Monthly Archives: July 2009

Value Focus Monthly Newsletter – Issue 3

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The third issue of Value Focus, our monthly investment newsletter will be sent on August 1, 2009. The newsletter is only available to Valuehuntr Premium Members. For more information, see here.



Warren Buffett’s Stake in Chinese Electric Car Company Generates $1 Billion Profit

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Alex Crippen (CNBC)

buffettWarren Buffett’s bet on a Chinese electric car company is generating sparks.

Bloomberg notes that Berkshire Hathaway’s stake of almost 10 percent in BYD has soared in value by about $1 billion since it was first announced last fall. 

The purchase was completed today at the September price after the China Securities Regulatory Commission gave its approval for the deal.

When Berkshire’s MidAmerican Energy Holdings agreed last fall to make its $230 million investment in BYD, the Chinese company was trading just over HK$8 in the Hong Kong market.

Now BYD’s stock is over HK$42, an increase of about 400 percent.  That means Berkshire’s original $230 million investment is now worth about $1.2 billion on paper.

Buffett’s willingness to back the company has helped boost the stock price, of course.  BYD soared 42 percent in the day after it was announced, but at that point it was still below its high of HK$20 from the previous year.

BYD’s all-electric E6 automobile made its Detroit debut last January at that city’s auto show, and then got major attention in April when a Fortune magazine cover story highlighted Buffett’s investment in the “car of the future.”

That story also notes that Buffett doesn’t get all the credit for this particular billion-dollar profit.  The investment was first suggested by his partner, Charlie Munger.

Update: SOAP Position Closed for 49% Gain

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We have closed our position in Soapstone Networks Inc  (SOAP).  SOAP was added on March 9, 2009, when the company was trading at a 49% discount to its net cash value (see original report here). On June 15, 2009, the company announced that its Board of Directors had unanimously approved a plan of liquidation. The company declared an extraordinary cash dividend of $3.75 per share, plus $0.25-$0.75 per share in the future. Correcting for the approved initial distribution of $3.75, SOAP is trading at $0.50, which is in the middle range of the future distributions expected by management. We do not think that an additional potential gain of $0.25 justifies the risk of owning the stock, so we have closed our position for a 49% gain.

GE Capital Presentation to Investors

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Yesterday, GE Capital executives updated analysts and investors on GE Capital’s progress on shrinking its balance sheet and reducing leverage. The presentation can be downloaded below.


When Good Thinking Goes Bad

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Brett Arends (WSJ)

What do Apple, Inc.’s craziest fanatics, Wall Street, and the case of the Harvard professor and the police officer have in common?


They don’t just show a lot of bad thinking. They show a lot of the same bad thinking.

After all, studies have found that human beings tend to fall back on a handful of common mistakes when analyzing complex situations.

As with Wall Street and the case with Prof. Gates, people tend to fall back on a handful of mistakes when analyzing complex situations.

When investors make these mistakes, they lose money. Which is what concerns us here.

Research says human beings tend to assume they know much more than they actually do. And they tend to overestimate their ability to guess, or predict, what they don’t know – from the future direction of the economy to what really happened on Gates’ porch.

People tend to seek out facts that support the beliefs they already have, ignore evidence that points the other way, and cling to their opinions, even wrong ones, like a drowning man to driftwood. Bulls and bears always find evidence to back them up. So do people on both sides of an argument.

Most humans want to be part of the crowd. Witness how many lined up in their usual “teams” (political or cultural) last week. Or how many investors jump on the “hot” stock that “everyone likes”.

On Wall Street, it’s frequently profitable to go against the crowd. But it’s tough to do.

Facile comparison

People are too quick to make facile comparisons — we assume the future will be like the past, our own experiences are typical, and so on. So we are apt to think a stock that has outperformed in the past will outperform in the future — or that a particular instance involving a black man and a white police officer will resemble other, completely separate, instances.

All of this brings me to Apple, Inc.

While the row about Prof. Gates was snowballing last week, I was getting a lot of emails from Apple fans following a column about their favorite stock.

Obviously, some of this is just from the crazy Apple jihadists — the Macahideen. But the stock is also popular with a lot of normal, grown-up Americans. And while they may not share the paranoia or derangement of their dysfunctional counterparts, many, it seems, are making similar errors of thought.

But the stock is also popular with a lot of normal, grown-up Americans. And many, it seems, are making some classic errors of thought.

A great company is not the same thing as a great stock. And Apple shares, while certainly not wildly expensive, are not dirt cheap, either.

Profit margins have been high so far. That doesn’t mean they will stay high. Competition does not vanish, nor does it stand still.

Sure, Apple may “win” the “war” of the cell phones. But investors cannot possibly know that now, no matter how “sure” they feel. And this isn’t like “winning” at baseball (a false comparison). If the “losing” teams respond by giving their products away cheaply, no one will make any money, not even the “champ.”

Several correspondents said I was “assuming” that Apple would launch no new killer products. Not at all. I am assuming nothing. It is those who are investing who are assuming Apple will launch such products, and that they will be as successful as previous products.

The alternative to owning Apple stock is not owning Microsoft or Palm stock. It’s owning an index fund, or a managed fund — or even just cash while you wait for better opportunities.

Entering a dangerous area

I will repeat my caution. Over the past five years Apple has gained nearly 60% a year. The chance that it will do the same over the next five is remote. That would make it worth $1.25 trillion. The returns are likely to be more modest. And the risks will be greater.

When investors get emotional or wedded to an investment, they enter a dangerous area. They start seeing nothing but good news and green lights ahead. They downplay the risks. This is a perennial human weakness. It’s especially the case with Apple.

Last Christmas, when it was $86, I recommended the stock. Today, at $160, it is a lot less attractive. It’s about 28 times likely earnings. That’s about twice the stock market’s long-term average.

James Montier, the brilliant investment strategist who just left SG Securities in London to join Boston-based fund legend Jeremy Grantham, likes to point out that glamorous growth stocks have usually proven poor investments. Investors, believing they can foresee what they can’t, have tended to overpay for growth.

Two years ago, when the iPhone was first launched, I observed that it was too expensive, and lacked downloadable third party applications, Voice over Internet, and the ability to download music and podcasts (from iTunes) over the air.

Steve Jobs subsequently … slashed the price, introduced third-party applications, Voice over Internet, and over-the-air downloads. The same fans who had taken issue with my initial criticisms then hailed Jobs as a genius for those moves.

The reality is that they don’t know what’s going to happen in the years ahead, and nor does anybody else.

As Mark Twain once said, it ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.

Of Banks and Bonuses

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(NYT Editorial)

Earlier this month, when Goldman Sachs reported record quarterly profits — and prepared to pay juicy bonuses — it was widely, and correctly, noted that the firm was leading the way back to a future in which outsized pay for short-term gains could once again foster excessive risk taking.

Sure enough, last week, Morgan Stanley explained its quarterly loss by saying that some of its traders were still “gun shy” after last year’s near-death experience in the financial markets, but that the firm now planned to increase its risk taking. To try to stay competitive with Goldman and other banks, Morgan Stanley has also allocated a big chunk of its net revenue for compensation.

This from a couple of firms that 1) probably wouldn’t even be around today were it not for ongoing government rescues of the financial system and 2) by dint of being too big to fail, now enjoy an implicit guarantee of future bailouts if their bets go wrong. The financial system may be stabilizing for now, but the danger to taxpayers if markets were to buckle again is at least as great as ever.

Financial regulatory reform is supposed to control that danger. For example, both the Obama administration’s proposal and ideas from Congressional committees sensibly call for banks to hold more capital with which to absorb losses. A wise variation on that basic notion is that the bigger the bank, the higher the capital requirement should be. Insurance premiums paid to the government could also increase along with a bank’s size. Such provisions would create incentives for banks to limit their size and in so doing, reduce the risk they pose to the system.

The problem is that the bonus-driven risk culture is reasserting itself now, while comprehensive reform will probably take until next year, if it occurs at all. A solution is for Congress to handle bankers’ compensation as a stand-alone issue, as the House Financial Services Committee has said it is ready to do. There is no question about the need to end the perverse incentives that helped to set off the financial crisis. There is ample, and justified, anger among Americans about outsized pay — often to the very same bankers who profited from the bubble — to warrant fast-tracking the issue.

Among the needed pay reforms are rules to tie executive payouts to long-term results, like prohibitions against cashing out equity-based compensation until many years after options or shares have vested. Bonuses need to be delayed to ensure that the profits on which they are based do not prove transitory. An insightful reform recommended by Lucian Bebchuk, a Harvard Law professor and director of the law school’s Program on Corporate Governance, would require that executive compensation be tied not only to the company’s stock performance, but also to the long-term value of the firm’s other securities, like bonds. That would encourage executives to be more conservative about using borrowed money to juice returns to capital, because it would expose them to the losses that leverage can exert on all the firm’s investors.

Reforming the way bankers and traders are paid needs to be part of a newly regulated financial system. But it needn’t and shouldn’t wait for comprehensive reform to see the light of day.

SEC Rule on ‘Naked’ Short-Selling Now Permanent

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By Associated Press

Federal regulators on Monday made permanent an emergency rule aimed at reducing abusive short-selling, put in at the height of last fall’s market turmoil.

The Securities and Exchange Commission announced that it took the action on the rule targeting so-called “naked” short-selling, which was due to expire Friday.

Short-sellers bet against a stock. They generally borrow a company’s shares, sell them, and then buy them when the stock falls and return them to the lender—pocketing the difference in price.

“Naked” short-selling occurs when sellers don’t even borrow the shares before selling them, and then look to cover positions sometime after the sale.

The SEC rule includes a requirement that brokers must promptly buy or borrow securities to deliver on a short sale.

At the same time, the SEC has been considering several new approaches to reining in rushes of regular short-selling that also can cause dramatic plunges in stock prices.

Investors and lawmakers have been clamoring for the SEC to put new brakes on trading moves they say worsened the market’s downturn starting last fall. SEC Chairman Mary Schapiro has said she is making the issue a priority.

The five SEC commissioners voted in April to put forward for public comment five alternative short-selling plans.

One option is restoring a Depression-era rule that prohibits short sellers from making their trades until a stock ticks at least one penny above its previous trading price.

The goal of the so-called uptick rule is to prevent selling sprees that feed upon themselves—actions that battered the stocks of banks and other companies over the last year.

Another approach would ban short-selling for the rest of the trading session in a stock that declines by 10 percent or more.

In addition to making the “naked” short-selling rule permanent, the SEC and its staff are working with major stock exchanges to make data on short-sale transactions and volumes publicly available through the exchanges’ Web sites, the SEC announcement said.

It will result in “a substantial increase” over the amount of information currently required, the agency said.

“Today’s actions demonstrate the (SEC’s) determination to address short-selling abuses while at the same time increasing public disclosure of short-selling activities that affect our markets,” Schapiro said in a statement.

Accountants Gain Courage to Stand Up to Bankers

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Commentary by Jonathan Weil (Bloomberg)

Turns out America’s accounting poobahs have some fight in them after all.  Call them crazy, or maybe just brave. The Financial Accounting Standards Board is girding for another brawl with the banking industry over mark-to-market accounting. And this time, it’s the FASB that has come out swinging.

It was only last April that the FASB caved to congressional pressure by passing emergency rule changes so that banks and insurance companies could keep long-term losses from crummy debt securities off their income statements.

Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month.

“They know they screwed up, and they took action to correct for it,” says Adam Hurwich, a partner at New York investment manager Jupiter Advisors LLC and a member of the FASB’s Investors Technical Advisory Committee. “The more pushback there’s going to be, the more their credibility is going to be established.”

Broad Consequences

The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.  The FASB’s approach is tougher on banks than the path taken by the London-based International Accounting Standards Board, which last week issued a proposal that would let companies continue carrying many financial assets at historical cost, including loans and debt securities. The two boards are scheduled to meet tomorrow in London to discuss their contrasting plans.

Differing Treatment

While balance sheets might be simplified, income statements would acquire new complexities. Some gains and losses would count in net income. These would include changes in the values of all equity securities and almost all derivatives. Interest payments, dividends and credit losses would go in net, too, as would realized gains and losses. So would fluctuations in all debt instruments with derivatives embedded in their structures.

Other items, including fair-value fluctuations on certain loans and debt securities, would get steered to a section called comprehensive income, which would appear for the first time on the face of the income statement, below net income. Comprehensive income now appears on a company’s equity statement.

Another quirk is that the FASB doesn’t intend to require per-share figures for comprehensive income. Only net income would appear on a per-share basis. My guess is that means Wall Street securities analysts would be less likely to publish quarterly earnings estimates using comprehensive income.

Imagining the Impact

Think how the saga at CIT Group Inc. might have unfolded if loans already were being marked at market values. The commercial lender, which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT’s reported shareholder equity. That tells you the company probably was insolvent months ago, only its book value didn’t show it.

The debate over mark-to-market accounting is an ancient one. Many banks and insurers say market-value estimates often aren’t reliable and create misleading volatility in their numbers. Investors who prefer fair values for financial instruments say they are more useful, especially at providing early warnings of trouble in a company’s business.

Religious War

“It’s been a religious war,” FASB member Marc Siegel said at last week’s board meeting. “And it’s been very, very clear to me that neither side is going to give, in any way.”  So, the board devised a way to let readers of a company’s balance sheet see alternative values for loans and various other financial instruments — at cost, or fair value — without having to search through footnotes. At last week’s meeting, FASB member Tom Linsmeier called this a “very useful approach that addresses both sets of those constituents’ concerns.”

This will not satisfy the banking lobby, which doesn’t want any significant expansion of fair-value accounting. “I guess the nicest thing I can say is it’s difficult to find the good in this,” Donna Fisher, the American Bankers Association’s tax and accounting director in Washington, told me.

If the bankers don’t like it, that’s probably a good sign the FASB is doing something right.

How to Make Presentations to Portfolio Managers

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by Bill Miller, Portfolio Manager of Legg Mason

I want to emphasize that if you go into capital markets, you will realize that portfolio managers have ultra-short attention spans. And there is basically no successful portfolio manager of my acquaintance who has ever wanted to hear a story longer than ninety (90) seconds.  Peter Lynch, when a senior analyst came into a pitch him a stock, would turn on an egg timer for 90 seconds.  The analyst had to complete the presentation within 90 seconds and be out of there.

If you can’t get the portfolio manager’s attention within that time with a convincing case then they will assume that you either don’t have a convincing case or you are not able to articulate it, and you should go back and figure it out.

Stories not Atoms

The world is made of stories, not of atoms. Most people think of the world as analyzing atoms and its constituent parts, and then I am going to figure out how to value it and then describe it.  The alternative way to think about it is to construct a convincing story. Take all your material together and construct a convincing story.

If you speak to a portfolio manager, the best thing to say is, “I want to talk to you about Homestore (HOM).  It is at $2.25. The 52-week range is $4 to $2 and the all time high was $100 in 2000. I think it is a buy for the following five reasons:

1) Bam
2) Bam
3) Bam
4) Bam
5) Bam

The stock is trading a $2 and change. I think it is worth $6 or $8 or whatever.  Here is why I think it is worth that.  Here are the risks. Present no more than five positive points, three negative points, and what the business is worth. Then you are done.

Private Equity: Better Times Ahead

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By Neil A. Martin (Barron’s)

John K. Castle knows a good deal when he sees one. In 1995, the chairman and chief executive of Castle Harlan, a New York private-equity firm, spied an advertisement for a beach house in Palm Beach, Fla., that had served for six decades as the vacation home of the Kennedy clan and once was President John F. Kennedy’s winter White House. Castle paid $4.9 million for the aging, walled Mediterranean estate, which had been listed for $7.9 million, and poured in another $6 million renovating it. Even in today’s stressed real-estate market, it’s conservatively worth perhaps five times what Castle has invested in it. Not a bad return.

“It was basically a distressed asset when I bought it, but its history and setting, including 200-foot ocean frontage, makes it very valuable — and we are value investors,” says the 68-year-old Castle, who had been CEO of Donaldson Lufkin & Jenrette before establishing Castle Harlan in late 1987.

Over his firm’s 22-year history, it has raised more than $3.9 billion in equity capital and completed more than $9.6 billion in acquisitions. The 10 companies in the private-equity outfit’s current portfolio employ more than 39,000 employees and last year had a combined $5.3 billion in sales and $440 million in cash flow (as measured by EBITDA — earnings before interest, taxes, depreciation and amortization).

Among those holdings: Morton’s steakhouses, Perkins & Marie Callender’s restaurants and bakeries, malt producer United Malt Holdings and book distributor Baker & Taylor. Since its establishment, Castle Harlan Funds have generated a 20.5% annual return on realized investments.

With markets in turmoil, Castle was on the sidelines over the past two years, but he now sees opportunities. To learn where’s he’s prospecting, read on.

Barron’s: Why would anyone want to invest in a private-equity deal in the current economic environment?

Castle: Because things are cheaper, for one thing. Prices for private companies are down substantially, perhaps 30% or more, versus two years ago. Furthermore, sellers are frequently being forced to sell premium assets because they may be overleveraged. And they might not be able to deal with it by selling second-tier businesses. So a private acquirer can frequently buy better companies at much lower prices than in normal times. Certainly, this was what I experienced in the difficult economies of the mid-1970s, 1987, early 1990s and 2001 through 2002. Deals may be fewer than they were two or three years ago because today’s sellers are generally limited to parties that have some level of distress, but it is a time of opportunity.

Where do your funds get their investment money from?

Our investment funds are limited partnerships that include public and corporate pension funds, endowments and other institutional investors and affiliated individuals as participants. The minimum investment is $5 million. There is definitely less money around today — less for equity investment, less money for financing. This financial crisis has wiped out a quarter of the world’s wealth. It has been more ubiquitous than at any other time in my career. Back in the 1970s, there were huge losses in securities markets, but there were princes and sheiks in the Middle East selling oil which was doing better than ever. But this crisis has affected everyone.

What about the cost of capital?

In this current environment, the cost and availability of debt capital for leveraged buyouts is much more challenging than they were two or three years ago. In part, this is the reason purchase prices are down so materially.

What are investors demanding now?

Investors are expecting much better investment performance for money that they commit in times like these. My own experience is that they will get it. Whether in the mid-1970s, 1987, the early 1990s or 2001-2002, investments made in difficult times have resulted in outstanding returns to investors.

With this tough economic backdrop, how has your business been doing?

Things have been tough, but our funds have performed well. Castle Harlan Partners IV, currently our most active fund with assets of about $1 billion, was up 3% last year, which compared to most investment classes is very good. So, on a relative basis, we’ve done well, but that isn’t to say that this has been a real easy year for money that is already invested. The opportunity here is for investing in new assets. This is going to be an extremely attractive time, going forward, to make new commitments.

How many partnerships do you have at present?

We have five domestic partnerships, and we also have three offshore partnerships, mostly in Australia. We have joined forces with one of Australia’s leading private-investment concerns to create Champ — which stands for Castle Harlan Australian Mezzanine Partners. Together, the two firms employ nearly four dozen investment professionals.

Are the five domestic partnerships open to investors?

Three are. One is nearly fully invested, so practically speaking, it isn’t really open to new investors. And the fifth has no investments yet and is available for new deals. Investors are making commitments to the funds, and we are looking at a lot of transactions right now.

We have a substantial amount of investment capital on hand and are ready to commit it for the right deal. The equities monies that are immediately deployable are a little over $700 million. But that would probably translate into at least a couple of billion dollars worth of transactions.

What kind of companies are you interested in?

We take a very disciplined approach and focus almost exclusively on control positions in middle-market private companies. We believe that achieving above-average returns requires investing at sensible prices in companies that offer opportunities for solid, attainable growth. Our goal is to expand and improve the companies we acquire, sometimes modifying and enlarging their market presence through add-on acquisitions.

Why the middle market?

We’ve done studies that indicate that there are probably as many as 60,000 companies in the United States that are in our mid-market area. If you try to do megabillion-dollar deals, the number of transactions that can be done are far more limited. The Fortune 500 starts at about $3 billion or $4 billion of annual revenue. So you are talking about just 500 possibilities. Maybe there are a few more, but it’s not 60,000. We like a bigger pool. We think the mid-market is a less efficient area, and so there is far more likelihood that we can identify a property that has solid value there.

Can you give us an example of that philosophy in action?

Of course. In July 2004, our Castle Harlan Partners IV fund acquired Horizon Lines [ticker: HRZ] for $650 million. Originally Sea-Land, which pioneered the container-shipping industry and later CSX, Horizon is the leading Jones Act shipping line between mainland U.S. ports and Alaska, Puerto Rico, Hawaii and Guam.

What’s the Jones Act?

It was a law enacted in the 1920s requiring that maritime trade between U.S. ports be conducted by American-owned and incorporated companies that use ships built and registered in the U.S. Because Coast Guard and Jones Act regulations also set strict safety and service standards that most shipping companies can’t meet, only a few serve these Jones Act markets. That provided Horizon with a strong niche-market position.

We felt that this, coupled with the operational excellence and bottom-line orientation of management, offered solid growth opportunities. We sold it about a year and a half ago, and we were able to make 3.2 times our investment and achieved a 115% compound return by carefully executing our business plan.

What’s been your main focus?

We’ve always focused on doing buyouts, which means that you are buying companies that are established, have established cash flows and a business history. We’ve focused on companies that have had moderate growth.

Our plan is to make them grow a little more rapidly. Instead of growing 3% to 5%, we can make them grow 8% to 10%. We can do some strategic things. We can do some acquisitions. We can do some development of new products and so forth to make them grow a bit more rapidly. We have always focused on value in our activities.

How much are you willing to pay?

Generally, we want to buy companies at less than 6½ times EBITDA. Sometimes, we go a little bit above that, but we are pretty disciplined in our value approach.

Where are the opportunities now?

I am salivating at the opportunities that I see coming forth here, probably over the next couple of years. Among the businesses that we might look at would be manufacturers, perhaps certain kinds of specialty chemical companies. Historically, we have sometimes invested in restaurants. People have to eat and, in many cases, restaurants sell at a lower multiple than an equivalent company in some other area.

How many deals might you be involved in at any given time?

In a given year, we are likely to look at 1,000 deals. Out of that, we’re likely to end up doing, at most, a handful.

You were pretty much on the sidelines during 2007 and 2008. Do you see an uptick in activity this year?

If you look at last fall and early winter, there was so much chaos [in the markets and economy] that most people were kind of hiding in their bunkers. Now, as the explosions stop, they’ll come out and say: ‘OK, here is where I am. This is the mess I’m in, and how do I deal with this? And maybe if I can sell this, I can put together the money that will pull everything else together.’ Or, ‘having lived through this war, I don’t want to live through any more wars. Let me out of here.’ My guess is that things will kind of start to get sorted out, and that, over the next 12 months, a lot of things will start happening.