Safe and Cheap

Washington Post

2010-08-17T20:06:00.000-07:00

Warren Buffet accumulated a position in the Washington Post Company in the early 1970’s and his influence on the management style, compensation policies and accounting is apparent. The Washington Post Company (NYSE: WPO) is a conglomerate with assets in education, cable, broadcasting and publishing businesses. The Company, under the leadership of Katherine Graham went public in 1971, primarily with publishing and broadcasting assets. In the 1980’s the company diversified and entered the education and cable businesses, which have grown and become a major part of the Company under the leadership of Donald Graham, who became CEO of the Company in 1991. Today, the education assets account for a majority of WPO's profitability. These assets are at a very high risk because of the increasing default rates.

Kaplan Higher Education
Kaplan was founded by the legendary Stanley Kaplan, and bought by the Washington Post Company in 1984 for $45 million. Kaplan was primarily engaged in the test prep business but over the years it has entered and prospered in the for-profit education business. The higher education division, which is the biggest, now accounts for 38% of Washington Post’s revenues and 62% of its operating income. The company invested heavily in this business during the late 1990’s and finally turned a profit in 2002. On average, the division, organically and through acquisitions, has since, grown revenues at 25%, and importantly, increased operating margins.

The Good
Kaplan’s Higher Education division within the for-profit sector exists to serve the market demand to educate individuals who the traditional schools have failed to satisfy. As the US economy transitions more and more into a service economy, and new employment opportunities require post-secondary schooling, higher education becomes essential for an individual to maintain their living standards. Kaplan and others provide individuals with the convenience of continuing with their present occupation while pursuing further education to enhance their credentials. The option to take courses online has further lit a fire under the growth engine and accelerated Kaplan’s growth. Their success is evident from the increase in market share of for-profit institutions, measured by degrees granted, which has gone from 2.3% in 1997 to nearly 6% in 2006 and rising. Furthermore, enrollments have grown exponentially in 2009 due to unemployment and, consequently, an increased interest in higher education. The growth in revenues in this division has mostly come from: (a) growing enrollments, and (b) tuition increases.

Kaplan Higher Education, through Kaplan University, Kaplan Colleges and Kaplan Career Institute operates in a fragmented industry with many competitors. Kaplan itself has few, if any, competitive advantages, but the industry as a whole is experiencing tailwinds due to pent up demand from the non-traditional student and the convenience of online education. Kaplan and others, however, have a few distinct advantages over traditional schools.

• First, their marketing prowess is unmatched. They advertise extensively. Non-traditional students are often not aware of the student aid available and consequently, are not sure if they can enroll in higher education. Kaplan admissions counselors help students with the paperwork and make the process effortless.
• Second, traditional schools do not have an extensive online offering, while Kaplan has a very advanced online education portal. Online education makes it very convenient for a student to obtain a degree as students can study and attend classes when they want and where they want. Importantly, it takes a lot of time and capital to develop and offer comprehensive, trusted, high quality online curriculum.
• Third, they are more responsive in academic program changes - their program offerings change as market conditions change. The bureaucracy and the public nature of most traditional schools cannot match the agile nature of for-profits.
• Fourth, because Kaplan is geared towards non-traditional students, they understand their customers and their special requirements. If students require extra help in the beginning or added counseling, it will be provided.
• Fifth, although the costs of an online school are comparable to an out of state public school, there can be many cost-saving advantages to attending an online school. With an online education there are no room and board expenses, travel expenses or other ancillary expenses

Kaplan competitively differentiates itself with: (a) a trusted brand name (which is due to test prep), (b) extensive offering, which is illustrated by its ranking as 4th among online universities in the number of degrees offered, (c) quality, where it is ranked in the top 10 among online for-profit universities by various sources, and (d) regional accreditation, which is superior to national accreditation as credits are transferable. Furthermore, Kaplan can and does raise tuition rates along with the budget constrained public schools, which have to raise rates to remain feasible. Psychologically, an expensive education is considered superior and this also helps Kaplan raise rates, but the rates will have to remain competitive with public institutions.

The Bad
The for-profit higher education industry, in which Kaplan Higher Education operates, has little to no barriers to entry. Accreditation, while difficult to obtain organically, can be bought, as evidenced by the sale of Waldorf College in May 2009. It is today a segregated industry. There are many other struggling colleges in the US which, as they capitulate, can be bought to expand or obtain accreditation by for-profits. In addition, the non-profit public and private universities are entering the online education market. Arizona State University (ASU), for example, has lenient admission standards and an extensive offering of online courses; the degree obtained by the online students is not distinguished from students who attend the brick and mortar school. Long term, as more and more traditional schools enter the fray the only students who attend non-profits will be the ones who are unable to get into a traditional school. Then given the admissions standards, how does a degree from Kaplan university fare compared to a degree from an online traditional school? Comparatively, what is the customer’s ROI on education? After talking to two admissions advisors from Kaplan, and after repeated attempts, I could not get any information on placement rates. Kaplan tuition rates are already at the high end of a public out-of-state college rates. Having said that, public schools, being public, will be slow to respond, will probably not be adept at dealing with non-traditional students, and will probably take a long time to widely enter the online education market. Moreover, there will always be a sect of students, those moving up in a small company for example, who will benefit from an education provided by for-profits. So, although there is a place for for-profit institutions, but long term, it is not a place that harbors 25% growth and 15% margins. For-profit institutions in this environment will only prosper based on the quality of their curriculum, placement rates and marketing. They will nevertheless, retain their distinct advantages in vocational programs. However, Kaplan’s presence is mostly in the non-vocational degree programs.

In addition to the increased competition from public and for-profits alike, Kaplan had a weighted average retention rate of less than 70% and a weight average graduation rate of 42% in 2007. This means that in order to just maintain the revenue levels these students have to be replaced, while even more students need to be added to grow. The story is similar among other non-profit institutions. Although the non-traditional student demographic is large, it is still finite. One has to question the long term sustainability of this business model.

And The Ugly
Kaplan and most other for-profit universities exist on the back of government funding. In 2008, Kaplan University derived 85% of its receipts from the Title IV programs. An institution with revenues exceeding 90% for a single fiscal year is subject to enforcement, which leads to ineligibility in participating in Title IV funding. Kaplan has hired additional personnel to manage these risks, and I believe it is a risk they can manage as they can filter students with a very high proportion of Title IV funding.

Also, during 2008, funds received under the Title IV programs accounted for approximately $904 million, or approximately 71%, of total Kaplan Higher Education revenues, and 39% of Kaplan, Inc. revenues. The business overwhelmingly depends on Title IV funding. Starting in 2009, in order to remain eligible for Title IV funding Kaplan has to maintain 3 year cohort default rates (CDR) below 30% (increased from 25% and 2 year) for three consecutive and below 40% for one year. Below is a table presenting the cohort default rate for various Kaplan institutions in 2007.

Name City Retention
Rate (FT) Graduation Rate Enrollment 2 Year Default Rate Trial 3 Year Default Rate
Kaplan University Davenport 66.0 35.0 53,212 13.3 23.2%
Kaplan College Phoenix 77.0 49.0 587 18.0 25.7%
Kaplan College Stockton 97.0 67.0 1,043 14.4 27.5%
Kaplan College Hollywood 92.0 85.0 1,328 17.0 12.2%
Kaplan College San Diego 89.0 74.0 2,239 8.1 15.3%
Kaplan College Salida 86.0 66.0 1,364 14.8 27.7%
Kaplan College Sacramento 79.0 52.0 861 18.8 33.5%
Kaplan College Vista 92.0 69.0 1,686 13.2 23.1%
Kaplan College Panorama 94.0 74.0 520 17.6 28.7%
Kaplan College Merrillville 57.0 20.0 676 17.3 28.6%
Kaplan College Indianapolis 75.0 60.0 1,702 12.5 22.1%
Kaplan College Las Vegas 69.0 48.0 832 21.2 31.5%
Kaplan College Columbus 61.0 30.0 931 22.8 32.8%
Kaplan C. Institute Boston 37.0 68.0 792 15.3 31.6%
Kaplan C. Institute Brooklyn 65.0 65.0 1,105 16.8 37.7%
Kaplan C. Institute Harrisburg 73.0 58.0 916 20.4 35.3%
Kaplan C. Institute Harrisburg 73.0 59.0 916 20.4 35.3%
Kaplan C. Institute Pittsburgh 86.0 34.0 1,827 21.9 37.9%
Kaplan C. Institute Nashville 57.0 47.0 616 7.9 22.2%
Kaplan C. Institute San Antonio 68.0 67.0 1,986 16.4 29.8%
Source: Department of Education and NCES

As we can see from the above, the 3 year CDR’s for some of the institutions are already higher than 30% and many are very close to the 30% mark. Please note that these statistics are from 2007. Here is a table showing the trend in Kaplan CDR’s:

Kaplan University 2 year CDR
Fiscal Year 2005 2,006 2,007
Default rate 5.90% 9.20% 13.30%
Source: NCES

The trend, in this case, is clearly not favorable. With increasing unemployment and general economic malaise, I would expect the CDR’s for 2008 and 2009 to be much higher. Kaplan is in serious risk of losing its Title IV funding under the new rules. Kaplan will have to change its enrolment strategies in the immediate term to recruit students at a lower risk of default. This again shows that growth will (should) taper, there are no signs however, that it is. Moreover, there is only so much Kaplan can do to stem the rise of CDR’s, Kaplan cannot, for example, control the macroeconomic environment. The Department of Education will not impose sanctions based on rates calculated under this new methodology until three consecutive years of rates have been calculated, which is expected to occur in 2014. Furthermore, the company is facing three separate lawsuits related to Title IV funding.

Although the company has a prudent board and an intelligent management, the rise in the rate of CDR’s cannot be ignored. It is quite ironic that such discrepancies occurred under such conservative leadership. Make no mistake, the cable assets in Cable One and Kaplan test prep are very profitable divisions, but when the higher education business accounts for 68% of the operating profit, and is at such high risk, one has to be careful.

Disclosure: No Position

The world according to Seth Klarman

2010-05-19T11:14:00.000-07:00

Mr. Klarman runs Baupost Group, a Boston-based investment firm with about $22 billion under management. He doesn't share his market insights that often, so when he does it's worth listening. Tuesday morning he spoke at a conference for financial industry professionals at the CFA Institute in Boston.In particular, he is looking at the deluge of government interventions to prop up the financial system in the past couple of years and what those may mean down the road. And he is talking about the danger–not a certainty, merely a danger–that governments around the world will trash their currencies in a continuous free-for-all of "handouts and no taxes." The near-$1 trillion bailout in Europe is just the latest worry.

Anyone rushing to throw more money into shares or high-yield bonds today should think twice. And anyone with a lot invested, especially if they are risk averse, might want to think about taking some chips off the table. Mr. Klarman warns that asset prices have risen too far, too fast, and returns from these levels may be poor. "Given the recent run-up, I would worry that we will have another 10 to 12 years of zero or nearly zero returns," he said. His firm is holding a remarkable 30% of its assets in cash.On high-yield bonds, Mr. Klarman's group found terrific bargains during the financial crisis but that window has long since closed. "The rally's been indiscriminate," he said. "On the credit side it's been overblown. Things are now being priced for almost perfection."

Most investors, Mr. Klarman warns, have rushed to embrace risk again as if the financial crisis never happened. "The lessons haven't been learned," he said. "People are back drinking the Kool-Aid again. It's very troubling." By keeping interest rates low and juicing stock markets with liquidity, the government is basically pushing people to speculate, he said. If there were another serious collapse, he said, many investors would be caught out–again.On the macroeconomic outlook, Mr. Klarman is remarkably gloomy–even by the usual standards of conservative value managers. "I'm more worried about the world, broadly, than I have ever been in my career," he says. Governments are spending, borrowing and printing money far too freely. Whereas the Great Depression generation learned to live within their means, the Great Recession generation is taking the easy way out, he says. The Greek bailout is just the latest example.

Inflation looks like the easy way out. "It's not clear that any currency is all that trustworthy," he says. "I worry about paper currencies."He goes further, mistrusting some official data and actions. "We don't know the extent to which we have been manipulated," he says. He believes the official figures–particularly on inflation–are suspect. "We are being lied to."Such sentiments have led to a stampede for gold, of course. But Mr. Klarman repeated cautions he has made before about investing in all commodities, including gold: They generate no cashflow, and so they are extraordinarily tricky to value. Gold has also just hit new highs, he added. That should make value investors–who tend to look for assets that are on sale–very nervous.

Instead, to insure his clients' portfolio against the dangers of runaway inflation he has been using complex derivatives. Baupost, says Mr. Klarman, has been buying "out of the money" put options on long-term government bonds. These are bets that long-term interest rates will eventually rise sharply. Mr. Klarman says he is using the put options to buy cheap insurance in case long-term interest rates go into double-digits. These puts, Klarman said he viewed as "cheap insurance," will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.

He said his firm is finding some bargains in the distressed area of commercial real estate. But he warned these were just in the private market: Publicly traded Real Estate Investment Trusts that invest in commercial real estate have mostly risen too far for his tastes, and offer poor value. "We are highly opportunistic," he says. "I will be buying what other people are selling. I will be buying what is loathed and despised." That today would be Europe, Oil and Gas Services, Large Caps..

Introducing India

2010-02-06T17:48:00.000-08:00

I was on a relatively long vacation in India, and although it was supposed to be strictly a vacation, I couldn't help but observe a few things. Now I was not present when the US was growing post WWII, but it seems that it would have been very similar to India's growth at present. In all the talk about China, although justified, India gets ignored. It is much smaller than China but I believe it has a few characteristics that make it very interesting, especially for the enterprising value investor. There are restrictions at present for non nationals, but in time, they will probably be eased.

The private sector in India is growing at a very crisp pace. The problem is that the public sector is not keeping pace. By public sector I mean infrastructure and bureaucracy. Infrasturcture here refers particularity to the roads, rail and electricity; and bureaucracy the slow judicial system, well, thinking about it - all public offices. Indian economy is growing at a 7-8% clip, but the productivity is low, comparatively, because of these issues. When and if the infrastructure is built, the productivity will receive another boost resulting in further growth (think turbo kicking in). Needless to say, corruption also plays a big part in hampering growth and there are no easy solution in sight. Importantly, India has a lot of people! A large number of people coupled with growth means increasing incomes. While this presents a huge social problem, it is good for business. Along with growth, think scale, which leads to increasing margins.

Now, in my opinion, the way a value investor (assuming he/she can invest) benefits, because being an emerging economy, the markets are volatile - something an enterprising value investor can take advantage of! There are many firms which are extensions of international corporations. Nestle India, Novartis India, Crisil (the leading bond rating agency half owned by S&P) would be some examples. Then there are others family majority owned firms where one can invest alongside the controlling family (Tata, Bajaj, Mahindra). These firms, in my opinion, will generally take out many cliche concerns of investing in a 'emerging' economy. I do not pretend to be an expert on India and am learning. The purpose of this post is to introduce India and present some links which I've found useful.

The Economic Times - The prominent business newspaper in India (in English).
Fundoo Professor - A blog by Sanjay Bakshi, who teaches behavioral finance and operates a fund in India.
Parag Parikh Financial Advisory - An advisory firm with a blog. Contains many research reports on Indian corporations.
A Collection of Value Investing blogs in India - ...

If you have something to add, please feel free to leave a comment..

Decision Making: Process vs. Outcome

2009-10-12T12:43:00.000-07:00

The Safe and Cheap blog was meant not only to be an exercise in Value Investing, but also, and importantly, a journey towards better Decision Making. Although I've often found that the worlds of value investing and good decision making are intertwined, I reckon a separate post on the importance of 'process' is warranted.

The essence of this post is this - Bad process will inevitably produce bad long term outcomes, they might however, produce good short time outcomes. On the other hand a good process, if efficiently executed, will naturally, over time, lead to good long term outcomes. I would like to emphasize long term here as even a good process will unavoidably lead to bouts of bad short term outcomes. It is important to note that, bad short-term outcomes do not necessarily imply a bad process, but the importance of luck in success.

Consider the game of golf (which I love, no..hate, nah..love), which highlights the importance of process than no other. In order to execute a good shot, it is important that you, (a) have a decent swing (backswing, downswing and follow through), (b) a proper grip, (c) a good stance, (d) focus, and importantly, (e) keep your eyes on the ball. Having said that, there might be times when you don't do any of these and hit a good shot, but make no mistake, you will not be able to hit anything close to a 72 when you play a round. This is because over time, this bad process will catch up to you and produce a bad overall, long term (over 18 holes) outcome. A good process however, might lead to a bad shot or two; (1) perhaps because you took your eyes off the ball - a mistake in execution, and/or (2) because wind suddenly starts blowing and herals your ball to a tree (I am sure golf enthusiasts will understand) - the cause usually is a known unknown or an unknown unknown. But overall, you have the chance of hitting a good long term score. The same analysis can be applied to most sports. In professional sports , skill is also a big factor, which essentially comes from the perfection of a process. Likewise, if you regularly drive fast - well you get the point.

But we ain't in the discussing academics business, we in the allocating capital (and making money) business. Retail investors often focus on the historical performance of a mutual fund. A fund with good historical performance numbers usually attracts more capital, while a fund with bad short term performance usually faces withdrawals. Is this warranted? Sometimes it is, and sometimes it's not! We have to analyse the process each manager is following, and then reasonably determine, (a) if the process makes sense, (b) if it will make money, and importantly, (c) what is the downside (and if I am comfortable with that downside). A good manager with a good process may produce bad short results, but over time, the performance of the fund ought to reflect the superior course of action. In keeping with the disclosures, I have never been able to nail down George Soros process of making money (well not fully), and he produced good results and did it over a long period of time (If I was an academic, maybe I'd talk in sigmas). Likewise, in stock selection, it is important to focus on the process, and importantly, the downside risks, than worry about the outcomes. This process, coupled with heaps of discipline, over time, will inevitably lead to good long term results. It is also noteworthy that the inputs to the process are of prime importance. Bad inputs, coupled with a good process, will lead to a bad outcome - Garbage In Garbage Out (GIGO) principle.

In conclusion, all other things being equal, generally:
1) Bad Process, Bad Outcome - Inevitable in the Long Term
2) Bad Process, Good Outcome - Luck (outcomes from known unknowns and unknown unknowns are favorable) - a Short term phenomenon
3) Good Process, Bad Outcome - Luck (outcomes from known unknowns and unknown unknowns are unfavorable) - a Short term phenomenon
4) Good Process, Good Outcome - Inevitable in the Long term

Stock Analysis: Birchcliff Energy

2009-09-02T11:08:00.000-07:00

BirchCliff Energy (TSX: BIR) is a junior oil and gas exploration, development and production company. Its objective is to acquire and hold, large working interests in several highly focused producing areas in the Peace River Arch where it can hold operatorship of its assets and control the infrastructure necessary to facilitate the exploitation, development and exploration potential of those areas. Birchcliff produces roughly 70% natural gas and 30% light oil and natural gas liquids (NGLs). It has two major properties:

(1) Montney/Doig - Montney/Doig is an unconventional natural gas resource play consisting of reservoirs in tight sands, siltstones and shales. Birchcliff has 166 net sections of land in the area where 57 sections have been assigned reserves of 314 bcf (57 mboe), assuming 2 wells/section and 2.8 bcf/well. Management (consistent with other firms in the area) believes that 4 horizontal wells can potentially be drilled on each section giving Birchcliff an inventory of around 600 wells with recovery reaching 5 bcf/well.

(2) Worsley - The Worsley oil and natural gas assets in the Peace River Arch area of Alberta was acquired in September, 2007 for total cash consideration of $270 million. The purchase price was equivalent to $17.53/boe of proved plus probable reserves, which after reserve additions has now come down to around $10/boe for 24.6 mboe. The Worsley property provides stable cash flow and commodity diversification when compared to the natural gas assets in the Peace River Arch. Birchcliff owns high Working Interest (WI) lands (>80%) and has been working essentially without partners or farm outs.

The 3 year average for the Finding and Development (F&D) costs excluding future development capital were $8.01/boe and including future development capital were $15.63. This average has been decreasing where the 2008 F&D costs excluding future development capital were $5.17/boe and including future development capital were $14.06/boe and are more indicative of future F&D costs.

Valuation
The valuation of the company is as follows:
Downside
The current Book Value (BV) of Birchcliff is $4.15/share and as per the market price of $6.4/share the company is currently trading at 1.5x BV. This is higher than many E&P in Canada which are trading for < 1x BV. Furthermore, with an Enterprise Value (EV) of $1.024 B and 2008 Cash Flow (CF) of $131 million; the EV/CF ratio for the company is around 7.8 which also is much higher than most of the comparables trading at 3-4x EV/CF.

2009 Cash Flows Assuming Birchcliff produces on average 12,500boe/day in 2009; at the current AECO natural gas price of $4/mcf and oil price of $50/bbl ($32/boe – 67% gas; 33% oil) Birchcliff’s 2009 cash flow would roughly look as follows:
Revenue: 12,500 boe/day*365 days*32 $/boe: $146 million
Royalties: 146 * ~15%: $21.9 million
All Expenses (~$16/boe):$73 million
Cash flow before taxes (Operating cash netback: $11.2/boe): $51.1million
The production could increase and/or fuel prices could increase resulting in higher cash flows, but the $80 million estimated by management for capital expenditures in 2009 is much higher than the current situation dictates and there is a risk of (a) equity dilution (b) increased debt load. Furthermore, assuming higher cash flows in 2010 and 2011, it still might not be enough after capital expenditures to repay the debt with an outstanding current balance of $250 million. Interest payments on the debt load come to around $10 million annually and this is manageable even under stress scenarios.

Upside
In order to analyze the upside it is important to decipher the Montney/Doig natural gas resource play. I have already analyzed unconventional gas resource in a previous post. The gas is there, essentially the challenge is to maximize the flow rate for the lowest cost. Specifically, Birchcliff has 166 net sections of land in the Montney/Doig resource play. AJM consultants have designed resources of 314bcf to 57 net sections assuming two wells per section each producing 2.8 bcf over its lifetime. Net-net there is only engineering risk and very little exploration risk. The management plans on drilling 4 wells per section giving them a total inventory of more than 600 wells, with each costing around $5million. Management also believes (in like with other firms in the area) that each well can produce 5bcf of natural gas over its life as technology improves. Conservatively, assuming on average 1.5-2.5 bcf/well and 600 well locations (certain), Birchcliff can potentially recover 900-1500 bcf or 150-250 mboe of natural gas. This will require a lot of future capital, where each well will cost around $5million and the company will need new processing facilities as production increases leading to additional capital expenditures. Presently, Birchcliff has proved and probable reserves of 98.5 mboe (82.3 net) adding all its properties, where the Worsley light oil pool contributes 24.6 mboe.

Comparables ARC, Encana, Talisman, Crew Energy, Canadian Natural etc. all have lands adjacent to Birchcliff lands in the Montney area, with Talisman’s lands being the closest to the Pouce Coupe area. Bigger firms in the area have been pioneering to economically extract resources from this area. Managements’ estimates of potential resources and technologies in the area are in line with these companies. Duvernay Oil Corp. which has the highest quality land in the Montney region was bought by Shell Canada for $5.9 billion including debt (it was an anomaly). Duvernay quotes gas-in-place of 50 bcf per section, while Birchcliff quotes at 30 bcf per section. Shell paid $38.87/mcf for proved and probable reserves of 152 mboe and received 450,000 acres of land. This purchase price discounted the future expected recoveries in the undeveloped lands. Birchcliff at present has 98.5mboe of reserves and 380,000 acres of undeveloped land.

Finally, – The current EV is equal to $1.024 B. Based on various combinations and comparable deals, we can assume that Birchcliff is worth between $2 B to $5 B for a 2.5x – 4x upside from the present prices. As long as management manages the balance sheet conservatively, Birchcliff should not have a problem attracting a bid in due time. Seymour Schulich a prominent Canadian investor owns 22% of this company and he is more or less waiting for a bid to cash out. Please note that the thesis here is for a takeover only, you are essentially buying a 'option' when you buy the stock. Personally, the 'option' has to be much cheaper than it currently is for me to purchase the stock, but I am posting the analysis nonetheless.

Disclosure: None

Stock Idea: Steinway Musical Instruments

2009-08-28T15:29:00.001-07:00

Steinway Musical Instruments (LVB: $12/share) is a renowned manufacturer of pianos and band instruments. The piano segment (60% revenues) operates under the brand names Steinway, Boston, and Essex. The premium Steinway brand has an 85% market share and represents roughly 80% of the revenue in this segment. The band and orchestral segments (40% revenues) operating under Conn-Selmer divisions sell a wide array of other musical instruments and accessories. Steinway is not a growth story. It is however, a distinguished brand which has delivered consistent cash flows and has the added margin of safety in hidden real estate assets - it owns the 57th Street building in Manhattan and a waterfront manufacturing facility in Queens.

Bird in the Hand: The margin of safety in this investment comes from the hidden read estate value and the working capital surplus. As per a press release by the management in Feb, 2006, West 57th street building was purchased in 1999 for $30 million, is carried on the books at $24 million and has a market value of at least $100 million. In addition, the Steinway manufacturing facility in Queens is on the waterfront, has views of Manhattan and is carried on the books for $3 million but is worth around $200 million. Furthermore, the company has $172 million in inventory and there is precedence that it will not be liquidated but sold piece meal. There are other assets on the company’s books that have substantial worth. I would roughly peg the total value of the hidden assets at $200 million or $23/share after tax. The company does not need to own the aforementioned real estate to operate and hence the assets can be monetized without substantial effect on the operations (add: lease expense for factory, subtract: rental income from building).

Bird in the Bush: The company has an enterprise value (EV) of $285 million (including pension underfunding) with a market capitalization of $100 million. Steinway’s revenues have been flat averaging $375-$400 million for many years. The company has consistently had gross margins in the 28-30% range and operating margins normalize at 8.5%. Due to the consistency in operating metrics we can normalize cash flows and determine the valuation. The company on a normalized basis does around $45 million in EBITDA and approximately $20 million in FCFE. At 8x EV/EBITDA the company would be valued at $360 million. Looking at the FCF multiples, at 10x FCFE the equity of Steinway would be worth around $200 million. The stock has a 60-100% upside to $16-20/share just based on the operations. The earnings are depressed right now because of the macroeconomic conditions, I reckon, however that (a) there are so secular forces against the company, and (b) the company has not suffered permanent damage from imports or consumer demand.

In addition, there might be some growth opportunities in countries like China where Steinway is working to establish a presence. Chairman Kyle Kirkland and CEO Dana Messina have majority voting control due to their 100% ownership of class A stock, and therefore have full control of the major strategic decisions faced by the Company. They have made prudent decisions so far and have been fairly compensated, but this does pose a substantial risk. In conclusion, the company seems to be worth around $35-$45/share. This is a classic ‘buy on assets, sell on earnings’ play.

Disclosure: None

Hedge fund jobs..

2009-06-30T21:39:00.000-07:00

A few posts ago I wrote about the Distressed Debt Investing blog, where Hunter brought some real insights into the process. Hunter's at it again! He's starting a new blog titled 'How to get a Hedge fund job'. Here he will dwell on his own experience and his networks to give reader a comprehensive understanding on what it takes to land Hedge fund jobs. At a time where unemployment is rearing its ugly head, Hunter's blog is a welcome relief. As someone who is looking for a mentor, I hope he comes up with some quality content helping me and people like me in their search!

what WB said about inflation..

2009-06-24T16:25:00.000-07:00

I fret every time a value guy talks about macroeconomic conditions, but here I am talking about inflation. Swarmed by the talking heads, I went up on the Himalayas (BRK shareholder letters) to get some real advice from the guru (Warren Buffett). 1978-1982 was a time where real inflation actually took place, before the then fed chairman Paul Volcker raised rates to as high as 21.5% (can you imagine that) to reign in inflation. Fortunately, we have WB's 1978-1982 shareholder letters to decipher the time and his strategy (which as always he just lists out!).

While you and I talk about commodities and real estate etc., he was still looking for businesses but with the following characteristics, " Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital." Essentially, business like See's Candy. When talking about commodities, he favors the lowest cost producers. We want to watch the downside, we want to make sure we make money even if inflation does not take hold.

Any fixed income security is likely to produce real term loses in a high inflation environment. He was absolutely against long term bonds, and mostly looked for bonds with conversion rights or distressed securities. When talking about return on capital you have to figure the inflation effects and then the taxation effects. A 10% bond with 8% inflation and taxes would not make any real return! In case of equities, the corporations will be paying taxes on nominal income and not real income. Considering owners can only use real income, this means the corporations would pay taxes on deficits!

I can only say so much and not a fraction as good as WB, so I would highly recommend the Berkshire Hathaway shareholder letters from 1978-1981.

What chu think about TicketMaster?

2009-05-28T13:19:00.000-07:00

Past
TicketMaster (TKTM) is the world’s largest live entertainment ticketing and marketing company. The company is a primary and secondary ticketing (thru ticketsnow.com) retailer in the US and over 20 international markets and provides a marketing portal for clients to over 58 million registered users on ticketmaster.com and affiliated websites. TKTM serves as an intermediary between the venues/promoters and their customers to provide the technology systems and distribution functions.

You and I both have had experience with TicketMaster and loathe would be too nice a word to describe the feeling. They make way above the economic rate of returns and have successfully passed price increases to customers - something a monopoly can do. Ticketmaster secures its monopoly by goading the venues into multi-year agreements that empower Ticketmaster to act as their exclusive vendor. So what was a cost center for venues (ticketing) has become a steady source of income. They have been a monopoly ever since the early 1990's and have maintained and increased their position even after the advent of the Internet and increasing number of players. They are very Microsofteqe in their business practices and took/are taking a lot of heat for their monopolistic actions. It was spun off of IAC in mid-2008. In essence, TicketMaster is a toll booth.

In 2008, Tktm had revenues of $1.45B with an ebitda of $225 million for ebitda margins of 16%. The margins have however come down from the mid 20's over the past few years. TKTM is trading at $7.50 for an EV of $1060 million and an EV/EBITDA ratio of 4.7. It traded for as low as $3.50/share in March 2009.

Present
This is where things get convoluted. Live Nation, TicketMaster's biggest client fired TicketMaster and said they'll do their own ticketing (LYV brought 13% of revenue in 2008 for TKTM). Live Nation also intends to poach TKTM's clients. Live Nation operats on razor thin margins but has a large presence in the live entertainment business. TicketMaster then bought a majority interest in Frontline Management and brought Irving Azoff (someone you wanna read about) as CEO. With this TKTM controlled a lot of very high profile artists and became a threat to Live Nation. Live Nation and TicketMaster then decided to merge (50-50 share) and have all the intended approvals except the regulatory approvals (which might be tough to get!).

In this business, the main parts of the puzzle are: (1) Artists (2) Promotors (3) Venues (4) Ticketing and (5) the Fan. Live Nation is the worlds biggest promoter, has control over various venues and artists (because they can pay them more than anybody else, given the scale). TicketMaster has ticketing and venues (thru exclusivity arrangements) and now artists thru Frontline. Combining these two business would vertically integrate an industry and crush the competition, but I don't think a stockholder would complain.

Future?
The files are with the Justice Department and they along with the states are taking a deep hard look at the merger. I'd say there is a 50-50 chance. They do have a case when they say touring is the main source of income for the artists and the record label model is broken with the illegal downloads etc. They might be asked to divest certain assets like ticketsnow.com for the merger to pass.

If the merger does not happen that is where things become uncertain. A couple of scenarios:

1) Live Nation comes back to Tktm for ticketing and they Frontline works with Live Nation, in essence they collude (kinda)- will they be able to pull this off?
2) Live Nation does not come back. TicketMaster decides to go into the live event promotion business (with Frontline managing artists) and these two operate in a duopoly - can they?
3) TicketMaster faces increased competition from Live Nation in the ticketing business. TicketMasters market share decreases - but by how much? Can Live Nation severely damage their moat?

They exposed themselves by announcing a merger. I watched the senate hearing on the TicketMaster/Live Nation merger and it was well worth watching. There is information on the history, business practices, competitors, future etc. etc. Now TKTM is cheap (given market position, margins, ROC), it might get cheaper but given all the uncertainties is it safe? what chu think?

Dimon and the Letter

2009-05-10T14:20:00.000-07:00

Most of what I've know has come as a result of 'hop' reading, which essentially means reading something, finding something interesting and hoping on to read about this something interesting. So when Warren Buffett at the AGM recommended Jamie Dimon's letter, I had to read it! Needless to say it is a wonderful letter. I second Tom Brown when he says this is the type of stuff we expect from Warren Buffett (the AGM fills in some holes). It is a must read..

It is becoming apparent that an equity investor doesn't just need a good understanding of the industry but also needs to comprehend the credit markets and value the political risks. WB famously said that even if Alan Greenspan (the then fed chairman) told him what his next move will be, it will not effect how WB invests. This makes sense because as value investors we look for under priced securities with a margin of safety and it is as simple as that. But on the other hand, I reckon, some awareness of the macro conditions is an absolute must and being 'street smart' important. JPM shareholder's letters gives a good summary of past mistakes, present challenges and a recommendation (not just a complain) on future reform.

Unconventional Gas

2009-04-16T15:34:00.001-07:00

This is not about a particular stock, but about the natural gas sector in general and an analysis of the unconventional reserves. This would be a good starting point if an investor wants to establish a position in the natural gas sector. Also, it explains the success of unconventional e&p companies.

Natural Gas
Natural gas is one of the cleanest burning hydrocarbons and an essential energy source. The depletion rates for natural gas in the U.S. for the fields put into production in 1990 were down 17% after the first year, those put into production today deplete more than 30% during their first year of operation. Demand for natural gas in the United States has more than doubled over the past two decades. However, since 1996, domestic production of natural gas has grown at an annual rate of well below one percent. This slow increase is due to a number of factors, a primary one being that currently producing gas fields are maturing and producing less gas. Overall Canadian production is projected to remain relatively flat and exports to the United States, after factoring in expanding Canadian use, are expected to decline. Canada is expected to use more natural gas to heat buildings and to produce unconventional oil from tar sands, which uses heat from natural gas.

At present, more than 25% of daily U.S. gas production is recovered from tight and unconventional reservoirs which have become an increasingly important part of the equation in meeting natural gas demand. These unconventional gas properties usually have low risk F&D costs less than $2.00/mcfe which are further decreasing over time as efficiencies increase and shale gas reservoir knowledge improves. The unconventional gas reserves are usually tapped using horizontal well technologies, which have depletion rates of upto 70% in the first year of production and require continuous drilling to meet demand. Notably, the overall marginal cost of natural gas supply, including finding, development and operational costs is around $6.50/mcf. Another positive factor effecting natural gas is the potential Cap and Trade system as natural gas is a clean burning fuel. The European experience shows, as carbon prices increase (>$25/ton), the marginal cost of an inefficient coal-fired vs. an efficient natural gas-fired plant will cause a partial switch towards natural gas.

The current situation is that about 45% (from 1,606 to 884) of U.S. rigs have been shut since September 2008. Drillers need to add more than 3.5 bcf/day to offset declines and this means that the gas production going forward will decrease, at a faster pace than demand. This will naturally in due time, lead to higher natural gas prices. Natural gas futures for delivery in January 2010 are trading at a 49% premium to the April contract.

Unconventional Resources
In order to analyze the upside it is important to decipher the unconventional natural gas resource play. These resources could be in the form of tight gas, shale to name a few. Tight gas is typified by large volumes of low quality rock, moderate porosity (ratio of the volume of openings to the total volume of material) and ultra low permeability (measure of the ease with which fluids will flow). fields. The complexities of the depositional setting influences both porosity and permeability in the region, resulting in rapid variation of rock quality over short distances. Most tight reservoirs have to be fractured before they will flow gas at commercial rates.

Advances in technology, principally the Horizontal well technologies with multiple fractures have allowed the unconventional resources to produce at very economic rates. Although no two unconventional resources are alike; tight gas sands and shales have been found and developed for decades. E&P companies (I would suggest, at a minimum to go thru their latest presentations) like Chesapeake Energy, XTO energy and more recently PetroBank among others have used advancing technologies to economically extract resources from unconventional reserves. Economics per well dictate returns of 25-100+% with horizontal wells depending on the natural gas prices.

My research suggests that most of the unconventional gas resources (tight sand or shale) economically speaking are similar in the sense that they are (as management states) long life, repeatable, low risk, large reserve, natural gas resources. Technological improvements have increasing made it possible to economically extract resources from such resources. The recovery factor in these resources usually ranges from 20-30%. The difference economically arises from the development costs. Therefore, factors such as technology, spacing between wells, frac positioning and drilling costs are central and will affect the rate of returns. The challenge is to maximize the flow rate for the lowest cost.

At a time, where most of the integrated oil and gas companies are struggling to add reserves, these unconventional E&P companies can be a good opportunity to add long term, low risk reserves.

Distressed Debt Investing

2009-04-14T17:25:00.000-07:00

This blog was meant to present my ideas and opinions, but there is something very interesting going on at the Distressed Debt Investing Blog. This is a topic that really interests me and for anyone who is interested in detailed distressed debt analysis this blog is a must.

I've been really busy and therefore have not posted as much as I'd like; having said that I'll try to post regularly from now on...

flation - In or De?

2009-02-20T16:06:00.000-08:00

"I don't know" is where I will begin (and end). But in between, let me present some differing views. Everyone (and I mean everyone) is convinced that Fed's actions will produce massive inflation going forward. I am sure you have seen the charts showing money supply a year ago and today and the chart is off the charts. The popular view is that we'll face some deflation and then massive inflation. OK, but my problem here is that when everyone is convinced something will happen, it usually doesn't!

Barron's recently interviewed Ray Dalio of Bridgewater Associates (excellent interview) and asked him the inflation question. He said, "A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years." So no inflationary worries there! Furthermore, a Matin Wolf article in the Financial Times (another excellent article) compared the current recession to Japan's and drew some lessons. He is more worried about deflation, than about inflation. The argument here is that this is balance sheet recession (similar to Ray's point) and these ones (a) take time (b) inflict pain (c) are not easy to tackle. But again, no inflationaly worries..

On the other hand a handful of very respected value investors including Seth Klarman, David Einhorn and Mohnish Pabrai are really worried about inflation and are putting their money where their mouth is! Seth Klarman as I mentioned in a previous post said, "We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges." David Einhorn of Greenlight Capital in his latest shareholder letter said, "Our current chairman of the Federal Reserve, Ben Bernanke, is an "inflationist". When times were good, he supported an easy money policy. Even when the Fed raised rates...bubble formation...money printing...Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed. Our instinct is that Gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself." Mohnish Pabrai in this annual letter to his investors went a step further and gave his macro view on the economy going forward. I mean this is an ardent Buffett follower and hes talking about the macro view and the massive inflation and high interest rates in the future. He has geared his portfolio towards hard assets like low cost barrels in the ground, low cost iron ore reserve etc. Said another way - hes buying commodities!

Only time will tell what will happen. This is a time when many wonderful business are selling for way below their intrinsic values. The challenge in this market is to identify and buy the safest and the cheapest stock (or debt). The macro world can change very fast; are you agile enough? As a value investor if you are overly worried about the macro view, a smart hedge I can understand, a core holding - not so much!

Value Investor and Shorting

2009-02-13T16:46:00.000-08:00

This is somewhat of a tricky subject for Value investors. Warren Buffett (WB) doesn't short - for very good reasons. Most of the seasoned value investors that we emulate are long only portfolio managers. Berkshire Hathaway shareholder letters are said to be everything one needs to know in order to make money in the markets but WB lists no rules for shorting. Ben Graham on the other hand pair traded, but WB dint copy that practise because he observed that for every 4-5 'wins' there was a 'loss' which would more or less wipe out the 'wins'. On the other hand, there are many enterprising investors Paulson, Watsa et. all that successfully shorted in the past 2 years and made a killing. Anyone who was long only in the last 2 years has lost money. Anybody who was short anything has made money. This means that the outcome was favorable, but was the decision right? If the decision was right the process must have been right. On the other hand, if the decision was wrong, then 'luck' must have all the credit and not the process. Lets look at this.

Now why doesn't WB short? As Keynes said, "Markets can remain irrational longer than you can remain solvent". WB has said that, Charlie and him had identified a lot of securities which were overvalued and would correct, but could never determine when they will correct. This is the essence of it. When a bunch of long/short hedge fund managers were asked to identify some mistakes - 90% answered that one of their biggest mistakes have been shorts going against them (the thesis was that the security is overvalued). A very good example would be VolksWagen, u'd probably be having nightmares if you were short VolksWagen!

One thing is clear, with the advent of large pools of capital the markets have been and will be a lot more volatile. Long only portfolio managers will probably have to suffer short (or long) periods of under performance. (A) There is nothing wrong with this (B) Volatility is good for the value investor because it creates opportunity. The catch here is that you can take advantage of this opportunity only is you have dry powder. So a lesson here could be that holding some amount of cash is good, you don't have to be 100% invested all the time. A more aggressive lesson could be to find out ways to capitalize on the volatility - to learn from Paulson, Watsa and Ben Graham.

In Security Analysis, Ben Graham says that if a bond is trading for 100 and its callable at 102, it would be a mistake to go long at 100 as the downside is way more than the upside (opposite of what a value investor wants). Well, but what about shorting the bond at 100? The downside now is $2 plus the interest and the upside is $100 (the bond was trading in the mid 60's a few months later). If the whole idea here is to make 'bets' with heads I win and tails I don't loose that much, then this makes sense. Today credit default swaps (CDS) are available which isolate the credit risk in the bond which is exactly what we are interested in. In a lot of these cases the downside to these instruments for a lot of companies in early 2007 was very little and the upside much much greater. It is a neat way to bet against a company or a sector, given that the CDS's are cheaply priced. Anybody thinking should study Paulson, Watsa and Ackman and their trades over the years.

Another possible solution here is LEAPS. Having determined that shorting a stock is a bad idea, a PUT might be useful in achieving the desired trade. This however reminds me of the guy who bought PUTs on Yahoo! in 1999 just to have them expire one month before the 2000 crash. In addition, yours truly shorted Countrywide Financial (CFC) in 2007 when it was at $35 using PUTs just to sell at a loss (around $38) on rumors that Bank of America will acquire them at around $45. But if one is convinced that a particular stock is a good short, a put strategy can be devised whereby the person starts with the small position and increase the 'bet' if the stock goes higher, use the increasing weight of bets to your favor - Kelly formula. These are also, heads I win and tails I don't loose that much investments, albeit if done properly.

In my opinion, shorting should be done very selectively and when the odds are greatly in your favor. Yes, same applies to going long, so maybe super selective is the right word. Another takeaway here could thinking about shorting stocks vs. shorting sectors (wherever your circle of competence falls). Having said all this, I am a novice when it comes to shorting and what is involved is another post. This post was meant to argue that shorting is within the value investing framework.

Stock Analysis: Domtar (UFS)

2009-01-01T15:37:00.001-08:00

Domtar (UFS: $1.70) is a manufacturer and marketer of uncoated freesheet paper in North America. The Company also manufactures papergrade, fluff and specialty pulp. This is not to be confused with newsprint where the demand is steadily declining and there seems to be no light at the end of the tunnel. Uncoated freesheet is the paper that you and I use in our printers, envelopes and books. Look around you and you will see a lot of it lying around, we will always need it! use it! Do you remember how much it cost you the last time you purchased a stack? How many times have we heard the phrase, "blah is not worth the paper it is written on"? It is definitely an expense for corporate America but one that does not hold much weight in terms of cost; it will probably be the last thing that is cut from corporate and household budgets alike.

Industry:
Demand is decreasing because of the digitization of everything. We don't need as much paper anymore - we use the internet, use kindle/iphone to read e-books, advertisers/retailers are not demanding much paper for pamphlets/catalogs. The demand has been declining at a 2-3% rate since 2000, I expect the demand to be flat to slightly positive going forward. The good thing is the industry saw this coming - they consolidated! Domtar is the largest producer of Uncoated Freesheet Paper in North America with market share of 34%; while International Paper has 26%, Boise Cascade has 9%, Georgia Pacific has 7% and Glatfleter has 4% market share. The top 5 companies control more than 80% of the market and that means a lot of pricing power.

Uncoated Freesheet paper is a commodity market. In a commodity market where price determines market share, it is important to be the low cost producer - Domtar is! The price setting mechanism at the margin is the cost of production of the highest cost producer. The paper industry is one of the most capital intensive industries in the US. As a comparison, per dollar of output, it takes twice as much investment in PP&E to produce paper as it does cars. In addition, manufacturers have to deal with strict environmental and health safety issues. Aldabra (a blank check company for UFS) notes that there hasn't been a new mill built in the last 12 years. Aldabra estimates that it is paying about $1.625 billion to purchase manufacturing assets that would cost in excess of $4 billion to build new. In other words, returns on capital for new capacity are so low that it's economically impossible to build new capacity. These costs create high barriers to entry making it unlikely that new players will emerge. In essence the view is this:
(1) New competitors will not come in as there are high barriers to entry
(2) The industry has consolidated and collusion can take place in terms of price increases
(3) Yes, demand is declining but prices can be passed to the customers (the view is that this is akin to the tobacco industry where they initiated price increases to combat declining demand - keeping the top line fairly constant)

Company Valuation:
Domtar has a market capitalization of $870 million and EV of $2.8 billion for a ttm EV/EBITDA of 3.5x. Domtar is producing around $800 million in EBITDA/year, which I will assume as fairly constant as the lack of demand in the short term will be taken care of by the savings from the synergies from the merger (yes synergies are real here!). Domtar's capex is around 30% of the D&A expense and it has been aggressively paying down debt (does not have immediate maturities) from the cash flow generated. We can value Domtar anywhere between 6-8x EBITDA conservatively and at those valuations I get around $5.20/share - $8.26/share.

I also did a DCF on this and without posting my model here - assuming no growth, capex equal to 30% of D&A and a 10% WACC I get around $7-8/share. Domtar also has some NOL's (from years of losses) which I will not bring into the equation to be conservative. What I guess I am trying to say here is that Domtar is grossly undervalued and it is obvious! It can be an absolute home run if the competitors keep behaving rationally - keep demand and supply in check and Domtar keeps paying down debt.

But I am not buying and here's why:

(1) A major major assumption is that the competitors will behave rationally and keep demand and supply in check. It has been happening, but will it keep happening? Game theory says otherwise!
(2) They only have pricing power to a point. According to some experts, it costs about 10%-20% more to import uncoated freesheet paper than to manufacture it domestically. So firms have room to raise prices but not by much - eventually imports will start kicking in!! The only thing that is keeping the industry profitable is consolidation. If there is excess supply, they will again be led back to their old unprofitable ways. Also in a soft market if the suppliers hold the line, firms from Asia or Latin America who themselves might be facing economic headwinds might 'dump' their paper in the NA market.
(3) Abitibi-BoWater is marketing a new kind of paper made from mechanical pulp. They also commissioned a study which found that this paper has a lower environmental impact than the paper from traditional chemical pulp.
(4) This is a company (and industry) that has huge operating leverage and in a scenario where soft demand persists the fixed costs will eat into any profits they might make. Although Domtar is a low cost producer and the price is essentially set by the high cost producers; the price of uncoated freesheet paper has to be around $ 500-$550 (it is at around $1000 right now) for them to break even.

In essence, I don't see what the team at Baupost is seeing. They have a 7.9% position in Domtar and are one of the biggest shareholders so they must be really convinced? Does anyone else see things differently?

Disclosure: No Position

Seth Klarman's Inflation hedge

2008-12-10T08:06:00.000-08:00

People far and near have wondered what Seth Klarman's inflation hedge is! In a Columbia Business School conference he said (along with other nibbles n bits), "We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges."

Only a part of his portfolio is disclosed publicly, a lot of his portfolio consists of distressed debt and derivatives which do not have to be disclosed. But from what he has disclosed I think I might have an answer! The popular view is that there will be some deflation, followed by massive inflation (the printing press is in overdrive). Now to be clear, I have no idea what the macro situation would be tomorrow or in 3-5 years (too many variables!), I am just making a humble attempt - trying to analyze his comment.

Energy MLP's, I think is the answer. He owns Linn Energy (LINE), Breitburn Energy (BBEP) and Atlas Pipeline Partners (APL). Why? I will explain the picks later, but the short answer is this: These MLP's have yields of around 20-50% right now and their oil production is hedged 5 years forward at oil prices of around $80/bbl and gas prices of around $8.50/mcf. This means the yield is 'safe' (if its really safe can only be determined by extensive DD) and that if we have any amount of deflation, the yield will more than make up for it. Now in 3-5 years if we have inflation the USD will probably depreciate and oil - priced in USD (and perhaps gold and other commodities) will appreciate as we saw in the last few years. The MLP's will again be able to lock in high oil prices and might increase in value. Again, this is a cheap inflation hedge, not a core strategy! There is a difference. Cheap inflation hedge means that if things don't work out as you expected you will loose, albeit less - the MLP's have a payback period of around 3-5 years because of the yield.

There is a lot of information on MLP's out there, not a lot with investors thou (they've been busy with the crisis). The MLP structure requires a steady and dependable revenue stream. For this reason, MLPs have traditionally been oil and gas pipeline companies. However, in recent years, a number of upstream oil and gas producing MLPs have come to market. These companies use extensive hedging to assure a steady revenue stream from an otherwise unpredictable commodity market. They are income vehicles which avoid both federal and state corporate income taxes by passing through expenses and income to the investor (Canadian energy trusts anyone?). To be sure, these are business and should be analyzed as such, the management, capital structure, finding costs, risks etc. should be thoroughly analyzed. I looked at LINE and BBEP and they looked decent (I have not done extensive DD), Leon Cooperman of Omega Advisors has been pumping the Atlas series of MLPs for a while. During 'normal' times they have yields of around 8-15%.

An interesting factor here (an one that value investors love) is that Lehman Brothers was big in MLPs (As of June, Lehman Brothers Asset Management owned $1.1 billion of MLP equities). So when it went under there was massive selling pressure on these vehicles! To be sure, many small oil and gas MLPs also used Lehman as the counterparty to their oil and natural gas hedges. In addition, Lehman provided lines of credit to some of these companies. But net-net this was a case of broken stocks and not broken companies (LINE terminated the contracts before Lehman bankruptcy) and therefore these MLPs are priced at a discount of around 30% to where Seth Klarman bought. Again, there is a lot of information on MLPs on the internet and if someone thinks they fit their portfolio, please do your due diligence before buying.

What were the signs?

2008-12-05T17:19:00.000-08:00

I have read about a few booms and bust, but this is my first bust in real time (and what a bust it is). Now going back to my notes, I see a few things coming back. what were the signs? Now I am not saying that I could see all these signs, but the next time I see something similar brewing, I'll know what will follow!

Exhibit A: Housing
This has been talked about in depth, everyone and their dog know now what exactly took place here. But looking back 2-3 years, some of the signs could be: anyone with a pulse getting a loan, 20 year old realtors, 2-4 shows on TV dedicated to flipping houses, flipping houses a 'sure' thing for making money to name a few. Going back to Charlie Mungers's power of incentives, if one just analyzed the incentives in the housing securitization chain, the fallout becomes really easy to predict. No one, and I mean no one had an incentive to keep the quality of the mortgages sane, everyone was concerned about volume (and that is obviously not good!).

Exhibit B: Private equity
Endowment and Pension funds are funny creatures. They employ the best of the best, manage insane amount of capital and serially fall prey to 'glamour' investments. In the late 1970's they lobbied to change the regulations so that they could hold more gold; this time it was Private Equity that took them down. Endowment and pension funds couldn't get enough of their cash in PE funds. Now consider the recent dumping of PE stakes by investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion. Interests in funds managed by KKR, Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent. Now ain't that smart! In addition, when in any field things get large, the likes of which have never been seen before you know that an access is developing. In PE's case the buyouts became larger and larger. In the late 1980's it was RJR Nabisco deal by KKR that signaled the end in that era, and this time it was BCE - the Canadian telecommunications giant that was to be taken over for $52 billion. Furthermore, they say that when you cant determine who the sucker on the table is, it is usually you. This was the case with the various Private Equity/Hedge Fund IPO's. When Stephen Schwartzman is selling, buying would be a bad idea! This was in my opinion the most obvious sign that the party is coming to an end.

Exhibit C: Risk..What Risk?
Yes, unfortunately that was what the world had come to believe. This was not just true this time, but every time people are feeling joyous. The spread between the treasuries and the junk bonds becomes smaller and smaller, the covenants become looser (pik toggles anyone) and investors just need yield, any yield as long as it higher than the treasuries (and they don't care how much more risk they are taking!).

Exhibit D: Net-Nets
Now method this is proprietary I must say, and is one that roughly works. One just needs to look at the number of net-nets available in the market and its as simple as that. You don't have to buy them, but as a rule when there are a few (or no) net-nets available in the market, you know some excesses have developed and its time to be cautious.

Now I can't (and no one can) tell you exactly when the kindgom will come, or what the catalyst would be, and none of the things mentioned above is precise but I rather be roughly right and be cautious than be precisely wrong and do nothing (or short it all).

BCE: Risky Arbitrage

2008-11-26T09:07:00.000-08:00

John Paulson's, the founder of Paulson & Co. (huge subprime bets) started his career as a investment banker and then worked as a risk arbitrager with Gruss Partners. He learned a very important lesson here that I'd like to reiterate: "Watch the downside, the upside will take care of itself". He also wrote a paper titled, "The 'Risk' in Risk Arbitrage", and its a must read! A caveat here is in order, risk arbitrage is very risky and should not be tried at home (as Joel Greenblatt would put it). The BCE buyout deal has been a non-stop soap opera for anyone who's watching. Today it was announced that the deal might be in jeopardy and the stock dropped 40% from around $37 to $24; the buyout price is $42.75/share. Arbitrage spreads in general have been very very wide over the last 3-6 months and for a good reason as deals have imploded left and right. While I am not going to talk specifically about the BCE deal, but will talk about arbitrage at the tail end of the buyout boom (and its common sense!).

But first, all this reminds me of something I read in the 1988 Berkshire Hathaway shareholder letter (which is also a must read for risk arbitrage). In that letter Warren Buffett explains arbitrage and his approach with relevant examples. Here's a synopsis: "To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?"

He goes on to explain a couple of transactions and but in the end the thing that I remember is, "Even if we had a lot of cash we probably would do little in arbitrage in 1989. Some extraordinary excesses have developed in the takeover field." He goes on further to talk about how he 'doesn't know' and 'no one knows', "We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders."

And this is the essence of it. Simply, do not engage in arbitrage at the tail end of the buyout boom. The ratio of collapsed deals to total deals has been very high this past year. It usually is when the buyout boom takes a form of its own, and the market values everything at private market valuations, exactly as WB said. It was high in 1988 and it was high in 2007 (read: Blackstone IPO). Michael Price once said that the folks who do risk arbitrage are the same ones that do distressed debt when the cycle turns, and this rings true today when a lot of hedge funds are unloading the risk arbitrage staff and beefing up their distressed debt teams (but just a little too late). If an investor as a rule refuses to participates in risk arbitrage during these times, a lot of pain and suffering can be avoided. When you are picking pennies (or dollars) in front of a road roller you really want to have the odds on your side.

Stock Idea: CBS Corporation

2008-11-25T11:02:00.000-08:00

Although it is a monkey and a dartboard (stockboard?) market right now, you always hope you can beat the market. CBS Corp. (CBS), in my opinion is a safe and extremely cheap investment and if bought at these prices ($6.50/share) will beat the market and then some.

CBS Corporation is a consolidated media company with four segments (Depreciation approximates maintenance capex so EBIT here is close to FCFF):
(1) Television - 66% of revenues, 60% of EBIT with 18% op margins;
(2) Radio - 12-14% of revenues, 24% of EBIT with 35% op margins;
(3) Outdoor - 16% of revenues, 14% of EBIT with 18% op margins;
(4) Publishing - 6% of revenues, 3% EBIT with 8% op margins.

CBS right now has a market cap of $4.5B and Long term debt ( 4.625% – 8.875% due 2010 – 2056) is $ 7.1B for a $11.1B in EV. With a TTM EBITDA of $2.9B the company is trading at a EV/EBITDA (ttm) multiple of 3.7x and a dividend yield of 16%. CBS is not a growth story, but a cash flow story and comes close to a Private Equity type investment. The company is a very stable cash generator and has generated, over the years on average around $2.6 billion in operating earnings (FCFF) and after $550 million in debt service around $2B in FCFE (not including growth capex) per year. So for a $4.5 B equity investment CBS is producing around $2 B in cash flow for a yield of 50%! The bull case is trivial, I will present the bear case here and try to refute the arguments.

Sumner Redstone: The CBS shares collapsed over the last few weeks and their collapse was made worse by the fact the company’s chairman and controlling shareholder, 85-year-old Sumner Redstone, was forced by lenders to sell a fifth of his family’s holdings in CBS to meet loan covenants for his holding company (NAI). He controls around 80% of the voting shares and therefore this company cannot be sold, unless he sells. I will not value CBS at a private market valuation. There is a concern that Sumner Redstone will take CBS private, but with margin calls n all, and the current debt refinancing environment, I don't think so! There is also an issue between Sumner Redstone and his daughter Shari Redstone. But really do I care? A part of the bid price today is because of 'forced selling', so this is a case of a broken stock not a broken company. I like I like.

Debt Maturity: $1,585.5 million in long term debt is due June 2010 and another $950 million is due 2011. CBS generates around $400-500 million of FCF every quarter and there are seven quarters left till the June 2010 maturity. With $500 million in cash and potential $2.8 B in FCF they should be more than able to pay the debt. One caveat thou: the dividend will have to be cut! The company is paying around $700 in dividends every year and that will need some cutting going forward (the market has already priced this in). This is all assuming the company cannot refinance at favorable terms in 2010.

Advertising environment: CBS is heavily dependent on advertising and this is supposed to be the worst advertising environment over the last 40 years (and the world is ending). CBS operates in segments that give advertisers the greatest bang for their buck and the stronger companies will advertise more in order to gain market share so net-net the effect would be minimal. These networks are like toll roads, where will the companies go? Even if I assume a 40% cut to the operating earnings (way too rich, management is expecting mid teens decline) the company will produce $1.56 B in FCFF and $1B in FCFE per year, and even this will be good enough to take care of the debt maturity and then some. The management is good, has good incentives to execute and is experienced and they know whats coming and have been and will manage the business accordingly. The loans seem covenant lite and I could not find anything in the 10K.

Pension Liabilities: This is a bummer, CBS has around $1.7 B in unfunded pension liabilities. The point here is that these are not loans and do not have a bullet payment. CBS is assuming a 7% long term return with 5.9% discount rate and has more than 80% of the assets in fixed income securities. I am not saying it does not matter, but this issue existed before the current decline. There is around $200-300 million that CBS will need to contribute to the plan every year, I've looked at the footnote and there is nothing that overly concerns me (esp. looking at the kind of cash flows they are producing).

I am sure there is something else, but net-net CBS is the number 1 rated network, is a strong cash flow generator which has produced strong returns on invested capital. Media companies have traditionally traded for around 10-12x EBITDA, have private market values of around 12-14x and after discounting the control by Sumner Redstone I am comfortable valuing CBS around 9x. In around 3-5 years, at 9x, the EV would be $27 B, and after debt and residual corporate costs (pension, operating liabilities) of around $11B (assuming moderate cash payments over 5 years) gives me an an equity value of around $16B - $18B or $22-25/share. The media sector is trading at very depressed valuations and these companies are cash flow cows. Prem Watsa recently increased his investment in Canwest Global, which is a similar investment but more levered. So in essence, more than the upside the important thing to consider in this type of an investment is what can impair your capital (and the upside will take care of itself)? In CBS's case I found no scenario (or only very low probability scenarios) that that could 'kill my investment'.

Disclosure: Long CBS

Bonds: Here's the Glory

2008-11-17T11:17:00.000-08:00

There is a lot to be said about these instruments. They are 'safer' than equity no doubt, but do not offer the glory of equity returns (ok I admit that you have to look at more than a 10 year period). Distressed Debt investing however has its own charms, it offers 'lower' risk than equities but equity type returns. Looking at the quarterly filings by some of the gurus, there's one common element: distressed bonds.

I will not explain how bonds work here or the different types of bonds, but offer a few examples of distressed investing and pepper it with my comments. The 2000-2002 period was also good for distressed debt investing. Warren Buffett bought bonds in L3 communications and Enron among others. Here's how Enron went, "in 2002-2003 we spent about $82 million buying – of all things – Enron bonds, some of which were denominated in Euros. Already we’ve received distributions of $179 million from these bonds, and our remaining stake is worth $173 million." (Some of the gain was due to the appreciation of the Euro)

Seth Klarman of the Baupost Group in September initiated a position on WAMU (again of all cos) covered bonds (a special type of bond secured by an over-collateralized pool of good quality mortgages) for 74 cents on the dollar. If WAMU survived they would have earned 15.4% yield to maturity in 2011. If however WAMU failed, the bonds were backed by good quality mortgages and could either be acquired by a buyer, become backed by cash placed in a trust or the bond holders would come to own the mortgages. Its really a win-win situation.

Today, Marty Whitman, one of the best (he was right there when Eddy Lampert was buying Kmart), is buying distressed bonds. This is what he bought: GMAC 7 3/4 Senior Unsecured Notes, Maturing 1/19/2010, Recent Price: $62, Yield to Maturity 53.42%, Current Yield 12.50%. In addition, he bought bonds in MBIA and Forest City and gives a lesson on distressed debt investing in his quarterly letter. Here is an expert, "It is important to understand that no one can take away a creditor’s right to a money payment unless he, she or it consents, or Chapter 11 relief is granted. What does this mean for a distress investor? If a company is going to avoid Chapter 11, a short-term maturity date gives the distress investor de facto seniority. If a company is to be granted Chapter 11 relief, seniority lies in the loan covenants; maturity dates for unsecured lenders become irrelevant." He explains his GMAC buy in the letter and assigns probabilities to the bonds remaining performing and the company defaulting. In any of the scenarios Whitman could not point out to a case which would lead him to take a loss on this investment.

In addition to the above mentioned managers, Francis Chou and Tim McElvaine are also bidding for distressed bonds. You can get your price by - A) forced seller willing to dump at any price B) genuine deterioration where the company is closing in on a covenant. Option A could be a no-brainer as long as you have done your DD (you will see a 'buy me' sign), but with option B there is a chance of Chapter 11. I am no expert at distressed investing, but from the little I know its bad to buy bonds of 'buggy-whip' manufacturers, but OK to buy bonds of companies that have a viable product but are in distress due to the debt burden. And again from my limited knowledge the Chapter 11 dynamics look like this: say a company has an enterprise value (EV) of $1.5 billion, with $1 billion in debt (at 6%) and $500 million in equity. The company needs $60 million every year to service the debt. Now lets say the economy deteriorated and the company can only service $50 million in debt. The creditors will force the company in Chapter 11, the equity holders will be wiped out and the debt will be restructured. The way debt would be restructured is the debt holders will now get say $700 million in newly issued notes (the company can comfortably service its debt now) and $300 million in newly issued equity. So if you paid 60-70 cents on the dollar for this bonds, you will be made whole and given an addition equity kicker. There are myriad scenarios and the process is very complicated.

Option A - the company doesn't default and the loans remain performing you get paid in full; Option B - the company defaults, you get debt and equity in bankruptcy and the price you paid ensures the safety of capital.

Lets use some WMFD's

2008-10-24T10:04:00.000-07:00

Derivatives or Weapons of Mass Financial Destruction as they have been fondly called by Warren Buffet (WB). He talked about this back in 2002-2003 right at the same time Alan Greenspan was talking about less regulation. We are lucky that WB was just half right, because I cannot fathom where we would be if he was fully right (mushroom cloud type stuff). Having said all this, he has used derivatives where he found mispricing. It is not in the use of the derivatives that he has a problem with, its the unchecked use, the wild wild west type of environment (read: CDS).

Lets see what he did and what we can learn/use in this environment. First in March we heard news that WB sold puts on the S&P 500 and 3 foreign indexes. These puts expire in 15-20 years and gave him $4.5 billion in premiums. What this essentially means is that WB is betting that the markets in 15-20 years will be higher than what they were in March, 2008. Again in October 2008 he sold Puts (~5 million shares) on Burlington Northern Santa Fe (BNI), with a strike price of $76-$80 and collected premiums of around $7/put. His index Put selling strategy might be more of a play on collecting premiums, but the BNI purchase seems to be more geared towards him wanting more stock in the company (he already has a large stake). Now if BNI trades at $74 in the future he would have the option of buying the stock at $76, but he has already collected $7 for the put, so he is essentially buying the stock at $69 - selling Puts is another way of buying a stock.

Call and Put option pricing depends on a lot of things, but one of the major determinants is Vega (volatility). This is a time of unprecedented volatility where the VIX is at historical heights, and therefore these options are priced accordingly - high (and this is where an opportunistic value investor comes in). One of the strategies (derived from WB options activity) could be to sell Puts on indexs/stocks that you want to buy, make some money on premiums and if the they fall to your sweet spot, well then good for you!

Let me give you an example: the S&P 500 (SPY) is trading at around the $88.0 area; you sell $75.0 strike put options on SPY expiring Jan 2009 and collect $4.7 in premiums. If the index falls to that level or below you can essentially buy SPY for around the $70.0 level. If it doesen't then you still get to keep the $4.7 in premiums (but don't get to buy the index, which is a downside if that is what your sole aim was). If you think that S&P at 880 is not the bottom, would you be comfortable buying at the 700 levels? The market would be more than 50% off its highs, and the P/S, P/E ratios would be more in line with previous bear markets troughs. Another example could be Goldman Sachs (GS), the stock is trading at around $100, you can sell the $65 strike puts expiring Jan 2009 and collect $5 in premium, how would you like to buy GS for $60? or keep $5? There are myriad things that you can do with options, but selling options is something that can work well when the volatility is high. Also exactly which strike/time to buy depends on the situation and the goals..

Update: GS is trading at $55 today (19th November), so if you had sold the put option on GS you would have been forced to buy the stock. Again, selling options just for the premiums is a risky strategy, however if you want to own the stock after selling puts or are writing covered calls, that's a different story..

Stock Idea: Contango Oil and Gas

2008-10-22T13:15:00.000-07:00

Contango Oil and Gas (MCF) Investment Thesis

Contango (AMEX: MCF) runs on two principles:
(1) The only competitive advantage in the natural gas and oil business is to be among the lowest cost producers
(2) Virtually all the exploration and production industry’s value creation occurs through the drilling of successful exploratory wells

Kenneth Peak, the founder and CEO of Contango is the largest shareholder in the company, has never sold a share and is a very good capital allocator (Buffett type). He has 6 full time employees, all focusing on the highest ROI part of the E&P value chain – exploration. Every other service in the chain is contracted out to an expert that can provide better value for that part of the chain than MCF can. They work with some of the brightest and most successful oil and gas finders in the business. Contango collaborates with a network of about 10 geoscientists with four small, privately held alliance partners. In all their deals, the alliance partners have capital at risk and the deals are structured so that the partners do not make money before Contango makes money. This strategy has paid off - Contango made the largest Natural Gas find (Dutch and Mary Rose) in the Gulf of Mexico (GOM) in the last 2 decades, combing through old publically available data. Contango has the best balance sheet in the E&P sector, with approximately $50 million cash, another $50 million line of credit and $18 million in debt. They have 369bcf in proven reserves and 70 undrilled GOM leases. The Dutch and Mary Rose wells, when operating at full capacity, generate approximately $20 million per month in after-tax cash flow at $7 natural gas and $70 oil prices. The firm has also carved out some properties before and sold them for 10-15x their initial investments, all without paying tax (capital allocation).

The current stock price of approximately $43/share buys 22 mcf of Natural Gas and contemplates $4 natural gas prices and $50 dollar oil. I believe it is not possible for the price of natural gas to remain below $6 for a long period of time (I am not saying it will go up, but below $6 econ 101 will kick in) due to the high cost of marginal supply. MCF can purchase after-tax reserves on the open market, in the form of share repurchases, for approximately $1.75/mcf, which is about half of the cost of developing new reserves through drilling. The company has recently done some buybacks (again capital allocation) but any further buybacks will substantially increase the value of the company.

Warren Buffet has talked about the 'finding costs' as the most important factor in valuing Oil and Gas companies. Contango has total costs (including finding) of $2.18/mcf and is one of the lowest cost explorers in the GOM. The company’s PV-10 valuation with $7.00/mcf of natural gas and $70.00/bbl oil, NYMEX prices flat forever after 35% for projected federal income taxes is approximately $1.3 billion or $78.00 per share. The firm recently got an offer between $75-85/share just for the Dutch and Mary Rose fields (there are other fields, leases and a computer system worth around $10-20/share), but it fell through because of financing. Reserves in the GOM area have traditionally gone for $3.50-$5/mcf; with all these valuation metrics Contango is worth somewhere between $80 - $ 110/share. I am not saying this is the best deal in town (there are E&P companies which have 3-5x potential, but there's more risk) but that there is high visibility and therefore low risk. They have a tangible asset value that can be realized easily and the assets can be easily converted into cash without discounting them.

Mark Sellers has talked about this idea in the Value Investing Congress conferences many times. I researched it and always liked it but Contango never had the margin of safety before, now it does.

Disclosure: No Position

Where is the consumer?

2008-10-17T10:28:00.000-07:00

This is unprecedented. The fact is that we have never seen a consumer lead recession in our lifetimes. The previous recessions in 73/74 – Oil; 80/81 – Interest Rates; 90/91 - S&L crisis; 2001 - Dot-Com collapse and 9/11 were all exogenous shocks to the economy that resulted in a contraction in business, but were not consumer lead. Every facet of the economy has enjoyed the pearls of leverage over the last 20 years. We were all operating at levels that were not warranted, levels that were sustained only by leverage on the household balance sheet. In order to pay this debt and get the household balance sheet in order, people have to work more jobs, spend less, and save more. Also, the unemployment rate after bottoming early last year at 4.4% is now close to 6.1%; this can easily go to 8-11% if history is any guide. Personal income drives consumption and with unemployment rising, personal consumption will go down. Furthermore, in all likelihood Senator Obama will become President of the United States; and he has talked about ‘taking responsibility’ and ‘saving’ etc. This is in stark contrast to the current administration’s message of ‘spend, it’s the American way’.

The US consumer on average has a disposable income of $10 trillion/year and the saving rate over the last few years has been negative. If we look at the 25 years ending in 1985, the saving rate was 10%. I believe the savings rate would go up substantially; maybe not 10%, but something like 5% over the next 5-10 years and factor in the absent leverage – the consumer (75% of GDP) will be a huge drag on the US economy. I believe that were will be smaller engines in the form of Asian economies (slowing down) but the net result will still be negative - via a negative feedback loop. Now the economy either needs: 1) A Large War 2) Major Technology breakthrough. I place a very low probability of any one of them occurring. In essence, this will be a consumer led recession, is unique, will by all accounts severe and last a long (3-4 years) time. We know that the economy and the stock market are rarely in sync, but as an investor this matters because it is crucial to know where the consumer is when valuing a company.

Warren Buffett in a Fortune magazine article once argued that if there is one indicator he looks at, it is the ratio of the market capitalization of the market to the GNP (I am using revenues). The current P/S ratio of the S&P 500 is 1.22. The current ratio sits above the long-term average of 1.14 since 1975 and the median of 1.10; and is substantially higher than the ratio reached in the 1990 bear market of 0.77 and in the early 1980's of 0.50. There has been however, a permanent upward shift in the level of profitability (although the profit margins of 2006-2007 are unsustainable) in the economy, and the S&P 500 should be able to maintain a relatively higher price to sales ratio. S&P 500's median P/E ratio now is at 13.5 and has fallen to just below its long-term average of 14 and below its median of 15. It's near the valuation levels reached in 2002, but remains noticeably above the levels reached in 1991 - 11, in 1982 - 7 and in 1974 - 5. Taking the P/E and the P/S ratios into consideration the market has further to fall - S&P around 750-800; and might trade flat to down over the next few years with a few bear rallies. There are no predictions, only probabilities. I believe in buying stocks and not markets. Balance sheet strength is as important as ever, and investors should buy stakes in stocks they are prepared to average down on. Although I strongly believe in fundamental bottom up analysis (90%), I think it is essential to have a perspective on the relative valuations (10%).

Update: GMO's Jeremy Grantham has completed the first part of this Quarterly Letter, very interesting commentary. He essentially said that they are nibbling right now, they might be early and that there is risk of a 20% overrun to the downside.

Margin of Safety: Three Most Important Words

2008-10-15T13:17:00.000-07:00

when it comes to investing! But what is it? What does it exactly mean? What we essentially hear is that it is buying $1.00 for $0.50, fair enough; but thinking about it over the last few days, I think there are two forms of margin of safety..

Form#1: This is the pure Graham version, where he determines that ABC Corp. is trading for $0.50 while the Book Value of the company is $1.00, the book value is solid. Mr. Market then recognizes that the Book Value is solid and sends the stock price up to reflect that fact. Now IF the company grew by 10% in that year the new Book Value would be $1.10, so we can buy this company for $0.50 and sell it for $1.10, remember most of the money has been made because of the value differential.

Form#2: And this is the modern form. When the US economy moved to a service based economy, there were fewer assets required to produce cash flow. Value investors could not really reply on Book Value's and with the times had to move on to Discounted Cash Flow (DCF) models. The intrinsic value of a business is the Present Value of its future cash flows (P/E and other relative valuation ratios are basically derived from a DCF). Now XYZ Corp.'s is growing at 20%, according to a DCF and has a fair value of $1.20 and the company is trading for $1.00. A value investor will only pay $0.60 for this company while a growth investor might pay around $1.00-1.20 (i really don't know what they would pay!). The value investor is banking that the valuation gap between the fair value (his) and the market will decrease and the growth investor is relying on future growth. This is all fine and dandy but will Benjamin Graham do it this way?

I think not! Remember in our DCF we are implicitly factoring in growth in the cash flows. And this comes down to how value investor's today value securities (and there is nothing wrong with this). We mortals like to label the different type of investing methods, some are value some are growth and so on n so forth. Warren Buffett has said that value and growth are joined at the hip, the only different in the price, and by price we mean margin of safety. Anyways, If we were to use Form#1 in modern day valuation what we would do is value this business factoring in a zero growth rate or a GDP plus (5%) growth rate and then demand a price which is 50% lower than what we figured. If the firm does grow 20% good for us, but we are not making money banking on the growth; we are making the money as the valuation gap seizes. Just something to ponder..

Arbitrage and Market Turmoil

2008-10-13T15:22:00.000-07:00

Seth Klarman and Joel Greenblatt have made careers correctly monetizing on the dislocations in the capital markets. They look for forced sellers where the stock price is depressed not because of the fundamentals but because of the stakeholders who are selling in bulk for one reason or the other. In spinoffs it could be the the holder do not want to or cannot hold on spinco, in additions and deletions from indexes there is opportunity for the astute investor. I am finding now there are opportunities where a deal does not go through and most of the float is held by the arbitragers.

Now suppose a stock is to be taken out at $30/share and was trading at $25/share, which seems to be its intrinsic value as determined by the market. The stock will trade close to $30 and most of the investors holding the shares would have sold their shares to the arbs in the $29 range. Now further suppose that this merger falls apart, for whatever reason (other than a material change in the business suppressing the intrinsic value). Ideally, the stock should go down to around $25/share (in a normal market), but the opportunity arises because it usually does not! The arbs are not in the business of buy and hold, they are in the business of 'buy at 58 sell at 60'. So they will sell their holdings, and because they are levered (to juice the returns) they will sell fast. The stock will have undue downward pressure in these situations and will come way below its $25 intrinsic value. The more it comes down the better it is for investor looking to scoop up a company for cheap. To be sure the window of opportunity here is narrow, the investor would need to do his HW before.

Let me give you an example, after Genesco terminated the merger with Finish Line the stock came down to around $2/share (while the merger was around $15). The price had come down to a fraction of book value for a profitable retailer, and this is mainly because of the forced sales by the arbs. An opportunistic investor could have loaded up and 6 months later sold the position at around $10/share for a 5x return!!

Another example could be the Cerberus-United Rentals buyout. The company went to court but the judge ruled in favor of Cerberus, there was no buyout but Cerberus agreed to pay $100 million termination fee. The buyout was at around $35/share and and URI shares fell to as low as $16/share in the following weeks. Again a opportunistic investor could see that this is way undervaluing the company. The company itself realized that its share price was too low and initiated a tender offer between $22-$25/share for around 20% of its float! The shares traded around $22/share in the ensuing weeks a which seemed to be its value prior to the buyout news.

Whats wrong with CA$H?

2008-10-12T01:14:00.001-07:00

People sometime have a problem sitting on cash. They might feel like they are not working if they are not deploying cash and that cash if not deployed is not really working for them. An investor would usually keep a portion of his portfolio in cash just in case he/she is confronted with a fat pitch. But how much cash should one keep in the portfolio? The answer is..it depends! Here, I will address the time when the investor is usually feeling pessimistic about the markets prospects or when the markets seem high. There are usually two positions people take when confronted with this:

(1) Increase their Cash holdings
(2) Speculate with Gold.

Let me get the gold issue out of the way first and let me tell you why I said speculate. Benjamin Graham said, "An investor calculates what a stock is worth based on the value of its business. A speculator gambles that a stock will go up in price because somebody else will pay more for it". Do you know what the intrinsic value of gold is? I sure don't! A lot of value investors including Jean-Marie Eveillard of the First Eagle funds have large positions in gold. Now on the other hand Warren Buffett has talked about gold as having no use, no utility. According to him we dig a hole to take it out, and then dig another hole to store it! Gold in the markets trades as other commodities trade - supply and demand. Gold however, is different from other commodities as gold is seen as money; more specifically the ultimate form of money. The demand for gold is mostly psychological and comes from the perceptions of investors depending on their views on the macroeconomic conditions at that time and in the future. Since the gold standard was ended on August 15, 1971, the U.S. government has been free to print as much money as they choose, and recently they have been printing a lot of it (M3 supply has risen to 9,873 billion in 2005 from 288 billion in 1959). So when the world around you is getting bubbly, the argument goes buy gold, as it is the only sure thing.

Now cash. The problem here is that when there is uncertainty in the markets (as is the case now), government bonds yield too little, they don't even yield enough to dampen the dilutive effects of inflation! Here my answer to that, so what? Warren Buffett sat on his cash reserves for most of 2002-2007 (and many other periods), he did take stakes in some rail stocks and bought a few companies, but he sure did not go on a spending spree. Now, look at his Goldman Sachs and General Electric purchases, he is getting some of the best deals of his life! I think the underperformance of his cash holdings would be more than offset by the performance of his investments going forward. We must not look a year ahead and think that the yield is not high enough, we should think about the opportunities we can have if we have 103% of the money we started with as opposed to 50%! As Jessy Livermore said, "Big money is made in the waiting". Charlie Munger has talked about sitting on 10-20 million at a time in T-Bills just waiting. He further elaborated, "It takes character to sit there with all that cash and do nothing. I didn't get to where I am by going after mediocre opportunities".

Coming back to Benjamin Graham's point, the problem with gold is that it can be too psychological dependent! I don't know what the "real" value is! I don't know if I bought too soon, too late or when I should sell. I rather have my money in T-Bills, just sitting there so that when Mr. Market throws a fat pitch in a security I really understand, I have enough power to swing hard and let that fat pitch take care of the underperforming years.

Down down down down...

2008-10-10T13:18:00.000-07:00

Wow, what a sell off. The market is down around 20% in the last week alone. This is the same as the 1987 crash except that it took a week as opposed to a single day (and the fundamentals then were better). So again coming back to the million dollar question..Is it buying time yet? I addressed capitulation before and determined there's still time, plenty of time. Really? But oil and gas sector is down around 60-80%, quality companies are selling for 1/6th the value they were selling at before and the market is factoring in $60 oil. Well there might be some bargains in this market but lets go through a quiz first; this is courtesy of Prof. Sanjay Bakshi of the Fundoo Professor fame, he teaches Behavioral finance (as important as knowing the numbers) and manages a hedge fund.

So here goes. You go to a store too buy a cell phone and its retailing for $500. The store clerk tells you that if you walk 10 blocks you can get the same phone for $400 (the clerks incentive structure is suspect!). Would you walk 10 blocks to save $100? 90% people would say yes (the rest are just plain old lazy)!

Now that you have a phone, you want to go buy a car and the car is retailing for $20,000. The salesman again tells you that if you walk 10 blocks you can get the same car for $19,900! Save yourself a $100. Would walk 10 blocks to save $100? Very few people here would say yes even though its the same $100. You are buying things that cost very different amounts, but the change to your net worth is the same $100. So rationally, it makes sense to walk and get your car cheaper!!

Professor Baskhi explains it as follows, "The brain, operating at the subconscious level, is often influenced by the presence of false “anchors”. Anchors are pieces of information to which a mind tends to latch on to while making a decision. And the human mind will often latch on to false anchors created by various influences like availability or contrast."

A stock many have fallen and fallen hard, but that does not mean we should look at where the stock was trading just a few months ago and 'anchor' our expectations! That would be a wrong way to look at it. The crash has indeed produced bargains, but these bargains are only to be had after a lot of research and due diligence. It should be determined that the stock is 'safe', has a strong balance sheet and can weather the downturn, if extended. Cheapness can take two forms: (1) Is the stock cheap because its market cap is way below its Book Value (the real book value as determined by you, and don't count the banks here) (2) Is the stock cheap as determined by the future cash flows it will produce. I believe, that in these environments, you can find both, cheap (both type) and safe. Some stocks in the oil and gas sector may have come down so that it is easily determinable that their assets (ignore them if their cost/bbl are high) are worth more than their market cap (after debt). These things take a lot of work and effort. So dig away and find these gems, demand a greater margin of safety but anchoring to the highs, well....

Book Review: The Little Book of Value Investing

2008-10-09T13:18:00.000-07:00

This is a book by Christopher Browne of the Tweedy Browne fame. They originally used to buy and sell illiquid stocks and then started money management. They have been value investors since Benjamin Graham's time (Walter Schloss worked in their offices), infact he was one of their regular clients. While this was a good read, it is for someone who does not know much about value investing and is a begineer to investing in general. They are the very old school type of value investors and focus on P/B, P/E metrics and are not afraid to go around the world to find value. There were some examples that Chris Browne cited which were useful in forming a prospective.

An example could be the Japanese insurers are selling for 1/3 BV, because the securities in their books are marked at cost and the stock market has had a big run up. They buy these insurers, the regulators change the rules and they can mark the securities at market now and they made some good money. Although, this sounds like a good value investment, but there are a lot of 'if's' in this case, because you are levered to the stock market. What if the market fell? A recent example of this could that Bill Ackman bought Wachovia right after the IRS announced a big change in how the firms can carry the tax losses. Wachovia now has $21 billion of these losses and consequently Wells Fargo announced made a big to acquire it for $15 billion (trumping Citi's FDIC brokered bid)! So knowing these things helps, but now you really need to be very very fast than back in the 1980's when Tweedy Browne bought the shares.

I read this book a couple of weeks ago; he in general about what to look for in a Balance Sheet and the Income Statement. He also presents some research on value stocks vs. other strategies over the long term. There are many other examples of European stocks and relative valuations and how in Europe they don't pay as much attention to the stock market as the US does; the various crises including the Russian debt default, Mexican Peso Collapse, the Asian defaults and the opportunities that arose. A good book, an easy read; buy it if you are starting out and want to get a good introduction to value investing.

Events and Valuations

2008-10-09T12:10:00.000-07:00

One of the recurring themes that many value investors use is to buy companies which have been battered by bad 'events'. The market thinks the sky is falling, and the value investor determines that the event is temporary and places a bet on 'reversion to the mean'.

The most famous examples of this has been Warren Buffett (WB) buying American Express after the salad oil scandal (he actually put around 40% of the partnerships assets in AXP!). Another example could be again WB buying Washington Post in the early 1970's after the Watergate scandal. He determined that these were solid businesses with deep moats and the events were temporary. A recent example could be Sanderson Farms (SAFM), they are a poultry processing company and were hammered after the constant bird flu scares in 2005-06. What did the market think? People will stop eating chicken? Usually what happens after an 'event' is that the company focuses on PR and people either forget (we all know we have short memories) or find safety in the fact that this happened, now the company is more careful (because the PR told them they instituted these state of the art QA process). Anyways during the ensuing few months people resumed eating chicken and the stock went up around 50%.

Now, after the pet food recalls hit (anyone remember?) the firms that produced pet food got severely beaten down. The pet food industry has GDP plus type growth (4-5%) and is fairly recession resilient. The future also seems to be bright for this industry as baby boomers buy pets to accompany them during their waning years. I read the 10K for Menu Foods, and determined the following, (1) Customers which accounted for 40% of the sales no longer would order from Menu (2) A lawsuit was filed (which is almost resolved with minimal damage to menu) (3) The restructuring cost Menu around $55 million (4) The existing customers have increased demand, so their sales are down around 20-30% on average.

This did effect Menu's intrinsic value, the question is by how much? Is the market too negative on Menu's prospects? I believe it is, menu produces an essential product and has its sales down and hence the profits are down (although it did turn positive last qtr). The company is taking the right steps in terms of reining in the expenses and assuring customers that it has put processes in place to make sure this does not happen again. Mr. market has hammered the stock around 80%, while I believe the value should be down around 30%. Running numbers on the company my model predicts that the firm should be valued at around $2.50/share while it is trading at $1/share today. Having said that, there are better buys avaliable in this market and Menu's debt level is higher than what I am comfortable with. This is a case study in value investing and not a buying opportunity.

Capitulation? What Capitulation?

2008-10-09T10:35:00.000-07:00

The markets have been ruthless over the last few days. Anything and everything is being sold. The major indices are down around 30% from their all time highs, and are dropping further as I write this. The emerging markets are down around 60% on average. Everyone is looking for a buying opportunity. Is this the time where a value investor should feel like a kid in the candy store? Prem Watsa doesen't think so and he's putting his money where his mouth is (70% of his portfolio is in government bonds). He is expecting markets go to down at least 50% from their all time highs (this will put the S&P in the 750 range!) which is akin to the 1974 market declines. According to him there's a significant recession coming, long and deep. It's going to spread all across the world; It's very difficult to not be caught by it and it'll will be difficult for the Fed to do too much now as they are running out of ammo. As George Soros and Warren Buffett have said, this is the unwinding of the great credit bubble of the last two decades, and something that takes decades to build up is not dismantled in a few months; this will be a prolonged recession perhaps lasting many years.

So when will there be capitulation?

Prem Watsa further clarifies the definition: You'll know about it when no one here is optimistic. You'll know when there's no expectation of a turn. In September, there were resumptions, significant redemption; but history shows you've got to have months of resumptions. That's an indication that people are losing their confidence and want to be out of the market. You'll see the average pension fund going down to 30 per cent, 40 per cent equity allocation. ‘Stock' will be a bad word. This is akin to the 1980's when gold was at its highest and Barron's printed an article recommending gold and shunning stocks. Pension funds got the rules changed so that they could hoard more gold, and we all know what happened to gold and equities in the decades that followed.

Now just to be clear, there is a difference between the economic cycle and the stock market cycle. They lag/lead each other and seldom are in tandem. I do not expect the stock market to go down for years. What will likely happen now is that the analyst estimates will come down, and then the companies will show earnings; as long as the earnings are not beating estimates the market will keep going down. When however, the analysts are very very bearish (this is after the company goes bankrupt usually) and have very low expectations, this is when the stocks are really crushed and even the slightest earnings beat will provide substantial upside. This is the game wall street plays and knowing this a value investor can be careful and can adjust his buying and selling accordingly. So stocks are beaten down at the expectation that it will not beat expectation and then traded up or down with the actual expectations accordingly.

Update (21st November): Prem is buying. He essentially said that while the recession might be long and deep, the equity markets have discounted much of it.

Paulson, CEO of the US and A

2008-10-08T10:31:00.000-07:00

Paulson and his performance as the CEO of the $50 trillion behemoth called the USA. Looking at if the privatized profits and socialized gains theory holds!

Bear Stearns:
Bear came way before the current crisis, and at that time was thought of as a bad apple which would impact the whole system. The stockholders lost their shirts, the only people who were saved were the employees (as many) and the bondholders (which I agree is not ideal). The fed did backstop $30 billion worth of looses, which some of this I think the fed would never see again! Again, the reason they saved Bear was so that they could restore confidence and be like there there, its been taken care of, get on with your business..
Stockholder 0; Bondholder 1; Taxpayer 0

GSE's:
FRE/FNM bondholders HAD to be protected, what did the stockholders get? nothing! Now the good thing about this is that he might be able to make the taxpayer money on that too, these GSE's have huge earning power. The problem here were that they were too levered, and the stockholders loved it until the music stopped. Now the GSE's under the government will be operating at moderate leverage, the government has the holding power to ride the storm and this should ultimately end up making money for the taxpayer.
Stockholders 0; Bondholders 1; Taxpayer 1

Lehman Brothers:
I believe, Paulson did exactly the right thing with LEH, making sure the moral hazard side of the equation is being taken care of. The stockholders were wiped out and the bondholders will be getting pennies on the dollar. The stockholders and bondholders going forward will demand more from their companies, expect better disclosure and not just expect a government put. It is a shame that LEH had to go, but now going forward firms will know and investors will know that the downside is zero. This is akin to a professor who only asks 2 big questions on a final exam, so you have to study everything..Its good that people are aware of RISK
Stockholders 0; Bondholders 0; Taxpayer 1

AIG:
Wow what a deal! Paulson is a loan shark!! AIG is a wonderful company and was solvent (given that there is a very fine line between liquidity and solvency in these markets). Paulson wrote a $85 billion check and got 80% of the company with a 8.5%+3 month LIBOR interest rate (8.5% on the unused portion)! The loan is secured by all the assets of the firm. Warren Buffet himself said that he wants to know who made the deal, he wants people like that at Berkshire.
Stockholders 0; Bondholders 0; Taxpayer 1

Bailout:
And now the 'bailout', and the word bailout is in quotes because its not really a bailout; and because this is one mistake (if you can call it that) that Paulson made - He dint sell it properly! Warren Buffet, Bill Gross and Larry Fink have all come out and said it will be a fantastic deal for the government IF the securities are bought at market. Warren Buffet said he'll personally buy 1% of what the government buys (and he does not swing unless he sees a really fat pitch). Again, theres a big IF here, if they start buying these things at inflated prices, then there are bound to be losses. But prudent buying of these securities would again help the taxpayer.
Taxpayer 1, Economy 1

Paulson is an investment banker, a really top notch investment banker and the US taxpayer is his client. I believe, he is doing exactly what he should be doing. The financial system is so convoluted and intertwined (derivatives of derivatives anyone?) that it is the perfect example of a real world domino. In all this there is one risk, the risk of executives who absolutely made the worst decisions and were grossly incompetent still have their jobs. Yes, their stock options are way under water, but they'll find ways to issue themselves cheaper options as soon as the clouds clear. I just hope the shareholders can see through all this. The other con is that everyone from the auto industry to the governments of California are asking for a bailout! Furthermore, although the government is not in the business of owning enterprises and making money (at least not in the US) this might set a bad precedent. But in summary, Paulson is absolutely doing the best he can with the cards hes been dealt!

Why?

2008-10-07T17:44:00.001-07:00

Hello and Welcome. I am passionate about value investing and over the years have read the works of several value investors including Benjamin Graham, Warren Buffett, Marty Whitman, and Joel Greenblatt to name a few. I am also enrolled in the Chartered Financial Analyst (CFA) program and have passed Level 2 of the curriculum. The ultimate aim is to work under a reputed value investor in the hope that something rubs off. I've also had the opportunity to learn from several blogs, where authors have selflessly shared their ideas and thesis on various subjects. Why Safe and Cheap? Well there are two rules of investing 1) Don't loose money 2) Don't forget rule number 1. Safe because I believe it is absolutely essential to have a strong balance sheet so that the company can survive the downturns and the capital invested is not permanently impaired - the downside is protected. Cheap is just another way of saying margin of safety, where I'll be looking to buy dollar bills for 50 cents - there is minimal upside. On this blog, I will be presenting thesis on various securities that I analyze, study the activities of the 'gurus' and evaluate general market events from the perspective of a value investor.