consistent throughout and I am selectively employing our flexible and tactical approach congruent with our investment framework."

Read Byun's Q3 letter to investors.

Posted by manualofideas at 09:51 AM | Permalink | Comments (0)

Joel Greenblatt is the founder and a Managing Partner of Gotham Capital and Adjunct Professor of Finance and Economics at Columbia Business School. He is the author of You Can Be A Stock Market Genius (Simon & Schuster, 1997) and The Little Book That Beats the Market (Wiley, 2005). He is the former Chairman of the Board of Alliant Techsystems, an NYSE aerospace and defense firm. Greenblatt is also Chairman of the Success Charter Network, a network of charter schools in New York City.

Greenblatt is famous in the investment world for his long-term investment track record, which ranks among the best ever and is believed to comprise returns of some 40% per year for more than two decades.

The following are books listed on the syllabus of the value and special situation investing course Greenblatt teaches at Columbia Business School:

• Greenwald, Bruce, et al., Value Investing – "required"
• Haugen, Robert, The New Finance (4th edition) – "required"
• Greenblatt, Joel, You Can Be a Stock Market Genius – "required"
• Greenblatt, Joel, The Little Book That Beats the Market – "required"
• Cunningham, Larry, The Essays of Warren Buffett – "required"
• Hooke, Jeffrey, Security Analysis on Wall Street – "recommended"
• O’Shaughnessy, James, What Works on Wall Street – "recommended"
• Dreman, David, Contrarian Investment Strategies: Next Generation – "recommended"
• Graham, Ben, The Intelligent Investor – "recommended"
• Plus – selections from Ben Graham, Thornton O’Glove, Mary Buffett
  

Posted by manualofideas at 02:20 PM | Permalink | Comments (0)

In a September 2009 interview with Portfolio Manager's Review, up-and-coming value investor Brian Gaines, founder of Springhouse Capital Management, provides the following book recommendations in response to a question:

Brian Gaines: "I tend to read and re-read more of the business history books as it is always useful to compare and contrast past periods to today’s times. Books like Barbarians at the Gate, The Vulture Investors or Merchants of Debt are consistently great reads. Market Wizards also provides some interesting comparisons to today’s markets. I recently read Lords of Finance about central bankers following World War I and through the Great Depression and it was fascinating."

See also books recommended by...

• Warren Buffett
• H. Kevin Byun
  
• Marc Faber
  
• Bill Gates
• Tom Gayner
• Eddie Lampert
• Peter Lindmark
  
• Dan Loeb
• Charlie Munger
• Mohnish Pabrai
  
• Guy Spier
  

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

David Einhorn is one of the most widely respected hedge fund managers.  He employs a value-oriented, research-intensive long-short strategy in managing Greenlight Capital.

General information:

• Bio at Wikipedia
• Op-ed in New York Times, January 3, 2009
• Research report on Greenlight Capital Re (Nasdaq: GLRE), December 2008
• New York Magazine article, entitled "The Short Game," June 15, 2008
• Financial Times article, entitled "How to play the short game," July 16, 2008
  
• SEC filings of Greenlight Capital
  

Speeches:

• Recent speeches
  
• May 2009: The curse of the Triple A (see related short thesis on ratings agencies)
  
• May 2008: Accounting "ingenuity"
  
• April 2008: Private profits, socialized risk
  
• October 2007: Housing crisis, securitizations, etc.
  
• November 2006: Concept of ROE
• May 2006: Microsoft
  
• 2002: Allied Capital (short) (video)

Letters to investors:

• 4Q08 letter
• 3Q08 letter
• 1Q08 letter
  

Other letters:

• March 2009: Letter to Ontario Securities Commission objecting to agreements between MI Developments (MIM) and Magna Entertainment (MECA -- bankrupt)
  
• July 2007: Letter to the Board of Directors of Washington Group opposing merger with URS

Videos about David Einhorn:

• CNBC, September 8, 2009 (Einhorn presents short thesis on McGraw-Hill)
  
• CNBC, September 3, 2009 (revisiting Einhorn's short thesis on Lehman)
• CNBC, May 28, 2009 (what Einhorn was buying at the time)
• CNBC, May 28, 2009 (Einhorn on gold)
  

Posted by manualofideas at 10:14 AM | Permalink | Comments (0)

By Ravi Nagarajan

In a conference call this afternoon, Bruce Berkowitz answered a number of shareholder questions regarding The Fairholme Fund, the state of the overall stock market, and prospects for health care reform.  Mr. Berkowitz’s record at The Fairholme Fund since its inception on December 29, 1999 has been nothing short of extraordinary.  Based on the fund’s semi-annual report dated June 30, 2009, annualized performance since inception has been a gain of over 12% annualized compared to a loss of over 3% annualized for the S&P 500.

This article documents some of the notes that I took during the call and are not necessarily direct quotations.  This is not a comprehensive transcript of the event, but focused on areas that I found particularly interesting.  A replay of the conference call should be available on The Fairholme Fund’s website in the near future.

Disclaimer:  I took notes quickly and while I believe the content of this post to be accurate, it is possible that some errors were made.

Due Diligence Process

Here are some of Mr. Berkowitz’s comments in response to a shareholder question regarding how he goes about performing due diligence on prospective investments:

• Review all securities in the capital structure of a company rather than just the common stock.  Common stock should be viewed as the most junior “bond” in a company’s capital structure.  The free cash flow generated by the business is akin to a coupon without a maturity date.  Count the cash after all bills, interest on senior securities, and maintenance capital expenditures.  The free cash flow can then be compared to market prices to come up with free cash flow yields.
• Fairholme reviews SEC reports, company conference calls, presentations, and other sources when researching an investment.  It is important to focus on every business element that requires management to exercise judgment.  Examine the accounting carefully and pay particular attention to pensions, health care liabilities, regulatory, and tax issues.  Management is “guilty until proven innocent” if there are inconsistencies between the balance sheet, income statement, and cash flow statements.  Be particularly wary of “kitchen sink” charges that could enter into the picture.
• Examine whether a business model can exist without leverage.  Avoid having to rely on the “kindness of strangers” whenever possible.  Examine where the security being analyzed lies within the overall capital structure.
• Examine whether managers are true owners rather than just option holders.  This test can be applied by determining whether an executive has actually purchased shares in the open market rather than only through option grants.  It is hard to make a good investment with bad people.  Examine their capital allocation decisions over time.
• Try to “kill the investment idea”.  If you cannot kill the idea, then it should be compared to other investment candidates that have gone through the same research process as well as existing portfolio companies.  Fairholme focuses on fewer investments than most others in order to have superior understanding of the businesses.  They try to avoid growing their circle of competence too quickly if the risk is losing money.
• Fairholme uses industry experts and consultants as part of the research process in order to contain costs by avoiding the need to retain such experts on payroll on a full time basis.

Health Care Reform

Many of The Fairholme Fund’s investments are concentrated within the health care sector.  A number of shareholders submitted questions asking about the impact of health care reform on the portfolio holdings.  Mr. Berkowitz turned this part of the call over to Charlie Fernandez.

• The fund’s analysts and managers are following developments in health care reform on a daily basis.  The mission of the various reform proposals is to expand health coverage for 20 to 25 million Americans and will result in modifying insurance rules and changing rules for Medicare payments.  Mr. Fernandez expects that a bill will pass this year and should cost around $900 billion.  He noted that most reforms do not begin until 2013 and that the plans under discussion include ten years of revenues to pay for seven years of the program.
• Medicaid expansion will result in opportunities for insurers while the key hospital groups and the pharmaceutical industry have already cut deals with President Obama.  Mr. Fernandez noted that hospitals will have lower bad debt expenses under the reform proposals and that part of the benefit will flow to pharmaceutical firms which typically have claw back agreements with hospitals related to bad debt expenses.  He expects that a 5% increase in revenues for pharmaceutical companies could result from lower bad debt expense for hospitals.
• Pfizer is The Fairholme Fund’s largest holding and a number of shareholders submitted questions or concerns regarding the investment.  Mr. Fernandez believes that the Wyeth merger will close in Q4 and probably prior to Thanksgiving.  $6 billion in cost reductions are expected within 18 months.  Within one year of the merger, no product will represent more than 10% of profits, a statistic similar to Johnson & Johnson.  Pfizer is also expanding its presence in generics.  The company has growth from 13th to 8th place in the United States in generic drugs.  Fairholme believes that double digit free cash flow yields will accrue to buyers of Pfizer common stock at current market prices.

Other Comments

• Inflation. Mr. Berkowitz believes that the best way to protect against inflation is to find companies with large and growing free cash flows which are either paid out or reinvested in the business at satisfactory rates of return.  Also, tangible assets will become more valuable if inflation accelerates which is one of the reasons behind the fund’s investment in St. Joe, a large real estate development company in Florida.
• Sears Holdings. Mr. Berkowitz does not appear to be concerned with the factors discussed in a recent bearish article on Sears that appeared in Barrons.  He still believes that the value of the sum of the parts of Sears is worth more than the current stock price.  If Sears Chairman Eddie Lampert can turn around Sears and K Mart, the shares would be worth considerably more, but this is not central to the thesis.  If Sears Holdings stock price declines, more repurchases of shares are likely and this will benefit shareholders.  If the stock price goes up, shareholders also win.
• Any Interest In Emerging Markets? Mr. Berkowitz believes that it is hard enough when you’re the home team and he doesn’t want to play “an away game” where he doesn’t know the rules.  There is plenty to do here in the United States.
• Thoughts on Berkshire and Leucadia. Although a great deal of information is available on these investments, both can be considered “blind trusts”, but being an investor for decades makes it sort of like marriage.  Mr. Berkowitz fully respects the managers of both companies.  He previously sold shares of Berkshire due to the company’s size, age of management, and Warren Buffett’s statement that Berkshire cannot be expected to beat the S&P 500 by large margins.  However, now that Mr. Buffett has put a significant amount of cash to work at higher returns, Fairholme bought back some shares at the “excellent prices” offered earlier in the year.

Value investors would be wise to pay close attention to The Fairholme Fund’s holdings as well as future statements by Mr. Berkowitz.  While SEC filings are available for The Fairholme Fund’s holdings, GuruFocus.com makes it easy to monitor Mr. Berkowitz’s moves along with the activities of many other super-investors.  Investors should always do their own work on any idea, regardless of who is buying a stock.  However, there is no shame in using super-investors as idea sources and coat-tailing when it makes sense to do so.

The author of this post, 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.

Disclosure:  The author does not own shares of The Fairholme Fund or any of the other companies discussed in this post with the exception of Berkshire Hathaway.

Posted by manualofideas at 09:12 PM | Permalink | Comments (0)

Up-and-coming value investor Ori Eyal of Emerging Value Capital Management provides some interesting commentary in his latest latter to investors. He points out that Chinese company presentations at the recent Rodman & Renshaw Investment Conference in New York were "not even 'standing room only'. 'Squeezing room only' would be a more accurate description." Eyal views this kind of torrid investor appetite for emerging market equities as a contrary indicator, supporting his view that it's once again time to be cautious on equities.

In the letter, Eyal also presents an investment case on G. Willi-Food International (WILC), one of Israel's largest food importers with a focus on the Kosher and health food segments. For those looking for global exposure at a reasonable price, this investment idea is worthy of consideration.

Read Ori Eyal's August 2009 letter to investors.

Posted by manualofideas at 08:37 AM | Permalink | Comments (0)

Posted by manualofideas at 11:47 AM | Permalink | Comments (0)

David Einhorn of Greenlight Capital, one of the 20+ superinvestors regularly tracked by Portfolio Manager's Review, apparently started shorting McGraw-Hill (MHP) after a court ruling against the company in early September. Einhorn has been short the other major credit ratings firm, Moody's (MCO), for quite a while. Listen to Einhorn lay out his bearish thesis on the ratings agencies in the following CNBC interview.

Same-day CNBC interview with Terry McGraw, CEO of McGraw-Hill:

Same-day CNBC interview with Sean Egan, president of Egan-Jones Ratings:

• David Einhorn's speech, "The Curse of the Triple A," May 2009
• Text of lawsuits against credit ratings agencies
• Judge's order, dated September 2, 2009

Posted by manualofideas at 02:57 PM | Permalink | Comments (0)

Posted by manualofideas at 10:50 PM | Permalink | Comments (0)

Robertson has been right on the money many times in his storied career -- his opinion is always noteworthy.

Posted by manualofideas at 12:50 PM | Permalink | Comments (0)

Pershing Square Q2 Letter

Posted by manualofideas at 05:16 PM | Permalink | Comments (0)

Follow this link to access the latest insights offered by the no-nonsense Marc Faber. In the Bloomberg interview, Mr. Faber has some harsh words for U.S. policymakers, provides his view on the direction of the S&P 500, and offers some interesting insights into prospects for Asian economies.

Posted by manualofideas4 at 08:39 AM | Permalink | Comments (0)

Fortune profiles Chris Flowers, one of the best-known private equity investors in financial services companies.

My working hypothesis, as I try to expand my manager selection skills from stockpickers to other platforms like real estate investing and private equity investing, is that these other platforms can and should also be viewed through the lens of value investing.  Simply put, you evaluate a private equity fund manager the same way you evaluate a hedge fund manager: by trying to predict that individual's ability to generate superior risk-adjusted returns over time.

"Risk-adjusted," in the value investor's dictionary, simply means the combination of the probability of permanent (as opposed to quotational) capital loss and the magnitude of that loss when it occurs.  In private equity, adjusting for risk in this way is especially important because private equity relies on leverage.  In private equity investing in banks, it's even more important because banks themselves are highly leveraged businesses.  Small mistakes in predicting the future by managers become big mistakes to limited partners.

A value investor creates superior risk-adjusted returns mainly by investing with a margin of safety.  "Margin of safety" is often defined simply as a bargain price, and it's certainly true that the lower the price of an investment relative to its intrinsic value, the lower its risk according to our definition.  I prefer the slightly more elaborate definition contained in Seth Klarman's aptly titled book Margin of Safety because it gets to the epistemological truth about why value investing works as well as it does:

Margin of Safety--investing at considerable discounts from underlying value, an individual provides himself or herself room for imprecision, bad luck, or analytical error (i.e., a "margin of safety") while avoiding sizable losses (my emphasis).

Value investing is ultimately a theory about the future, in particular the future of any given set of cash flows one chooses to predict.  Value investors like Klarman see the future, almost intuitively, as subject to imprecision, bad luck, and analytical error, and seek to minimize the impact of this on their investment returns.  They do this primarily by looking only for bargains, but also by making sure what they think is a bargain is actually a bargain--by investing only when they can predict the future of a given set of cash flows with relative certainty.

Protecting yourself and your investors from imprecision, bad luck, and analytical error, and making sure you invest only when you can reasonably predict the future--that is, ensuring you have a margin of safety--becomes especially important in private equity because of the leverage involved.  Leverage does not change the probability of a given universe of outcomes so much as it magnifies the effect of those outcomes to equity holders.  The more leverage, the greater the probability of a great outcome if things go well, but also the greater the likelihood of permanent capital loss is if they don't.

So figuring out whether your PE manager invests with a margin of safety is very very important.  This Fortune profile only gives a glimpse of whether Flowers does it.  It cites two examples of permanent capital loss, but also gives ample evidence that Flowers really knows his way around a bank.  So I can't draw any firm conclusions.  And I take no comfort from the fact that Warren Buffett is quoted as saying of Flowers "I think he's a smart guy."  In the language of Wall Street, "I think he's a smart guy" is a way of saying something without revealing anything.  Also, I'm familiar with the Warren Buffett style of personal testimonials, which he takes as seriously as haiku, and can say with confidence that when Warren Buffett wants to praise someone, he doesn't simply say "I think he's a smart guy."  He says something like this:

Jim Kilts transformed Gillette.  Before his arrival, the company was a study in self-deception.  Great brands were being mishandled, operational and financial discipline was nonexistent, and fanciful promises to investors were standard practice.  In record time, Jim excised these business pathogens.  I've learned much from Jim.  So, too, will readers of this book.

or this:

In this book, Adam Smith says I like baseball metaphors.  He's right.  So I will just describe this book as the equivalent of the performance of Don Larsen on October 8, 1956.  For the uninitiated, that was the day he pitched the only perfect game in World Series history.

or this:

I knew Ben [Graham] as my teacher, my employer, and my friend.  In each relationship--just as with all his students, employees and friends--there was an absolutely open-ended, no-scores-kept generosity of ideas, time, and spirit.  If clarity of thinking was required, there was no better place to go.  And if encouragement or counsel was needed, Ben was there.

Walter Lippman spoke of men who plant trees that other men will sit under.  Ben Graham was such a man.

Because I can't draw any conclusions from the Fortune article, I'll instead close with two more general point about margin of safety in PE, especially famous PE investors with great reputations:

1) It's important to keep in mind that a famous PE investor enjoys a personal margin of safety that his L.P.s do not:  If a given fund goes badly, he can always say "bad luck, who could have predicted these macro shocks" and go raise another fund, while if it goes well he'll become extremely rich, or extremely richer.  So a given PE investment may pass the personal margin of safety test while failing to provide an adequate margin of safety to his investors.     

2) The intuitive understanding of and desire for a margin of safety when investing are independent of a PE manager's pedigree, brainpower, contacts, fame, deal flow, skill at chess*, etc.  If you possess all of the latter but lack the former, you may be more dangerous to your investors' long-term wealth than if you possess all of the former but none of the latter.  If you put a gun to my head and forced me to say what Buffett meant by his faint praise of Flowers, I would speculate that he thinks of Flowers the same way he thinks of John Meriwether: "I think he's a smart guy, but . . . he doesn't invest with a margin of safety."

*As an aside, I hate it when skill at chess is presented as a metaphor or proxy for competence in general, especially when applied to investors.  It is factually untrue.  Chess masters and grandmasters have been studied to see if their skill at the game translates into skill at anything else, or IQ, or other measures of intelligence.  Generally it does not: skill at chess implies only that you are skilled at chess.  The most you could say is that skill at chess is a proxy for the ability to practice hard enough to get good at a mental exercise like chess.  That aside, judging investors by their skill at chess, or bridge, or other games of skill, is like judging offensive linemen by their bench presses at the scouting combine.

Disclosure: Long Berkshire Hathaway.

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.

Posted by manualofideas at 10:14 AM | Permalink | Comments (0)

One of our favorite bloggers, Miguel Barbosa of Simoleon Sense, recently attended Mohnish Pabrai's investor meeting in Chicago. Here are his notes.
Mohnish Pabrai Chicago Meeting 2009 Notes

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In the CNBC interview shown below, Becky Quick asks Warren Buffett about the flurry of calls he received during the “extraordinary weekend” one year ago. Apparently Mr. Buffett was the go-to guy that weekend for the cast of characters facing imminent financial ruin. Although none of the deals offered to him that weekend worked out, Mr. Buffett has no regrets regarding any missed opportunities.  I suspect that the deals he was able to put together in the subsequent month fully rewarded his reluctance to hurry into transactions in an overheated crisis situation.

The author of this post, 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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In the second part of the CNBC interview shown below, Warren Buffett comments on Kraft’s recent bid for Cadbury.  While he expressed confidence in Kraft’s management, he was very clear in stating that Kraft already made a “full price” offer and is at a disadvantage since part of the deal involves using “undervalued” Kraft stock. Mr. Buffett also comments on a variety of other topics including the residential real estate market.  The first part of the interview was posted with some comments on this site last night.

The author of this post, 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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The upcoming "Magic Formula" Issue of Portfolio Manager's Review will feature an exclusive interview with one of the most impressive up-and-coming value investors of recent years -- Brian Gaines of Springhouse Capital Management. We are pleased to bring you this sneak preview.

MOI: Tell us a little about the genesis of your firm. What goals did you have at the outset, and what operating principles have guided you since then?

Brian Gaines: The way Springhouse started was slightly unusual in that I never sat down and had any grand plans to start a firm. I had worked for Gotham Capital as an intern and then full-time during my second year of business school at Wharton and had plans to join them upon returning to New York in the fall of 2002. Upon arrival, Joel Greenblatt sat me down and asked if I wanted to start my own fund, which would be seeded initially with their capital. I could work out of their offices, use their infrastructure, and focus all my time on company research. For anyone who loves picking stocks as much as I do, this was a dream scenario.

[...]

MOI: In one of your guest lectures at Columbia Business School, you presented a case study of the video rental industry. What struck us was your ability to “follow the story” and keep discovering new opportunities in the sector as your work on one company led you to look into its competitors, and so forth. One of your major investments in the space ended up being in Netflix (NFLX), a major disruptive force in the industry. What motivated you to invest in a company like Netflix and how did you decide when to sell?

Brian Gaines: Netflix is a prime example of an idea that came from researching another idea. We had an investment in Movie Gallery (MVGR), which subsequent to our investment went on to leverage up and buy Hollywood Video. Throughout my research on Movie Gallery, Netflix kept popping up as a clear competitive threat. I always think back to the CEO of Movie Gallery saying in 2004 that Netflix would never be more than a niche service and that people liked going to the video store too much.

As an aside, CEO’s often speak in absolutes, but we have learned to be wary of individuals, including investors, who view the world in absolute terms. Yes, there were some people who liked going to the video store but there were many people who would sooner go to the dentist.

As for investing in Netflix, the important thing for us was we never paid for the growth. When we first invested, we were paying around 5-6x operating income if you backed out the growth portion of the subscriber acquisition costs and made a fair assessment of what it would cost to maintain the subscriber base. Basically, on a story where you had clear evidence in early entrance markets like San Francisco that the product was taking well, you were able to get the growth for free. This was a good example of where we thought we had excellent downside protection with more than 50% upside. We were able to invest very successfully in Netflix on two separate occasions when the market refused to give credit for growth. When the market was willing to give any credit for growth, which was happening at a rapid pace, we elected to exit.

[...]

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

Brian Gaines: I tend to read and re-read more of the business history books as it is always useful to compare and contrast past periods to today’s times. Books like Barbarians at the Gate, The Vulture Investors or Merchants of Debt are consistently great reads. Market Wizards also provides some interesting comparisons to today’s markets. I recently read Lords of Finance about central bankers following World War I and through the Great Depression and it was fascinating.

[...]

MOI: More recently, Joel Greenblatt has been associated with so-called “magic formula” investing in companies that trade at high EBIT-to-EV yields and earn high returns on capital employed. However, those who have followed Joel for a long time know that he has been adept at identifying all sorts of pockets of inefficiency in the public markets, including spinoffs, equity stubs, and LEAPs. What types of situations have you found to be particularly fertile hunting grounds over the years, and where are you finding the most interesting opportunities right now?

Brian Gaines: It’s been a crazy seven years since we started...

Don't miss our full interview with Brian Gaines! Join us in time for a completely new version of the widely acclaimed "Magic Formula" Issue of Portfolio Manager's Review. Subscribe now.

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Andy Kern of Empirical Finance LLC makes an interesting case for microcap biotech company CombiMatrix (CBMX). While biotech is not typically fertile hunting ground for value-oriented investors, CombiMatrix may be different.

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Disclosure: No position.

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We have enjoyed reading the transcript of Sequoia Fund's recent investor meeting, and believe you will, too. Here is a quick excerpt on the topic of investing in publicly held real estate companies:

Question: Being aware of what’s going on with real estate, I wonder whether it could be attractive for the fund?

Bob Goldfarb: I’d say with regard to real estate itself, it has several characteristics that are almost antithetical to the characteristics that we look for when we make an investment. It has a pretty low return on capital. It’s highly levered, and that means that it doesn’t take a large decline in demand to cause real problems. I noticed just yesterday that Forest City, which is a company that has been around for a long time and has been through many of these cycles — and it’s controlled by the Ratner family — was forced to sell stock at very unattractive levels. We saw Vornado, which is considered one of the best REITs, sell stock just a few weeks ago at a fraction of the price they could have sold stock for a year ago. So I think
real estate itself ... a lot of money has been made in real estate, and it will be made in real estate going forward. But a lot of money has already been lost and will be lost in real estate.

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One of the top-performing mutual fund managers of the past decade, Bruce Berkowitz of The Fairholme Fund (FAIRX), recently sat down with Steve Forbes for an interview that's worth watching. Berkowitz highlights key tenets of his investment philosophy and discusses several holdings of The Fairholme Fund, including Pfizer (PFE) and St. Joe (JOE).

Part 1 of 3:

Part 2 of 3:

Part 3 of 3:

Read full interview transcript.

• Portfolio evaluation: Fairholme Capital Management (FREE)
• PMR evaluation: Hertz Global Holdings (HTZ) (FREE)
  
• PMR evaluation: American Express (AXP)
  
• PMR evaluation: AmeriCredit (ACF)
  
• PMR evaluation: Boeing (BA)
  
• PMR evaluation: Forest Labs (FRX)
  
• PMR evaluation: Leucadia (LUK)
  
• PMR evaluation: Pfizer (PFE)
  
• PMR evaluation: Sears Holdings (SHLD)
  
• PMR evaluation: Spirit AeroSystems (SPR)
  
• PMR evaluation: St. Joe (JOE)
  
• PMR evaluation: TAL International (TAL)
  
• PMR evaluation: UnitedHealth Group (UNH)
  
• PMR evaluation: WellCare (WCG)
  
• PMR evaluation: WellPoint (WLP)
  
• PMR evaluation: Winthrop Realty (FUR)
  

Disclosure: No positions.

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A Barron's article on Sears Holdings (SHLD) is getting quite a bit of attention among investors, with opinions diverging widely on the future of Sears as a company and an investment. Call us incorrigible, but we would not bet against Lampert, despite the obvious challenges facing the retailer.

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We introduced up-and-coming value investor Ori Eyal of Emerging Value Capital Management on this blog a few months ago. Ori has beaten the market indices with a conservative approach since starting his fund. Here is his latest letter to investors.

Read Ori's recent interview with Noise Free Investing.

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Brian Bares of Austin, Texas-based Bares Capital Management has outperformed the market indices by wide margins since inception of his firm in 2000.

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

MOI: Since starting your firm nearly ten years ago, you have focused on investing in small public companies. What prompted this focus, and has your approach changed at all in light of the fact that many large companies have looked inefficiently priced recently?

Brian Bares: There are really two reasons for our focus on small companies. The first is that small companies are more likely to be inefficiently priced. Our investment process mandates a comprehensive understanding of our portfolio companies. It is much more likely that we can profit from this understanding in small caps, where information scarcity allows for opportunity. We also cap assets to maintain our focus on small companies. Our competitors have a difficult time running a strategy like ours because success creates profit motives that tend to move them up the market cap spectrum or into excessively diversified portfolios in order to accommodate a larger asset base.

The second reason is structural. Our firm manages money in replicated separate accounts, and our relationships are largely direct with foundation and endowment clients. These clients employ many specialist managers in a number of different niche areas. They understand that our value to them is our area of competence — small-company common stocks. And they pay for our best ideas as we typically hold between 10 and 20 positions. Our clients allow us to do this because they have other managers looking at mid- and large-caps, international, commodities, real estate, etc. So we have really absolved ourselves of making many difficult macro and asset allocation decisions. Instead, we simply hunker down and focus on our little corner of the market. Our success is judged against small company benchmarks. The only time we think about what is happening with large-caps, international stocks, and other asset classes is when factors affecting these could affect the underlying business performance of the companies we own.

MOI: High returns on capital are generally of little value if they can’t be replicated with reinvested capital for a long period of time. Many businesses with apparent sustainable competitive advantage — such as Polaroid or The New York Times — actually had no such advantage. How do you determine the sustainability of competitive advantage?

Bares: That is a great point, and one that debunks multi-factor screening as a useful tool, in my opinion. A screen for high returns on invested capital may provide you with a list of companies that did well in the past, but tells you nothing about what will happen going forward. And for the going concern, value is 100% driven by what happens in the future. Our process is shaped by the premise that stock returns will follow the value created by internal business compounding over time, and that above average-business compounding will inevitably decline through competitive forces absent a durable advantage. Not to beat a dead horse, but this is why we spend so much time on the qualitative issues that influence internal compounding.

As you illustrate, competitive advantage is most often temporary. Even though we think of ourselves as long-term investors, we have the luxury of a liquid portfolio. This allows us to be decisive and sell out of a position if we perceive deterioration in a company’s competitive position.

To determine the sustainability of a company’s advantage, we must look at all of the factors that make the company unique, and understand how their positioning fits within their industry. We walk through a Porter’s “five forces” analysis of each of our ideas before they make it into the portfolio. We try to assess management’s competitive strategy. Each idea is very different; some companies have natural network effects that create huge barriers to entry, some have IP or trade secret protections, some lock-in their customers through complexity and contracts, some have locked-in superior distribution, and so on. We’re not perfect in our analysis, but we usually have a good handle on the competitive threats facing our businesses.

In the case of The New York Times, their historical advantage was real, but certainly not permanent. And this may be presumptuous, but we feel like we would have sold Polaroid long before the mass adoption of digital photography had we been investors. We have gotten it wrong in our portfolio before, and we will again. The keys for us are to get it right a lot more than we get it wrong — which in our opinion is easier with a concentrated portfolio — and to be decisive in our selling when we recognize deterioration in competitive position. I think our track record over the last nine years illustrates above-average execution in these two areas.

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

Bares: I think all investors would be well served to read Pat Dorsey’s The Little Book that Builds Wealth. I also liked Creating Shareholder Value by Alfred Rappaport.

My favorite reads are usually business biographies. I just finished Stacy Perman’s In-n-Out Burger, A Behind the Counter Look at the Fast Food Chain That Breaks All the Rules. I loved it. It shows what kind of personality, commitment, intelligence, and drive it takes to create an enduring business. I think reading like this helps us in our identification of individuals and business models with the right recipe to grow meaningfully larger.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Bares: My experience tells me that individual investors run into the most trouble...

Subscribe to Portfolio Manager's Review to read the full interview.

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Dan Loeb of Third Point recommended the following books in a speech in 2009:

• Joel Greenblatt's You Can Be a Stock Market Genius
• Edwin Lefèvre's Reminiscences of a Stock Operator
• Jim Loehr's The Power of Story
  
• Howard Schilit's Financial Shenanigans
• Kathryn Staley's The Art of Short Selling
  
• Rohinton Mistry's A Fine Balance
  

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In an interview with Portfolio Manager's Review, Guy Spier, founder of Aquamarine Capital Management, shared the following on some of his favorite books in recent years:

"I sent Alice Schroeder’s book out to a bunch of investors. I think that it is a very valuable book to read. I know that it has been controversial, but setting that aside, I think that Alice probes into aspects of Warren Buffet’s mind and psyche to reveal more of his personality with all of the foibles of the human being behind Warren Buffett.

For those of us that are big Buffett fans, that is a huge advantage. It helped me to understand why I am different than Warren Buffett. I think it is a valuable read in that regard. It helps to place his mind in the center of the decisions he has made. The book lets you look at the kind of emotional life that Buffett had growing up. I do not think his phenomenal track record could have come about without that emotional makeup.

There are three books that I have read not so long ago on complexity theory. I think that they are extremely valuable. One is by John Gribbin.  Even though I studied economics and I felt I had a good grasp of the kind of economics taught academically, I feel that the study of complexity theory as applied to the global economy is actually a much better model for understanding how the global economy evolves.

One of the books is by Benoit Mandelbrot who is famous for the Mandelbrot set. He also wrote a book about the fractal nature of financial markets. Mandelbrot is obviously a very modest guy because his fractal approach to financial markets predicts that sooner or later something like what happened over the last 18 months was going to happen. Unlike other commentators, who get in front of the TV cameras and say “I told you so,” he has not done that. He is a true scientist.

Lastly, an investor of mine gave me one of the two books by Atul Gawande who is focused on the very small things that make hospitals better. One of the books is actually called Better. The other book is called Complications. Atul Gawande gives a sense of how you can be extremely knowledgeable and totally focused on the right outcomes and still fail by a wide margin to get close to the ideal that you would like. Of course, this has massive lessons for investors.

I recently took up bridge, so I have been reading a lot of bridge books. I am looking forward to going outside Borsheim’s at the next Berkshire Hathaway meeting and playing bridge with whoever is willing to play me. I don’t think that it is a coincidence that Buffett chose to put an area to play bridge outside of Borsheim’s rather than chess or table tennis or any one of a number of other things. It is not just that Buffett likes bridge. He likes an awful lot of things. I think that he is sending a message, in his inimical way, which is not to force it down anyone’s throat. But by placing an area to play bridge right outside of Borsheim’s, Buffett is saying that bridge is more than just a great game, it is something that has really helped him, I believe, develop his mind. I think it can develop all of our minds in a way which is helpful to investing."

Read our exclusive interview with Guy Spier.

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The Manual of Ideas Interview with Guy Spier, July 2009

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Well-regarded fund manager Peter Hodson of Sprott Asset Management presented a compelling investment case for Gravity Co. (GRVY) in an interview with Canada's Business News Network on August 6th. Hodson's argument is in line with the thesis presented in a recent issue of Downside Protection Report.

Gravity is a Korean software company, developing massively multiplayer online role-playing games (MMORPG). Despite the company's recent profitability inflection point, the shares continue to trade roughly in line with net cash and investments. While the shares have appreciated considerably this year, they remain undervalued and still trade at a price that is lower than two years ago. Gravity's valuation compares favorably to public companies such as Shanda Interactive Entertainment (SNDA), Giant Interactive Group (GA), NetEase.com (NTES), Perfect World (PWRD), and The9 Limited (NCTY).

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Paul Sonkin, Columbia Business School professor and manager of the Hummingbird Value Fund, highlighted a few interesting microcap investment opportunities in an interview with StreetCapitalist.com, published on August 10th. The companies mentioned in the interview include Fortress International (FIGI), Southpeak Interactive (SOPK), and Rand Logistics (RLOG).

Most notably, Sonkin likes grand piano and band instrument maker Steinway Musical Instruments (LVB). Says Sonkin,

"You always want to look for a catalyst but sometimes there is no catalyst. So with Steinway there’s no real catalyst there. Earnings will recover and that will be the catalyst but the catalyst isn’t obvious and when it is obvious it’s too late."

Steinway was the subject of an investment profile in the June issue of Portfolio Manager's Review, which pointed out Steinway's hidden real estate value. According to PMR,

"Steinway has leading market shares in the premium piano and U.S. band instrument markets, world-class brand names, and significant “hidden” real estate holdings, including a prime Manhattan office building and property on the Queens waterfront. While demand for Steinway instruments collapsed in Q1 and is expected to remain soft, it is quite clear that the shares are a bargain. The company bought back some debt at a discount in Q1, signaling management confidence in the liquidity position."

Click here to read the Steinway Musical Instruments investment profile.

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Disclosure: No positions.

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The Fairholme Fund, Semi-Annual Report 2009 (includes Bruce Berkowitz's Commentary)

The recently released semi-annual report of The Fairholme Fund (FAIRX), a mutual fund managed by respected value investor Bruce Berkowitz, reveals some noteworthy portfolio changes during the fund's second fiscal quarter ended May 31st.

Berkowitz significantly boosted the fund's ownership of Hertz Global Holdings (HTZ) during the period, from 30.0 million shares at the end of February to 46.4 million shares at the end of May. Hertz shares rose sharply during the period, suggesting that Berkowitz was likely adding to his position at higher prices. The shares have continued their upward climb since the end of Fairholme's fiscal Q2, rising from $6.85 per share on May 29th to $10.93 as of August 7th. The rapid ascent of Hertz shares likely reflects investors' changed perception of the company's ability to service its considerable debt load, which amounted to roughly $9 billion, net of cash, at the end of June (most of the debt is used to finance Hertz's large inventory of rental vehicles). Hertz's earnings remain depressed, but analysts estimate that profitability will recover somewhat, to $0.33 per share, in 2010.

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Another significant change to Fairholme's portfolio reflects Berkowitz's aggressive selling of American Express (AXP) shares following their strong bounce off a low of $9.71 per share in March.  The Fairholme Fund had built up a position of 17.7 million American Express shares at the end of February. Berkowitz reduced that position to 5.9 million shares at the end of May. AXP shares had risen from $12.06 per share on February 27th to $24.85 on May 29th. The largest holder of American Express remains Warren Buffett's Berkshire Hathaway (BRK.A), with ownership of 13% of the payment card company.

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In addition to the above major changes, The Fairholme Fund increased its ownership of Spirit Aerosystems (SPR), Humana (HUM), The St. Joe Co. (JOE), and Sears Holdings (SHLD) during the fiscal second quarter. Meanwhile, the fund cut back on Northrop Grumman (NOC), Boeing (BA), UnitedHealth Group (UNH), WellPoint (WLP), and Forest Labs (FRX). Berkowitz sold out of Canadian Natural Resources (CNQ) and Mueller Water (MWA) in the three months ended May 31st.

Track the holdings of more than 20 superinvestors, including Bruce Berkowitz, when you subscribe to the monthly Portfolio Manager's Review. Learn more.

Disclosure: No positions.

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Financial innovation, new laws and regulations, and the financial meltdown of 2007-2008 are just a few of the forces that have shaped, and continue to shape, today's distress investment environment. Combine this with the fact that the descipline of distress investing doesn't always follow what conventional wisdom says, and you can see why it is one of the most challenging areas in finance.

Nobody understands this better than Martin Whitman--the legendary founder of Third Avenue Management LLC and a pioneer in the field of distressed markets--and leading academic Dr. Fernando Diz of Syracuse University. That's why they decided to write Distress Investing. As an outgrowth of annual distress and value investing seminars the two have taught together at Syracuse University's Martin J. Whitman School of Management, this reliable resource will help you gain a better understanding of the essential principles and techniques associated with distress investing and show you how to effectively apply them in the real world.

Martin J. Whitman is Chairman and co-CIO of Third Avenue Management LLC. He has taught courses in value investing and distressed investing for the past thirty years at the Schools of Management at both Syracuse University and Yale University. Whitman is also the author of the Wiley titles Value Investing and The Aggressive Conservative Investor.

View Distress Investing on Amazon.com.

(References: Financial Sense Newshour, Simoleon Sense)

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Marty Whitman of Third Avenue Funds is a value investing pioneer. Here are some great videos about investing.

On Graham and Dodd (and Today's Academics):

Thanks to Greenbackd for the find.

On Risk:

On Wall Street versus Main Street:

Background on Marty Whitman:

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Here are some never-before aired portions of Consuelo Mack's wide ranging May 2009 interview with Yale's renowned endowment chief, David Swensen. In this video, Swensen assesses the new investment reality and talks about where he is investing his and his family's money.

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Evillard and Whitman need no introduction. Well worth watching.

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John Rogers of Ariel and Robert Kleinschmidt of Tocqueville are value investors worth watching.

Official intro: "Meet two veteran contrarian investors with successful track records spanning a generation or more. John Rogers founded value oriented Ariel Capital Management at the tender age of 24. The first African-American owned mutual fund company is now the nation's largest black owned investment management firm. Robert Kleinschmidt has run the large-cap Tocqueville Fund since 1992. Going against the crowd has earned him and his investors market beating performance over the years and high ratings from Morningstar."

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Here's the intro by Consuelo Mack's program: "Two innovative hedge fund managers challenge conventional investment wisdom and explain why they have recently brought their hedge fund skills to the mutual fund world. MIT's Professor of Finance and portfolio manager of the ASG Global Alternatives Fund, Andrew Lo, and AQR Capital Management's Cliff Asness, portfolio manager of the recently launched AQR Diversified Arbitrage Fund discuss their investment outlook and strategies."

"Innovative" is an interesting word to use in investment management. As most Ben Graham and Warren Buffett adherents know, innovation is not necessarily a positive in the world of investing. Sticking to some tried and true principles of buying into undervalued businesses might be more advisable in the business of investing.

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Here is an interview with "bond king" Bill Gross of PIMCO. Gross's monthly commentary is always an enjoyable read. He clearly applies an interesting and knowledgeable perspective to investing. However, as Marc Faber points out, Gross's views on inflation may prove to have been too sanguine. If this ends up being the case, it won't be the first time that someone focused on one particular discipline -- in this case, bond investing -- ends up missing the signs of a once-in-a-hundred-year flood. Studying books like A History of Interest Rates is helpful, but history alone is not sufficient to predict the future. The fact that the U.S. has never seen hyperinflation doesn't mean the latter can't and won't happen. We shall see...

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Bob Rodriguez of FPA Capital is one of those under-appreciated superinvestors, a guy who has consistently and substantially outperformed the market indices -- and has done so by applying an investment approach that is understandable and makes sense. Rodriguez should be studied by all those looking to improve their investment skills.

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We generally don't pay much attention to short-term tallies of whose stocks are up or down, but Warren Buffett's success in picking investments over the past year is notable because the media has been beating up on him about "being too early" for quite some time. We recall several segments on financial television that criticized Buffett's investment in Goldman Sachs because the warrants he obtained quickly went underwater. Well, the naysayers have to move over because Buffett's long-term style has once again produced solid results in the short term, too.

Read the Bloomberg article on Buffett's recent successes.

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Interesting interview. Zell slipped in a bombshell statement that slid largely by Bartiromo: Zell expects commercial real estate to turn down in earnest in another 2-3 years if/when interest rates rise.

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Pershing- Square- Q2- Letter -

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Dan Loeb, founder of activist hedge fund Third Point, speaks at the Jewish Enrichment Center:

Thanks to Yaser Anwar for the link.

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Buffett comes on CNBC to promote a cartoon but ends up giving invaluable insight into equities, inflation and a whole host of other topics.

Posted by manualofideas at 09:24 AM | Permalink | Comments (0)

Investment Philosophy

• Quote from Homer's Odyssey: "...he sailed past the island of the Sirens, whose song draws men to their death: Odysseus* bid the crew to cover their ears, while he himself was tied to the mast, so that he might listen, yet not be seduced."
• Like Odysseus, Rational seeks to avoid the siren’s call… In our case, the cycles of fear and greed and the short term noise of the equity market

Investment Ideas: Lowe's and Home Depot

• Current opportunity should not be ignored: Rational's knowledge base has a high number of companies with significant potential for appreciation, which is reflected in the number of long positions currently in the portfolio.
  Rational's back testing analysis shows that undervaluation relative to the proprietary "fair value" is a strong indicator of future performance.
• Market's overly simplistic approach to valuation: "When we superimpose the share price of a stock and the average NTM EPS (Next Twelve Months EPS) estimates from sell-side analysts it is clear that “the market” is using an over-simplistic approach to investing –it uses an almost constant multiple over a short term forecastAlthough this is clearly a wrong approach to investing, it offers a lot of good opportunities for the rational and methodical investorOur analysis indicate that both Lowe’s and Home Depot are currently more than 50% under-valued."
• Lowe's margins should rise in the future: "The current recession –which has been focused on the housing sector –has obviously impacted LOW’s margins, but we have good reasons to believe that they will increase from the current low level."
• Rational's equivalent square footage concept: "When analyzing a retailer’s growth dynamic it is necessary to adjust calculations of sales and costs (per square foot) given the average age of the storesAt Rational we do what we call an “equivalent square footage” calculation –it shows how many “mature” square feet would be necessary to replicate the current sales levelWhen a retailer stops an accelerated growth pattern, the increase in their “square footage age” will provide a strong tail-wind for margins."
• Summary: "Lowe’s and Home Depot are probably experiencing the worst downturn on their sector they will ever face. Nevertheless, current market valuation provides a significant margin of safety for both companies even assuming (i) a small increase on real same-store-sales (we actually think that our base-case might be too pessimistic on this driver), (ii) gross-profit per equivalent square foot below long-term historicalsand (iii) room for increase in SG&A per total square foot. As both Lowe’s and Home Depot stop new store expansion, margins will increase due to a tailwind provided by the increase in average age of their stores since “equivalent square footage” (that driver gross-profit dollars) will grow faster than “total square footage” (that drives costs). According to our proprietary analysis both Lowe’s (LOW) and Home Depot (HD) are more than 50% under-valued."

Access the full presentation.

About Danilo Santiago

Mr. Danilo Santiago is a founding partner of Rational Asset Management, a long-short hedge fund, which he co-manages with Mr. Cláudio Skilnik (CBS ’02). The fund operations started in April 2008, focusing on publicly traded, liquid US equities. Rational has also firmed a partnership with Turim Investimentos, one of the biggest multi-family offices in Brazil. Rational core strength is its proprietary company analyses – differently from most funds, Rational’s knowledge base is quasi- static, which provides the fund with an extra edge when triggering a new long/short position.

Mr. Santiago has an MBA from Columbia Business School (CBS ‘01) and a bachelor degree in Electrical Engineer from the University of São Paulo (class of 1994). Before founding Rational, Mr. Santiago worked for three years on a multi-billion dollar, fundamental focused hedge fund in New York City. Prior to that Mr. Santiago spent six years at McKinsey & Co, the majority of which at the Corporate Finance Practice, also in New York City.

Disclosure: No positions.

Posted by manualofideas at 10:07 PM | Permalink | Comments (0)

Wienerberger, founded in 1819 in Vienna, Austria, is a global leader in the production of clay construction products. It is the world's largest producer of hollow bricks, Europe's largest and America's top two producer of facing bricks, Europe's second-largest producer of roof tiles, and central Europe's second-largest producer of pavers.

Click here to view the full presentation.

About Gabriele D'Agosta

Vice President in Morgan Stanley since 2001. In 1998 and 2000 worked for Goldman Sachs in London in the Private Wealth Management as brokerage and asset management. From 2000 through 2001 has worked for Lazard in London in private investor area. He has a degree in Economics from the University Bocconi in 1996 and he is a CFA since 2003.

Disclosure: No position.

Posted by manualofideas at 09:39 PM | Permalink | Comments (0)

Mr. Russo's presentation may be accessed by clicking here.

About Roberto Russo

39 YEARS OLD HAS A DEGREE IN BUSINESS AND ECONOMICS,  DIRECTOR OF PROJECT “INDEPENDENT ADVISORY” IN COFIN SIM. Portfolio Manager for Duemme Sgr. (2006-2008),  head Manager of Abaxbank  Risk Arbitrage Desk (20000-2006). Roberto has also worked as director in Caboto Sim (1999-2000), Banca Monte dei Paschi di Siena (1998-1999) and Banconapoli & Fumagalli-Soldan Sim (1994-1998). He’s an AIAF member since 1998. From 2004 he is on the Board Member of Cattolica Partecipazioni S.p.A.

Posted by manualofideas at 09:24 PM | Permalink | Comments (0)

Investment Idea: Vicat (Paris: VCT)

Company Overview

• Leader in South East France (~50% of sales) and strong regional positions in mature markets (Western Switzerland, California, South East USA) and in emerging countries (Western Africa, Egypt & Turkey)
• Vertically integrated: 2/3 cement, 1/3 aggregates / RMC
• 60% family controlled.  Free float increased from 5% to 40% in 2007
• Management strategy is to use group cash-flow to improve vertical integration, diversify from home base and increase exposure to faster growing markets

• Uses - housing, commercial construction, infrastructure, RMI
• High weight to value
• Limited substitutes
• Barriers to entry: ownership of quarries / environmental constraints; capital intensity; geographic/transport costs; control over import terminals; and vertical integration

Valuation

1. Earnings-based:
   • trades on 9x 2009E EPS and 5x 2009E EV/EBITDA --> Don thinks 2009 should represent trough in earnings cycle
   • FCF-yield on maintenance capex ~15%
   • trades at ~20% discount to peer group despite better pricing power, stronger balance sheet (net debt ~1.6x EBITDA), superior track record and higher medium term growth prospects
   • industry-average transaction multiple of 8-9x EBITDA over last 17 years --> Don thinks given family control and cyclical trough a transaction is unlikely but implied equity value ~€75 per share vs current market price of ~€40
2.  Asset-based:
   • Don estimates current replacement cost of 1M tonne cement plant at €200M in developed markets and €100M in emerging markets
   • This implies €61 per share of equity value for Vicat (assuming €1.8B of EV for Vicat's cement assets in developed markets, €1.2B in emerging markets and €0.5B EV for aggregates and ready-mix concrete)

Key Risks

• Prolonged deeper recession
• Price deflation – Don thinks this is mitigated by: industry consolidation; focus of geared players on cash generation, not market share; capacity additions delayed / cancelled; and limited risk of falling prices for Vicat due to market mix
• Antitrust enquiries
• Co2 compliance costs

How Don Differs from the Consensus View

• Consensus concern is industry-wide price deflation –> Vicat protected due to pricing power in key markets
• Consensus focus on cyclical downturn, not trough in the earnings cycle
• Don thinks next cycle’s earnings power for Vicat should be higher due to: increased earnings from capacity additions; efficiencies from industrial upgrades; and possible acquisitions at bottom of cycle

About Don Fitzgerald

Mr. Fitzgerald joined Tocqueville Finance in February 2007 as a Financial Analyst and has co-managed the Tocqueville Value Europe Fund since February 2008. He previously worked 7 years for Citigroup in Dublin, London, Frankfurt and Paris in different corporate finance roles. Subsequently, he worked as an investor in distressed debt for WestLB in Paris from 2003 to 2006. He is a CFA charterholder and graduated from Trinity College Dublin in 1996 with a degree in Business Studies and German.

Robert Vinall, founder and managing director of RV Capital, presented at the Value Investing Seminar in Molfetta, Italy today. His presentation was (ambitiously) entitled, How to Come Out of the Financial Crisis as a Winner with Certainty. Our notes from his speech follow:

Rob's Investment Checklist

1. Is the business within my circle of competence?
2. Does the business have a sustainable competitive advantage? Can come from cost leadership, network effects, brand, switching costs, licenses/permits/patents, ecosystem effect, culture
3. Is the company run by honest and talented management? Rob is big believer in being able to tell good managers from bad by using references, track record, ways of communication, a CEO's role models, own behaviour 
4. Does the company have engaged and responsible owners? integral part of research process, skeptical of open share registers where management does not have anyone to answer and owner/manager interests not aligned 
5. Is the valuation attractive? central valuation methodology is "owner earnings yield" defined by dividend yield plus growth; considers 15%+ as attractive

"Invert, Always Invert"

Invoking Charlie Munger, Rob cross-checks above by asking what kind of investment will make you come out as a loser:

• buying business you do not understand
• buying business that won't be around in 10 years
• partnering with people who promise miracles
• leveraging yourself up to the hilt
• using short term capital to buy long duration assets such as equities
• throwing common sense out of the window
• trusting your emotions 

What to Buy in Germany Now

Rob highlights three investment opportunities:

1. GrenkeLeasing (XETRA: GLJ):
   • leading provider of small ticket IT-leasing equipment (<€10k equipment value)
   • multiple moats: cost leadership, customer switching costs
   • owner-run: Mr. Grenke is founder, CEO and largest shareholder (40%)
   • attractive valuation: owner earnings yield of 15%+ (3% dividend yield plus 12%+ growth); downside protected by stock trading at close to liquidation value
   • winner from current crisis: strong double digit growth as competitors retrench
2.  Takkt (XETRA: TTK):
   • leading B2B mail order company for small business equipment (160k products ranging from sack barrows to designer lamps; ticket size <€1k)
   • multiple moats: cost leadership from scale, customer switching costs
   • high management quality
   • Haniel family (owns 70%) are engaged and responsible owners
   • attractive valuation: owner earnings yield of 15%+
3.  Beiersdorf (XETRA: BEI):
   • manufacturer of branded consumer cosmetics
   • multiple moats: cost leadership from scale, Nivea brand
   • high management quality
   • Herz family are engaged and responsible owners
   • attractive valuation: owner earnings yield of 15%+ driven by growth into new markets and categories
   • Rob thinks current undervaluation due to market's disappointment with 1Q09 results as Beiersdorf was perceived as a safe haven

About Robert Vinall

Mr. Vinall is the Founder and Managing Director of RV Capital. He is based in Zurich, Switzerland where he lives with his wife and two children. Rob is from the UK and was born in May 1973. He graduated with an honours degree from Cambridge University in 1996 and was awarded the CFA designation in 2000. He began his career in April 1997 at Goldman Sachs Asset Management where he participated in the graduate trainee program. In October 1998, he joined DG Bank which later became DZ Bank where he was a sell side analyst covering the telecoms sector. In October 2004, he moved to Switzerland to join CDL Principal Investors, a boutique consultancy where he sourced investment opportunities in public equity markets which required active ownership.

Disclosure: No positions.

Interesting Links

www.businessowner.de

Posted by manualofideas4 at 05:38 PM | Permalink | Comments (0)

Benjamin Graham's three timeless ideas for investing:

• Evaluate stocks as part-ownership in the business
• Make Mr. Market your friend by taking advantage of prices he quotes you when these prices deviate substantially from fair value
• Invest with a "margin of safety" --> build a bridge able to withstand 15,000 pounds if you're going to drive a 10,000 pound truck across it

Investment-related observations:

• Equity markets around the world show disappointing 10-year track records with major indices in US and Europe down 30-50%
• Now a good time to look for investments and review value investing toolkit
• Ciccio favors "investing with flexibility" meaning can invest in undervalued stocks, risk arbitrage, special situations, distressed securities --> all can have different risk/reward and time horizon profiles but value investing basis for investing is the same (look for situations with motivated sellers and missing buyers leading to large price dislocations)

Understand your edge when making an investment:

• Information?
• Analysis?
• Psychology?
• Time horizon?

Do a few things well when evaluating an investment:

• Understand the business
• Understand the people running the business
• Get safety from the price paid
• Concentrate on best ideas
• Discipline, rationality and patience are key

Investment Idea: Banco Popolare (Milan: BP)

• 4th largest Italian commercial bank with market share of approx. 10% in 6 regions of northern Italy 
• Network of approx. 2,200 branches
• Business model focused on retail banking
• Sound balance sheet and liquidity: loan/deposit ratio of 0.91 as of 3/31/09; funding needs covered until 2011
• Asset base is low-risk: focus on local domestic market (where no real estate bubble); merchant banking portfolio valued at market; strong diversification and strict loan provisioning
• No investments in toxic assets: no exposure to subprime mortgage sector or structured products
• Ciccio estimates intrinsic value per share of €8.5-11 (based on 10-12x normalized EPS of €0.85-0.95 assuming €1.4B of pre-tax, pre-provision earnings, €300-400M of losses, 45% tax rate and 640M shares outstanding) vs. current market price of ~€5 and tangible book value of €7 per share

About Ciccio Azzollini

Beniamino Francesco Azzollini (Ciccio) attended University of Bari and has a degree in Business and Economy. After graduating in 1997, he obtained a diploma as “Financial Analyst” at the European Association of Financial Analysts. He worked from 2001 through 2003 as Fund Manager in “Abax Bank” Milan. Since 2003 he is CEO of Cattolica Partecipazioni S.p.A,  an investment vehicle; he is also founder of the first “Value Investing Seminar” in Italy. Ciccio was born in 1974 and lives in Italy, city of Molfetta (Bari) with his wife Linda.

Disclosure: No positions.

Posted by manualofideas4 at 05:28 PM | Permalink | Comments (0)

Victor Fasciani, Managing Partner of Praetorian Value Fund, made a compelling case for Contango Oil & Gas (MCF) during his presentation at the Value Investing Seminar in Molfetta, Italy today. Our notes from his speech follow:

Praetorian Value Fund -- Investment Philosophy

• Wants to understand every detail of the business (financials, management, industry, competition) --> "leave nothing to chance"
• Thinks current market volatility and irrationality presents opportunities across all market cap segments (although traditional small/mid-cap focus)
• Diversification is not risk management

Praetorian Value Fund -- Selected Investments

Long (as of 4/30/09):

• Alliance Grain Traders (AGT.UN-V.TSX): company in commodity business without commodity-like characteristics
• American Express (AXP)
• Contango Oil & Gas (MCF)
• Cresud (CRESY)
• Gigamedia (GIGM)
• Transocean (RIG)
• Vulcan Materials (VMC)

Recent Short:

• Dollar Thrifty (DTG) - over-levered year-to-date outperformer that should come crashing down

Investment Idea: Contango Oil & Gas (MCF)

• Company focuses on highest ROI part of the value chain: exploration
• Founded by CEO Ken Peak in 1999 with $30M of capital (at $43/share current market cap approx. $670M with stable share count since 2001)
• Buffet-like company philosophy: give smart people capital, give them large incentives for doing well, and then let them do their thing
• Leanest operation in the Gulf of Mexico: 7 employees in small Houston office (everything except planning and idea generation is outsourced)
• Underfollowed by sell-side: no analyst coverage
• Robust balance sheet: no long-term debt
• Motivated and incentivized management: CEO owns 20% of company

Compelling valuation:

• $1.3B or $78/share intrinsic value of proved reserves only (based on net present value of after-tax income assuming $7 per Mmbtu natural gas price and $70 per barrel of oil)
• Reserves in place for last ~50 million years and not going away
• Other assets and free options add up to an additional $30-40/share (MCF bought more than 70 lease blocks in the Gulf at $35M cost basis; Victor thinks this is worth $100M today because of seismic data and the company's successful drill track record of 67%)

Catalysts:

• Continue drilling in the Gulf potentially converting probable into proved reserves
• Company was for sale in summer 2008 - received offers in the $70-80 range but CEO would not sell as these prices viewed as fire-sale
• Assets remain in play and CEO is 65 years of age
• Company has $100M stock buyback in place

Reasons for mispricing:  

• Natural gas stocks trade partly based on spot or front-month natural gas futures price movements --> as 12 month forward curve significantly higher than spot prices (around $5.50 vs. $3.50 per Mmbtu) market seems to ignore the implied increase in prices  
• Market won't pay for optionality value of assets in oil & gas, especially in current environment 
• Market doesn't give enough credit to good management teams in this industry

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Why Natural Gas Stocks Present Opportunities

• Assets can be easily converted into cash and non-perishable inventory
• Currently reserves are cheaper on Wall Street (--> M&A) than in the ground
• Ratio of oil to natural gas prices at 16:1 currently vs. 10:1 historically --> Victor convinced of reversion to mean and thinks this will happen by natural gas prices rising from their recent lows in the $3.50 range (thinks long term floor  for natural gas prices is around $6 for companies to achieve 10% ROE --> if prices fall below that for long, higher cost onshore wells are shut reducing supply and eventually leading to higher prices again, as happened in fall of 2006)

About Victor Fasciani

Mr. Fasciani is the Managing Partner of Praetorian Value Fund. Praetorian Value Fund utilizes a bottom-up, research driven value approach focusing much attention on small- and mid-cap value opportunties.  Mr. Fasciani was a Senior Analyst and Co-Portfolio Manager with Sellers Capital from 2007 through 2009.

Posted by manualofideas4 at 05:13 PM | Permalink | Comments (0)

Josh Tarasoff, General Partner of Greenlea Lane Capital Partners, gave a presentation at the Value Investing Seminar yesterday. Tarasoff described his partnership's investment framework and made the case for Ambassadors Group (EPAX), his fund's largest investment. Our notes from his speech follow:

Investment Framework

• Runs concentrated portfolio (top 5 positions represent 66% of total fund capital)
• Before investing in a business, asks himself if he would be comfortable if the position was his only asset and he could never sell it (ie the only money he would made is the cash taken out of the business) 
• Employs investment checklist with the following criteria: (1) minimal risk of product obsolescence; (2) minimal financial leverage; (3) high return on incremental capital; (4) strong, sustainable competitive position; (5) pricing power; (6) potential for long-term unit growth; (7) demonstrated propensity to return capital to shareholders; and (8) management economically aligned with shareholders.

Investment Idea: Ambassadors Group (EPAX)

• Represents ~20% of Greenlea Lane's equity capital --> single biggest position
• EPAX is an educational student travel company (activities incude home stays, community service, meetings with political figures, general tourism)
• ~90% of revenue represented by international programs travel to >50 countries
• 2008 geographic breakdown: 60% Europe, 17% Asia, 16% South Pacific, 6% Other
• Risks include worsening economy, operational missteps, terrorism, war and health concerns; also possibility that recent enrollment declines symptomatic of long-term headwinds
• Potential catalyst is Q3 earnings release; Josh thinks there is good chance that enrollments will show Y/Y growth based on pent-up demand (due to deferral of trips last year when marketing season coincided with sudden and sharp deterioration in economic environment and consumer confidence) and operational improvements undertaken during past year

First key question: Is it a good business?

• Unique, non-replicable brand franchise based on a relationship with a non-profit organization called People to People International (PTPI); one of the core activities of PTPI is The Ambassadors Program which has been outsourced to EPAX since 1983 (this exclusive relationship runs through 2020 on current terms); EPAX is also academically accredited (90% of participants receive high school credit, 10% of participants receive college credit) 
• Pricing power ($6,300 average price of international programs in 2008 - no competing programs command comparable prices) 
• High ROIC (little tangible capital needed; only $30M of fixed assets on BS) and minimal need to put up capital as the business grows
• Large unit growth potential (29M 11-19 year-olds in the US of which EPAX estimates >20M have financial means to travel; in contrast 2009E enrollments are 35k; marketing domestic programs to students abroad is an untapped market)

Second key question: Why is it cheap?

• Operational trends are negative (critical enrollment season in July-October negatively affected by use of faulty maling list in 2007 and sudden deterioration in consumer confidence in 2008  (led to -20% Y/Y enrollment decline in 2008 and estimated 17% decline in 2009 after 1997-2007 revenue CAGR of 20%)
• Premium, discretionary product which is currently out of favor

Third key question: What is it worth?

• Student acquisition cost, defined as marketing expenditures/ number of enrollments, a key metric to gauge potential value
• Thinks average SAC of $1,045 in 2008-09E should return to its 2003-07 average of ~$620 because causes of recent increase are temporary (faulty purchased list name in 2007, recession will end)
• SAC of ~$620 drives FCF/share of $2.38 (5x EV/FCF), whereas SAC of $850 (average of historical and recent) would imply FCF/share of $1.34 (10x EV/FCF); estimated 2009 SAC of $1,167 implies FCF/share of $0.80 (16x EV/FCF)
• Expects 15-20% FCF growth over next 10 years (would be similar to performance over last 10 years) and on this basis believes a private buyer with long time horizon would earn very attractive returns buying EPAX at 20x FCF today
• Depending on above SAC assumptions, 20x FCF/share of $0.80, $1.34 and $2.38, implies per share fair value of $17, $28 and $49, respectively, vs. current share price of $14

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About Josh Tarasoff

Mr. Tarasoff is the General Partner of Greenlea Lane Capital Partners, LP, a private investment partnership he founded in 2006. Josh graduated from Duke University in 2001, with a degree in philosophy. He has worked at Goldman, Sachs & Co. and has an MBA from Columbia Business School.

Posted by manualofideas4 at 04:27 AM | Permalink | Comments (0)

Alvaro Guzman dé Lazaro Mateos, fund manager at Bestinver, gave a presentation at the Value Investing Seminar in Italy today. Our notes from his speech follow:

Bestinver Investment Philosophy

• Seeks profitability in absolute terms and not in relation to benchmark indices.
• Considers risk in absolute terms, defining it as the possibility of losing the money invested and not in terms of volatility or deviation with respect to a particular benchmark index.
• Are asset managers, not asset gatherers.
• Invest in companies that are trading at a reasonable discount to their true economic value.
• Patience. Are in it for the long term and like what they do so are prepared to wait (Most of alpha due to patience).
• Daily goal is to increase the portfolio’s potential, swapping companies with less upside for others with more, factoring in the time needed to analyse the company (in contrast to the UStax regime, in Europe mutual funds are taxed on capital gains at just 1%, making divestments less inefficient).
• Have a very high effective turnover but quite low turnover by name. For example, since the starting of the current drop have seen a 120% effective turnover with only one new company in the global portfolio.
• Management vision aligned with Austrian School of Economics, with its deep understanding of human actions and its implications in business cycles, people behaviour, market structures, etc.

Investment Idea #1: Fuchs Petrolub - A High Grower in a Non-Growing Market?

• At €39/share, market cap is €923M
• Valuation: Normalised FCF of €135M --> trading at 6.8x FCF. Worth €90/share
• Description of business: #1 independent lubricant manufacturer worldwide. Fuch’s lubricants are used in a variety of end markets (metallworking fluids, mining specialties, corrosion preventives, car manufacturers, etc..). Sells over 10K products to around 100K clients. 70% of revenues generated from a direct sales force in over 100 countries. Products mainly manufactured where sold (50 plants worldwide).
• Market Structure: Market volume in 1990: 40mn Tonnes; 2007: 39mn T. The “big boys” (14 integrated oil majors) hold 60% of the market in volumes, the rest spread out among 700 players (1300 players 5 years ago).
• Historical Performance: CAGR in sales, EBITDA, EBIT 01-08 of 6%, 12% and 16% respectively. Never a year of losses in its 75-year history. Key to sales growth is Fuch’s expertise in application engineering (sales people are Engineers with MBA) and a focus on specialties. Systematic emphasis on organic growth with smaller add-on acquisitions. Key to profitability is bargaining power with clients/specialties focus
• Management: Third generation of the Fuchs family. Honest, candid, able people. Extremely sound incentive system in place. Focused on the business vs “selling the story”.

Why is Fuchs Undervalued?

• Under-researched.
• Misunderstood. It has ability to pass on base-oils price rises and keep a lot when they decline (EBIT margin 6% in 2001, 14% in 2007). The product is essential, and attempts to save on it politically risky for clients. Over-emphasized “Auto” exposure.
• The 2008-09 “Tsunami” has had an effect on Fuchs: 1Q09 sales down 20%, EBITDA down 40% and very little visibility.
• Bestinver xpects volumes will recover and Fuchs will keep expanding market share. Earnings will recover  sooner rather than later.
• Business is NOT capital intensive. ROCEs have averaged 20% over the last 9 years. Net debt<0,5x EBITDA. R&D is expensed and amounts to 2% sales.
• No strategic issues, it is a competitive market. Fuchs’ clients somewhat captive. Fuchs has among the biggest R&D budgets in absolute terms that gets “diluted” over the largest specialties volume. Its management has a culture of austerity one can smell at all parts of the organization.
• Bestinver values Fuchs at 15x its stable FCF earning power of 135mn. This implies 8.7x EV/EBITDA, in line with PMV deals involving structurally LESS profitable competitors. The family owns 25% of the shares and has cancelled 10% of its stock through buybacks over the last 3 years.

Investment Idea #2: Esprinet - True Competitive Advantage + Turned-Around Operation at 5x FCF?

• At €6.6/share, market cap is €337M
• Valuation: Normalised FCF €50M. Worth €16/share.
• Description of business: Italian leader in IT distribution with 3x the market share of the next competitor. The best margins of the European peer group (Also, Actebis, Ingram, Tech Data). A classic example of “regional economies of scale”.
• Why the market share differential? Optimal logistics and an internet focus has allowed Esprinet to carry a big number of references and a big service ratio at competitive prices. Profited big time from 02-03 crisis.
• Why the margin differential? Better purchasing terms with vendors, better working capital management, more efficient SG&A.
• Why a true sustainable competitive advantage? Very difficult-to-replicate logistic set-up, economies of scale, switching costs for clients.
• Spanish expansion: Expanded into Spain by buying 2 companies at peak of the cycle. Had several operating problems: '06 EBIT was €23M and '08 EBIT a NEGATIVE €8M. Today the operation has recovered service levels, enjoys the highest market share, and is streamlined after massive restructuring. Bestinver only relies on HALF the historic EBIT levels as remain pessimistic on Spain.

Why is Esprinet undervalued?

• Market correctly penalized Esprinet as the first profit warnings from Spain started to be released. The base for the share price fall was a 17x near-term FCF multiple= the stock got crucified and fell from €17 to €2 in less than 2 years. Management lost credibility, but in Bestinver's view they’re only liable from not “timing” Spain.
• Italian operation kept outperforming and now faces a GREAT consolidation opportunity AGAIN as it did in the previous crisis.
• As badly-timed as the Spanish purchase was, they are now outperfoming the market significantly and reported “black EBIT” again in Spain in 1Q09. Plus they’ve learned many lessons about what capital allocation means!
• Market has partly recognized the improvements, but still, the Italian operation is worth €12-13 per share or 2x current price. Spain is a free option. Balance sheet is debt-free.
• Business has a ROCE close to 30%. Management is excellent as an operator, and capital allocation wise.
• Stable shareholder base and management also a shareholder with a SIGNIFICANT personal stake.
• Business + people + a very good price = a safe good, undervalued business.

About Bestinver

• Incorporated in 1987
• Shareholder structure: 100%-owned by Acciona
• Investment decision-making independent of Acciona
• Focused on returns nor volumes under management
• Spain´s leading independent fund manager
• €3,1Bn and 30,000 customers
• Investment philosophy based on “Value Investing”
• 90% of managed assets are in equities
• Largest Spanish equities fund (Bestinver Bolsa)

About Alvaro Guzman dé Lazaro Mateos

Born in 1975, Mr. Guzman dé Lazaro Mateos began his career in 1994 as an auditor for Arthur Andersen in Madrid. He continued his career at Bankers Trust in Paris, where he eventually headed the Middle Office at the early age of 21. In 1997 he started as a stock market analyst at a Frankfurt fund management company (Value Management) founded by a former employee of the legendary Peter Lynch. Subsequently, he returned to Spain, where he worked as a financial analyst at Spanish broker Beta Capital and later Banesto Bolsa. In 2003, he joined Bestinver to work with Francisco García Paramés, with whom he had frequently exchanged investment ideas since 1998, given their common liking for the "value school of investing". Alvaro speaks Spanish, French, English and German.

Disclosure: No positions.

Posted by manualofideas4 at 03:46 PM | Permalink | Comments (1)

Noted value investor Guy Spier, CEO of Aquamarine Capital, gave a presentation at the Value Investing Seminar in Italy today, entitled Navigating Between Fear & Gread Using Checklists. Our first-hand notes from his speech follow:

Importance of Neurology in Investing

• Human brain has different parts, each leading to different behavioral responses when engaged, eg the neocortex elicits a rational response whereas the "reptilian" part of the brain responds to greed and fear
• Great investors (Soros, Buffett, Klarman etc) are "wired" to engage the necortex while  others are susceptible to enaging the reptilian brain when faced with the same situation
• Value investing is the art of using the neocortex
• Studies have shown that when thinking about making money, for most people the same part of the brain responds as when thinking about gambling, drugs, sex
• A lot of very smart investors lose money because they lose discipline and become guided by their reptilian brain (eg Isaac Newton's losses in the South See bubble in early 18th century)

Examples of Companies "Targeting" the Reptilian Brain

Below examples are all about companies/management who have figured out different ways to tap into our reptilian brain ranging from nearly criminal to very subtle.

• Interactive Services Worldwide (delisted): serial promotions and spreading of hype through frequent press releases about partnership deals (eg with Sportingbet) that are not value-creating upon closer evaluation  
• EVCI Career Colleges (delisted): Management manipulated enrollments and published information that portrayed the performance of the business better than it actually was 
• DeVry (DV): Reputable management but was overconfident about operating performance of the business and communicated to investors rosy forecasts for enrollments based on hope, not actual underlying facts
• American Express (AXP): Reputable company and management, but again company communication about estimated write-offs in lending business too optimistic
  

• Investors' intellectual understanding of the fallacies of the reptilian brain is not sufficient --> a behavioral change is required!
• Examples of behavioral change from the non-investing world: 1) Losing wallet in NYC taxi: Train yourself to stop and look before exiting taxi; 2) Infections in hospitals: Include regular washing hands after each patient contact as a routine; 3) Airline pilots: Creation of to-do checklist in emergency situations
• Use checklists in investing to help brake reptilian brain responses to specific situations: For example, ask yourself what type of data am I looking at: data that can be manipulated by humans (eg loan write-offs) or facts (eg meat consumption in rich versus poor countries)
• Checklists will help in situations susceptible to a response driven by greed and fear (usually stirred up by media)     

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Signal Value Ranking: Warren Buffett's Berkshire Hathaway

Every three months upon release of 13F-HR filings, Portfolio Manager's Review updates and reviews the best ideas of more than 20 top investment managers:
• William Ackman, Pershing Square
• Zeke Ashton, Centaur
• Bruce Berkowitz, Fairholme
• Warren Buffett, Berkshire Hathaway
• Ian Cumming & Joe Steinberg, Leucadia
• David Einhorn, Greenlight
• Glenn Greenberg, Chieftain
• Brian Gaines, Springhouse
• Tom Gayner, Markel Gayner
• Mason Hawkins, Southeastern
• Chris Hohn, Children’s Investment Fund
• Carl Icahn, Icahn
• Seth Klarman, Baupost
• Eddie Lampert, RBS (ESL)
• Dan Loeb, Third Point
• Steve Mandel, Lone Pine
• Mohnish Pabrai, Pabrai Funds
• Rich Pzena, Pzena Investment
• Kenneth Shubin Stein, Spencer
• Prem Watsa, Fairfax
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By Ravi Nagarajan

In a CNBC interview today, Berkshire Hathaway Chairman and CEO Warren Buffett stated that the economy is not “moving yet” and that “green shoots” were not yet visible.  Mr. Buffett joked that he was hoping the cataract operation on his left eye last month would help him see “green shoots” but he has not seen many hopeful indicators of economic growth.

Mr. Buffett’s comments on the economy are well worth considering carefully and not only because of his investment track record.  Through Berkshire’s ownership of a diverse portfolio of operating companies, Mr. Buffett receives a broad array of reports that shed light on numerous important industries.  This is particularly true for areas such as homebuilding given Berkshire’s exposure to building materials.  In addition, reports from HomeServices of America, the second largest full service real estate brokerage in the United States, certainly provide a great deal of insight into the troubled real estate sector.

Other notable comments included statements of general support for the actions of the Treasury and Federal Reserve.  In particular, Mr. Buffett appeared to endorse the reappointment of Federal Reserve Chairman Ben Bernanke.  Mr. Bernanke’s term expires early next year.

Also, in a comment that I completely agree with, Mr. Buffett was critical of Apple’s decision to not disclose the extent of Steve Jobs’ health problems and recent surgery:

“If I have any serious illness, or something coming up of an important nature, an operation or anything like that, I think the thing to do is just tell the American, the Berkshire shareholders about it. I work for ‘em. Some people might think I’m important to the company. Certainly Steve Jobs is important to Apple. So it’s a material fact. Whether he is facing serious surgery or not is a material fact. Whether I’m facing serious surgery is a material fact. Whether (General Electric CEO) Jeff Immelt is, I mean, so I think that’s important.”

Here is the CNBC Video of the interview:

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

When Bruce Berkowitz of The Fairholme Fund has something to say, investors are well served to listen carefully.  I was particularly interested in his comments regarding health care given the reform proposals that are currently under discussion.  Berkowitz makes a strong case regarding the prospects for continued prosperity among many existing players in the industry.

Berkowitz is also bullish on defense related investments.  I found his views particularly interesting as a contrast to a recent article in Barrons regarding the sector.

The video is provided by Morningstar.

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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. A week or so ago, we conducted an exclusive interview with Zeke, and it’s our pleasure to bring it to you here.

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.

The above interview appeared in the May issue of Portfolio Manager's Review.

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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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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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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...

Subscribe to Portfolio Manager's Review to read the full interview.

If you are already a subscriber, no action is required -- you will receive an email alert as soon as the upcoming issue of PMR becomes available.

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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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Download the video in WMV format.

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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.")
  

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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
  

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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.)

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

Watch video of Bill Ackman presenting his ideas on Target.

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