John Maikin's Comments re Inflation & Fed policy

In this essay by John Makin of the American Enterprise Institute, he suggests that monetary policy may need to be tightened more than most investors anticipate.

The Learning Curve: Inverted Yield Curve Links

Gawd...starting to feel like a frustrated economist. Got to get back to my comments on stocks! Some terrific commentary though.

Further thoughts on yield curve inversion

Some value investors become almost evangelic about their need NOT to utilize economic inputs in their thinking. I apologize if I offend you, but since I believe that most companies do have some economic sensitivity, particularly smaller companies, I do find it useful to spend a bit of time in economic thinking. Though signs of excess seem to be present primarily in housing and real estate markets, and less so in other capital markets, one should always be somewhat defensive in at least considering the downside risk in your portfolio.

Some further thoughts on yield curve inversion from “The Big Picture.”

“Growth of less than 1% in real M2 in the past four quarters, combined with a sharp contraction in total bank reserves, reinforces what the yield curve is telling us: The economy is headed for a slowdown. That means either less inflation, less real growth, or some combination of the two."

See also: WSJ (Subscription required)

An academic dissertation by Paul Francis Cwik at Auburn University addresses at some length the reasons why the yield curve inverts prior to recessions.

Quoting from his excellent dissertation:

“The analysis then shows that short-term credit can create both short- and long-term malinvestments in the social structure of production. The restricted model demonstrates that, during the malinvestment boom phase, both short- and long-term malinvestments emerge in the early stages of production. These malinvestments are unsustainable and must be liquidated.
The crunch phase of the business cycle begins this process of liquidation. This phase may take the form of a credit crunch, a real resource crunch, or a combination of the two. Each scenario culminates in an inverted yield curve approximately one year before the upper-turning point of a recession. Each recession since the mid-1950s is categorized and is placed into either the credit crunch or the real resource crunch scenarios.”

Despite some comments that I have read regarding the nature of the “new economy” and its lower reliance on inventories, I do not believe that recessions are an artefact of history. The cleansing of excesses that occurs with recession is never pleasant and unfortunately is cyclic and repetitive just as the development of excesses.

As value investors, this signal reminds us to pay attention to balance sheets, to bank and debt covenants, and to operating cash flows. It suggests that is a great time to temper and modulate the risk in your portfolio.

Buy quality when it is there, not when it has a chance of happening!

Inverted Yield Curve

The yield curve rarely inverts. And when it does, it usually spells trouble for the economy. It means that investors and the Federal Reserve are fretting about inflation in the short term, and that investors are pessimistic about long-term growth. Most economists believe that periods of prolonged inversion of the curve between two-year and 10-year government bonds have generally presaged recessions. The most recent period of inversion ran from February 2000 through December 2000—just before the 2001 recession. Note the duration of that inversion. At this point, this represents a faint glimmer of an amber caution light.

Beware the Yield Grinch

Marginal Revolution

Kerry Packer and the Media

“The fact that I have entered into IT-related business is proof that businesses have to evolve and keep with time. One has to re-invent continuously.”

Kerry Packer passed away yesterday, December 26th. He was only 68. He was considered to be the wealthiest man in Australia.

His wealth came primarily from media, where his power and control at times were feared. Women’s Weekly, a magazine that his father started became the core, but led to Packer’s ownership of some 60% of all magazines in Australia. He owned the major Sydney newspaper, the Daily Telegraph.

He failed in his attempt to purchase the Fairfax chain. He described the profits that methodically come out of this media company as “a river of gold.”

He had significant holdings in other forms of media including television, pay-TV, and Internet holdings.

He pursued his love of gambling with investments in casinos, primarily in Australia, but with a growing interest in Asia. The business empire was controlled through an Australian public company called, Publishing and Broadcasting Limited (PBL)

Here is how the company profiles its non-traditional publishing interests:

PBL owns and operates two of Australia’s leading gaming and entertainment complexes, Crown in Melbourne and Burswood in Perth. It also owns the highest rating free-to-air television network, the Nine Network, and the largest magazine publisher, ACP Magazines.A strategic portfolio of investments has been accumulated to complement PBL’s existing core businesses and to provide for future growth. It includes:

1. 25% of Australia’s leading subscription television business, Foxtel.


2. 50% of subscription television content provider The Premier Media Group, producer of leading sports channels Fox Sports 1 and Fox Sports 2.


3. 33.3% of Sky News Australia.


4. 50% of Australia’s leading internet portal, ninemsn.


5. 25% of the nation’s number one online employment business, SEEK.


6. 100% of Ticketek, Australia’s largest ticketing provider.


7. 100% of Sydney SuperDome.


8. 50% of leading cinema entertainment company Hoyts Corporation.


9. 25% of the successful Hollywood cinema and television production company, New Regency.

Interestingly, James Packer, Kerry’s son is not terribly interested in making further investments in publishing media.

Essentially, the competitive landscape has changed, and News Corp as well as the Internet have become formidable competition for Fairfax.
"I think it would be a much riskier proposition than I would be willing to recommend. You just have to look at the sharemarket - our shares today trade at $12 and Fairfax trades at around $3.30. And they were the same price 10 years ago.
"I think that however much John Fairfax has underperformed the rest of the media market over the last 10 years, the competitive threats facing that company are more severe and more dangerous and more daunting today than they've been before.
"My hope is not that those comments create a flashing headline that Fairfax management and directors get upset about by my being argumentative - I'm not. Personally and professionally I wish them well. But I think they've got two competitors: News Ltd/News Corp have proven to be the best operators of newspapers in the world - and their other competitor is the internet, which I think is a technological change that comes along once in a lifetime. And both of those guys are gunning for Fairfax."
Kerry Packer may have been a brilliant and tough businessman, but his legacy includes the remembrance of his soft heart for his employees and staff. What a great way to be remembered! R.I.P.

Happy Holidays!

Merry Christmas, Happy Hanukkah! However you celebrate this holiday season, we wish you the best of the season!

I'd also like to take this opportunity to thank everyone for reading this blog!Your readership and suggestions are very much appreciated.

Wishing you a happy and prosperous New Year!

Rick

Concentrate by thinning out

As most of you know, diversification has been described as a hedge against stupidity. Unfortunately, most investors tend to cower when they see very concentrated portfolios. Those stocks that present the greatest consternation to the average investor, because they represent a departure from conventional thinking, cannot really provide major league hits in a portfolio where they are accorded a minor league weighting.

Many investors at this time of year are concerned with tax-efficient strategies and ensuring that tax-losses are being taken appropriately. I suggest that you consider the quality and valuation of your holdings. Ensure that the “bets” that you have made are appropriate and that you are being adequately compensated for the risk you are undertaking. The only real compensation that we get as investors is an adequate entry price and we are the only ones who can control that.

This is a great time to be thinning out your stocks. Get rid of the deadwood and those names that provide more agita than returns. Get rid of the weeds and the "bad seed." Focus your thinking...concentrate your portfolio. Make it evident in your portfolio what it is you are "rooting" for.

I note in TaylorTree, a magnificent post about this thinking and how it applies to crops. I think, much like Munger drawing insights from disciplines outside of economics and business, you can use these insights in your portfolios.

Crop Stock Management

Finally, and most importantly, here’s wishing all the very best of the season. Wishing you the happiest of holidays and a prosperous and fulfilling New Year!

TSYS loses major client

TSYS (TSS) formerly, Total System Services, was one of the worst performers on the NYSE yesterday as a result of the loss of its contract with Bank America.

Bank America (BAC) announced that it is terminating their contract with TSS and intends to have de-converted all of its accounts by October of 2006. The lost revenue for TSS amounts to $140M or about 10%-11% of TSS revenues. BAC will have to pay a termination fee that at this time is unspecified.

Since BAC was on contract until 2014 and has 8 years left on the contract, I believe it could be a sizable breakup fee. Most of these contracts have breakup fees that require the minimum guaranteed payment for the remainder of the contract.

Most analysts this morning are nattering about the vulnerability of TSSS to bank consolidation. What seems to be forgotten however is that for all the bank consolidation that takes place, there appears to be a great rise in de-novo banks. I recall looking at some statistics for Florida banking, one of the hotbeds of consolidation, where one year 143 Florida banks merged or were bought out. That same year, 126 de-novo banks started up!

I agree that the loss of BAC does represent some short term pain, and a loss of face. But let’s look at what’s left:

1. Some kind of a breakup fee for contract termination.


2. Excess capacity that will begin to fill up as the Capital One contract picks up in late 2006.


3. Marketing internationally…just signed a deal in China, and exploring opportunities in Central Europe.


4. Greater chance for separation from Synovus (SNV) parent

The relationship with SNV in some ways is a lose-lose situation from the standpoint of both companies’potential. SNV is less attractive as a bank merger candidate because the purchasing bank has to buy the 81% of TSS held by SNV. TSS, as this event demonstrates, is to some degree tainted by its parent.

Optics aside, this has been a terrific business. No debt, returns on invested capital in the high teens to 20%. There has been $473 million in free cash flow over the last five years. Yesterday’s $3.05 drop in price equated to a drop in market capitalization of $600 million!

Revenues have grown in the last five years at a CAGR of 17% and this has accelerated in the most recent TTM to 28%. The five year growth rate in dividends has been 28% as well.

On an EV/EBITDA basis, the business is trading at less than a ten multiple.

Clearly, more of a GARP value than a traditional value, but one that I find quite intriguing.

Housing Affordability

This morning’s WSJ Personal Journal section features an article on Housing Affordability hitting a 14 year low.

WSJ subscription required to view

Here is a link to the actual data:

Realtor data

I agree that there is a “systematic erosion of affordability,” certainly compared to the some of the data that we have seen in the last decade.

The sensitivity of the data to interest rates and hence mortgage principal and interest payments demonstrates the fine thread on which a robust housing market hangs.

One should not lose sight of the fact that for most locations in the U.S. with the notable exception of the West, at least according to this calculation, housing prices are affordable.

The methodology combines two broad median measures to come up with the index. The index measures whether or not a typical family could qualify for a mortgage loan on a typical home. A typical home is defined as the national median-priced, existing single-family home as calculated by NAR. The typical family is defined as one earning the median family income as reported by the U.S. Bureau of the Census.

To interpret the indices, a value of 100 means that a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home. An index above 100 signifies that family earning the median income has more than enough income to qualify for a mortgage loan on a median-priced home. An index value of 120 means that the family has 120% of the income needed to qualify for this mortgage.

The index assumes that the buyer has a 20% down payment. Big assumption.

The index also assumes that there is a 25% qualifying ratio, in other words, monthly P&I cannot exceed 25% of the median family income. As we all know, in today’s mortgage world, this is a very conservative and conventional assumption.

Some of the anecdotes in the article are quite disturbing. Only 43% of homes sold in the third quarter were affordable to the median income family…this compares to 50.4% a year ago and is the lowest since 1992. The article also mentions that in Tucson, roughly 60% of buyers make no down payment and use 100% financing.

The Importance of a Sustainable Competitive Advantage

Understanding the sustainable competitive advantage period should be the most important focus in understanding any business. This is true both for us as investors as well as for management itself.

Regrettably, or perhaps to our advantage, Wall Street and most investors spend very little time thinking about this concept.

Without a competitive advantage, a corporation has limited economic reason to exist. A company’s competitive advantage is the only reason that it can achieve excess returns for its shareholders. Ultimately, when the competitive advantage period ends for a business, the return on invested capital falls to their cost of capital (or worse!)

An interesting study is cited by Paul Kedrosky here.

Restaurants- Too many seats, not enough...?

Historically, I have not been a fan of restaurant stocks. I can think of few industries that have such ease of entry. I can recall the story of one restaurant chain’s CEO who proclaimed at his retirement party (after far too much libation) that there is one problem in the restaurant business, too many seats and not enough a##holes! The chain would likely prefer that both it and he remain anonymous. Despite his admonitions of some years ago, a lot of smart money has been looking at this industry.

The spectacle of McDonalds and Wendys is very well documented by others far more talented (see Shai Dardashti Value Hedge Funds focusing on Burger Joints). These investments are predicated by reallocation of capital resources to recognize value.

How wide is the moat for the successful chains? For example, Domino’s (DPZ) at first brush, I would believe to have almost no moat. Yet, this has been a spectacularly successful investment since its IPO. Return on invested capital has been 37% in its TTM period. Debt/ total cap is still uncomfortably high for me. The moat seems to be a function of three things, first, the product seems to represent great value; second, the reliability of delivery time, something the chain is noted for, and finally, its relationship to its franchisees. The franchisees’ willingness to shift more of its revenues to national advertising in 2005 and to repeat it again in 2006, underlines franchisees faith in the parent company. In addition, franchisees seem to love the distribution system, something you rarely hear from a franchisee in any business. Dominos is being a good partner in buying back stock as well as having a healthy dividend.

Cracker Barrel (CBRL) also intrigues me. Compared to DPZ, this is a much cheaper stock with EV/EBITDA less than 7 times versus DPZ at 10 times. Where is the moat here? I guess, compared to most restaurant chains CBRL just leaves their consumer with a better taste in their mouths! During 2005, for the 15th consecutive year, Cracker Barrel was named the "Best Family Dining Restaurant" in the Restaurants & Institutions magazine "Choice in Chains" annual consumer survey. For the 12th consecutive year, Cracker Barrel was ranked as the "Best Restaurant Chain" by Destinations magazine poll. In the 2004 J. D. Power and Associates' inaugural study of customer satisfaction in the restaurant industry, Cracker Barrel scored the highest among family dining chains in overall customer satisfaction in its core market regions and the second highest in those regions among all family and casual dining chains.

Last year, the company reported net income of $126.6 million of which $108 million was free cash flow. In the last five years, the company has bought back $441 million of stock. The company has always focused on treating shareholders well with a ten year dividend growth rate (CAGR) of 37%. Though recent earnings have been affected by high gas prices and some merchandising mistakes in the front-end general store, the merchandising issues are being addressed. This has generally been a 15% return on invested capital business.

In short, though I remain quite skeptical of most restaurant chains as having real franchise value because of the lack of competitive advantage, I am spending some time mulling over these names as possible purchases.

NIKE reports its second quarter

NIKE ( NKE) reported record results for its second quarter with revenues up 10%, net income up 15%, and earnings per share were up 18%.

During the quarter, the Company purchased a total of 2,926,400 shares for approximately $240 million accelerating its pace versus the previous quarter when about $150 million was purchased. The company’s share count has been reduced to about 263.7 million shares outstanding on a fully diluted basis versus a year ago at 270.5 million. In addition, almost $300 million in long term debt has been paid down in the last 12 months. On a TTM basis their return on invested capital was 24%.

The negatives…

1. gross margins fell slightly to 43.5% from 44.1%


2. European footwear revenues grew 0%. Total revenues on a YTD basis were +4% but pre-tax income is up 18%.


3. Futures orders were somewhat disappointing…up only 2.5% after currency effects, up 7% before currency.


4. U.S. gross margins down 170 basis points


5. Japan remains slow but improving

The positives…

1. Gross margins in Europe were actually up slightly.


2. Total soccer business is $1.5 billion…this was a $40 million business in 1994. Take that Adidas!


3. U.S., South and Central America, China, and Central Europe are very strong.


4. U.S. had 20% unit growth in footwear. An amazing franchise.

The company has bought back close to $1 billion of its $1.5 billion authorization after only 18 months. The dividend has increased by 24% in the last year. Likely more to be seen both in dividend increases and increased buybacks.

The stock sold off about 3.5% after the close reflecting some pessimism about the slowing futures data.

In my opinion, the company is demonstrating that it continues to grow despite being 25% of the footwear market. There appears to be tremendous opportunity worldwide both in footwear and apparel. From the conference call, it seemed that challenging areas such as France, Germany, and Japan were beginning to show some signs of life.

Any weakness tomorrow based on what appears to be mostly currency related slippage in the futures data, will likely represent a buying opportunity, at least from my perspective. The company is trading at only about a 4.5% free cash flow yield and below an S&P P/E. The median of analysts' growth rate is only 13.5% but I think it could sustain 16%.

Flextronics (FLEX)

I note that a research analyst at Morgan Stanley upgraded Flextronics (FLEX) this morning to an overweight.

There has been anecdotal evidence of a turnaround in demand in both quick turn and volume work. The book-to-bill ratio has firmed for the printed circuit board manufacturers. Better pricing conditions seem to exist. Conclusion...the macro picture looks decent, especially in North America.

The median earnings growth estimates for the 18 analysts who follow this is 18.75%. The actual calculated sustainable growth rate for the last five years has been approximately zero! The company, in the last five years has issued $2.5 billion in stock. Insiders have been heavy sellers of the stock as well, with net sales of over $16.6 million recently.

The return on invested capital in the last twelve months has been about 3%, down from historic levels of about 9%. This is a very tough business with gross profit margins at 5.76% in the latest quarter and operating margins in the 2% area.

The company has generated significant free cash flow in its March 05 FY but has a history of reinvesting in its business rather than returning capital to shareholders. Dividend is zero...buybacks are nada. Over $5.50 per share in goodwill tells you where the FCF went. Tangible book value is $3.53.

My conclusion...the macro recovery is there. Will shareholders experience it?

Irving Kahn

Barron’s features a wonderful article on Irving Kahn this weekend. Today is Mr. Kahn’s 100th birthday. Mr. Kahn served as served as the second teaching assistant to Benjamin Graham at the Columbia Business School after Leo Stern. He helped Ben Graham with some of the statistical work for his seminal book, Security Analysis.

He continues to relish in his work:

He's in the office every business day, reading scientific periodicals, annual reports and newspapers in search of undervalued stocks in the tradition of his friend and mentor, Benjamin Graham, widely considered the father of value investing.

The Kahn Brothers’ website conveys the essence of value investing:

“Kahn Brothers employs a bottom-up stock selection approach, and invests in undervalued equity securities that are usually out-of-favor in the market. We select securities one at a time based on assets, operating performance and long-term fundamental business prospects. Unlike many investment managers, our staff spends a considerable amount of effort evaluating the downside risk of every investment. We are long-term investors with a typical 3-5 year time horizon. If there are very few values to be found, we are comfortable holding cash.
Value Investing is a philosophy highly dependent on price. Security selection is therefore a process of identifying situations where companies trade at a significant discount to their liquidation or going-concern value. This discount, defined as the margin of safety, is critical in two respects. A large margin of safety component reduces the risk of capital loss. Further, superior returns often result when the marketplace recognizes the true value of the enterprise.
The market's recognition of value is often dependent on a catalyst - an event which corrects the margin of safety discount. The identification of potential catalysts is therefore an integral part of our research process. Without a catalyst, a prospective investment can remain underpriced indefinitely and thereby result in a mediocre return.
Kahn Brothers views investing as a combination of art and science. Each investment decision has both quantitative and qualitative aspects. While the former can be readily duplicated by a novice, the qualitative component is acquired only from decades of analyzing investment opportunities. A key element to outstanding investment performance is the discipline and patience to maintain principles that stand the test of time.”

Happy Birthday Mr. Kahn!

Goldman Sachs Comments on Oil

According to Arjun Murti, the peak in oil production will occur sooner than the consensus expects, and the post-peak production decline will be more rapid as well unless there is a sustained increase in investment in production, greater consumer efficiency, and development of alternative energy sources.

Methode Electronics (METH)

Methode (METH) receives about 75% of its revenues from automotive electronics, switches and connectors for the steering column as well as instrument panels. Non-automotive business focuses on telecom and network markets and produces PC cards and poly-optic connectors. Since the bulk of the business is auto OEM's, METH has been weak.

The stock hit another new low on Friday following downward guidance for earnings and revenues announced on December 8th. Currently, the business is trading on a Enterprise Value/EBITDA ratio of about 4.8 times. The balance sheet carries zero long-term debt and about $2.10 per share in cash. There are no post-retirement liabilities. The risk is that most of the revenues are tied to domestic OEM producers with significant programs on F-150, Explorer, Grand Cherokee, Dakota, Ram pickups, and Chrysler minivans. The company has added Honda as a customer.

The business has a return on invested capital of just under 10% for the last 12 months. Operating profits which had been in a downtrend since the late 90's have been improving. CFFO has improved significantly as working capital appears to be under better control.

The stock has addressed many corporate governance concerns with a single class of stock. A director has purchased a small amount of stock recently. This stock appears to be trading significantly below both other electronics companies as well as auto parts companies on most cash flow measures.

C R Bard announces $500 million Stock Repurchase Program

Yesterday, BCR had an analyst meeting where it forecast earnings growth of a minimum of 14% for next year as well as reviewed its product pipeline. Bard, which I suspect suffers from a false perception as a relatively boring and staid company, has actually demonstrated significant growth in the last five years. Earnings per share have grown at about a 20% rate and return on invested capital has improved steadily to20% versus about 11% in 2000.

The company highlighted its significant leadership positions in its four segments. In its oncology division, 95% of its revenues come from products where BCR is #1 or #2. For surgery, such products represent 93% of revenues, for urology 88%. Only in the vascular area is BCR a me-too with 56% of revenues coming from #1 or #2 products.

At first glance, the $500 million buyback appears significant relative to BCR's five year history of buying back "only" $295 million in stock. However, the company also issed some $220 million in stock as well, resulting in a net buyback of a mere $75 million. Recent history suggests that BCR is "getting it" with YTD net repurchases of $40 million.

The company indicated at yesterday's meeting that it would be buying back 5% of its stock in the next five years, not exactly a fast pace. However, when we look at the fully diluted sharecount in BCR over the last five years, shares outstanding has actually grown from 102.4 million to the current 108.3 million.

The company has some $500 million in cash on its balance sheet, an 'A' rating on its debt, and plenty of flexibility to make acquisitions.

In my view, this is an undervalued high quality stock.

Amgen acquires Abgenix

Amgen (AMGN), the world's largest biotechnology company, and Abgenix, Inc. (ABGX,) a company specializing in the discovery, development and manufacture of human therapeutic antibodies, today announced that they have signed a definitive merger agreement under which Amgen will acquire Abgenix for approximately $2.2 billion in cash plus the assumption of debt. All in, about an 80% premium to Abgenix’ market cap.

Amgen benefits in two ways:

1. full ownership of an advanced pipeline product, panitumumab, and


2. elimination of a royalty from Abgenix sales of denosumab (formerly AMG 162)…this represents about 20% of sales of AMG 162

Panitumumab is Amgen's and Abgenix's most advanced cancer therapeutic.

The purchase will add to Amgen’s protein manufacturing capabilities with a 100,000 square foot manufacturing plant in Fremont, California. Abgenix also brings scientific knowledge and assets, such as the ownership and capabilities of the proprietary fully human monoclonal antibody technology, XenoMouse. Amgen also obtains another human antibody for postmenopausal osteoporosis and bone related cancer indications.

The XenoMouse technology creates a fully human monoclonal antibody that contains no mouse protein and was deployed to create Panitumumab. The goal in producing fully human monoclonal antibodies is to avoid immune or allergic reactions.

Unlike most biotech companies, AMGN is profitable, pays taxes, and produces free cash flow. Despite what seems to me a fairly steep price on more traditional valuation metrics, AMGN does pick up about $300 million in tax loss carryforwards. Abgenix SG&A can also represent a significant cost saving.

Sabre Group (TSG)

TSG announced after the close an improved outlook for 2006. Return on capital should exceed 18% this year and has steadily improved from levels post 9/11 that were only 1-2%.

The company is projected FCF of $300 million for 2006. Compare that to a current enterprise value of $2.6 billion The business could trading at a 11.5% FCF yield given these projections and Travelocity growth and margin improvement should exceed that of its peers. Witness Cendant's "challenges" at Travel Distribution.

Travelocity revenue is expected to grow by 40% YOY according to management's projections.

The stock looks quite cheap to me.

Diebold (DBD)-Significant Management Change

Yesterday, Diebold (DBD) announced the retirement of chairman and CEO, Wally O'Dell. O'Dell who had been CEO since 1999, had lost credibility in recent years with the execution difficulties that the company had experienced. Tom Swidarski, who had been appointed COO just two months ago, has assumed O'Dell's position.

The company has a long history of excess cash flow generation. Almost every year, earnings have been below CFFO and free cash flow is generated. This year has been a mess, with YTD CFFO at only $43 million, below net income YTD of $86 million. Free cash flow has been negative $9 million.

The company has been a buyer of its stock with 3.3 million shares purchased YTD, a remaining 500K authorization and a fresh authorization to buyback another 4 million shares.

This is a turnaround situation with a return on invested capital of only about 4.5% in the last 12 months versus a history of about 11-12%.

O'Dell's relationship with the street and key investors also appears to have soured. The board is to be congratulated for its resolve and its action in my opinion.

Salesforce.com (CRM)

One of the best performers of last week was Salesforce.com (CRM) which rose over 12% for the week. Clearly, CRM does have a commanding share (some 60%) of the on-demand CRM market. Siebel in the midst of its takeover by Oracle has other priorities at the moment; Microsoft and SAP both appear to be slow off the mark. In the most recent quarter, it appears that subscription revenue has grown by 79% YOY.

Yet, valuations appear to endorse a brilliant future with little regard for potential risks. P/E of 160 times trailing earnings, price to sales of 14 times require little comment. The company has grown its FCF in the last few years as a result of its subscriber revenue model. However, at a price/FCF multiple of 73 the FCF yield is only 1.4%.

The subscription model defers revenues to the balance sheet to be amortized over subsequent quarters. Hence, earnings tend to have less relevance than cash flows in their business model. Similarly, fluctuations in ongoing business tend to be less transparent and smoothed by the amortization of the deferred revenues.

The current EV/EBITDA is a staggering 386 times. Trailing twelve months ROIC is about 17% though in the most recent quarter, ROIC was 30.7%!

Obviously, the fundamentals appear stellar but the valuation is cosmic. Insiders tend to agree with my assessment, it appears. In the last six months, directors and officers have sold off in excess of $63 million of stock.

To be fair, Marc Benioff, the seller of the bulk of the stock, receives no salary as Chairman and CEO. Nevertheless, this amount of selling is striking in light of the company's operating profit which totals only $18 million for the last twelve months!

GDP growth with and without mortgage extraction

"Calculated Risk," has a fascinating chart which demonstrates the enormous effect that mortgage refis have had in holding up GDP. The impact of the bursting of the housing bubble would greatly diminish expected growth rates due to the direct effect on a loss in housing and construction related employment, and indirectly on personal consumption expenditures.

See also: LA Times

: Arizona Daily Star

Link-A conversation with Ben Graham

The stock market resembles a huge laundry in which institutions take in large blocks of each other's washing...without true rhyme or reason. This quote is from the Financial Analysts Journal September-October 1976. Twenty nine years later, the words still ring true.

Foundry Networks (FDRY)

Foundry Networks (FDRY) was downgraded by Robert Baird this morning based on valuation and increased competition. Let's look at the fundamental picture. Hewlett Packard has introduced its own high end Ethernet switch and this could potentially affect the sourcing relationship that FDRY currently enjoys with Hewlett. Similarly, Alcatel and Nortel are becoming more formidable competitors.

Wall Street has estimated growth for FDRY at a median of 17.5% versus the calculated historical sustainable growth rate of 6.6%.

Unlike most of its confreres, FDRY has generated FCF since 2000 totalling almost $400 million in that time. Common stock issuance has totalled $125 million which was used to fund its acquisitions. There is almost $5.00 per share in cash.

Return on invested capital peaked in 2003 at over 35% but has headed down to its current 8%, which is still fairly lofty by most industry standards. However, the potential competitive pressure on margins should keep a lid on returns for some time.

Though the company is noted for its technological leadership and its strong governmental relationships, the sustainability of its competitive advantage period is moot. The stock is currently trading at 22.6 times EV/EBITDA which seems to suggest a far more robust future than I can comfortably see. In the last six months, insiders have sold about $1.6 million of stock.

Do you really want to own a Steel Stock?

If the basis of owning a steel stock is global demand emanating from China, this article should cause you some concern.

Cyclicality can be exaggerated or mitigated by economic cycles. However, industry behavior is quite telling.

The recent interest in steel has been predicated by the ongoing battle for the Canadian steel producer Dofasco. This company has been a remarkably consistent performer in the North American marketplace. Since 2000, the company has had CFFO of Cdn$1.9 billion and capex of only Cdn $1.04 billion for FCF of Cdn $860 million.

However, year to date, the company has generated negative cash flow of Cdn $218.5 million. Return on invested capital has dropped from 10% plus levels to less than 1% in the most recent quarter.

The understanding of competitive advantage period, that limited period of time during which a company can earn excess returns is very important to investment.

Insiders have also demonstrated some interesting behavior in these stocks:

Company Insider Sales last 6 months
NSS Group $6.263 million
US Steel $7.145 million
Nucor $6.090 million
Carpenter Tech $11.518 million

If you believe that the picture for steel is different in India, read on.

McKesson (MCK)

McKesson Corp announced a replenishment of its $250 million share buyback authorization.

Many investors greet share buyback announcements with some jubilation, yet ultimately, we have to investigate what is being created in shareholder value versus what is being given up. It is also important to determine the effectiveness of share buybacks...i.e. is there a reduction in shares outstanding or is it used to merely sop up employee stock options?

In the last 8 quarters, MCK has issued a total of $1.17 billion in common stock. The sharecount on a fully diluted basis has expanded to 316 million shares by the end of Sept 2005 versus 298.7 million 8 quarters ago. In the same period, the company bought back $628 million in common stock, for a net issuance of almost $550 million in stock.

The return on invested capital has been negative for the last four quarters. Clearly, there seems to be little reason for the company to reinvest in itself given such a return. Seemingly, insiders agree. In the last 24 months, insiders have sold, net of modest purchases, 1,014,160 shares of stock.

On the plus side, the company does generate tremendous free cash flow, with FCF in excess of $1.25 billion in FY ended March 05 and another $1.86 billion generated in the last six months!

With a paltry yield of 0.48%, a seemingly ineffective share buyback program, and negative returns on invested capital, it surprises me that shareholders wanted to celebrate the announcement.

Magna International (MGA)

This morning, KeyBanc Capital Markets (formerly McDonald Securities) initiated coverage of Magna International with a buy.

I couldn't agree more. This truly is a magnificent business, which I could like a lot better were it structured in a more shareholder friendly conformation. From a governance standpoint, the business is ruled by the supreme master and potentate Frank Stronach.

A benevolent emperor, Stronach has ruled Magna under his "Fair Enterprise" philosophy which provides a percentage of profits to employees, management, and shareholders. Through a family trust, as well as through his right to direct the voting of the Magna Deferred Profit Sharing Plan, Frank, his wife, and son control 55.4% of the total vote carried by the Class A and B shares...essentially, as minority shareholders, we have no say. "Fair Enterprise" is especially fair to Frank and not necessarily magnanimous to the rest of us. In order to make ends meet, Frank in FY 2004 supplemented his modest $200,000 salary with a bonus of $1,500,000 PLUS $38.6 million in consulting fees to the eponymous Stronach & Co as well as Stronach Consulting Corp. Terms and conditions of this consulting gig have never been disclosed to shareholders.

Now don't get me wrong. Strong suppliers will get even stronger in this backdrop of bankruptcies and disruptions for Detroit and its suppliers. Magna is an exceptional company with average content per North American vehicle of over $750 and a very diverse product offering. Magna, in fact, is one of few suppliers that can outsource not only parts but also complete assembly. In short, Detroit (and all other auto manufacturing centers) need Magna. The restructuring of GM and F will depend on continued outsourcing benefits and consequently greater reliance on companies like Magna. It is much easier for assemblers to go this route rather than to eke out concessions from the UAW.

Magna has expanded its North American production base to incorporate production worldwide. Magna has quadrupled its production in China in the last five years with 20 locations in place. The company has 9 locations in Eastern Europe.

The company has generated free cash flow since 2000 and CFFO has exceeded net income from 2000-2004. Year to date, the company has generated a modicum of FCF. Return on invested capital is about 9% for the last full fiscal year, and has shown improvement in the last few years.

I like the strategic position as well as the current valuation of the stock. It is a shame that one of the best positioned companies in auto parts with the safest capital structure is relegated to the lowest valuation by these easily rectified corporate governance issues.

It is what it is.

Seth Klarman

Wharton grad Seth Klarman returns to campus to discuss value investing. He warns that value investing has hit a new high in popularity. Beware of the value pretenders, those who buy stocks because they are down but not necessarily cheap.

Sanderson Farms (SAFM)

One of today’s brokerage downgrades was Sanderson Farms, Inc (SAFM) resulting in about a 7% drop in the stock.

Though chicken processing is hardly an exciting business, historically, this has been a very exciting business.

Revenue growth in the last 3 years has compound growth of over 14% versus the S&P 500’s 10%. E.P.S. growth in the same time frame has averaged almost 50%, more than twice that of the S&P 500.

Return on invested capital in fiscal year 2004 was over 35%. Cash flow from operations for the year to date is almost $90 million, essentially flat with last year’s CFFO. The company has a long history of free cash flow generation, This year, the business is not generating free cash flow due to the $133.6 million fiscal 2005 capital budget which includes approximately $7.2 million in operating leases, $13.0 million for the construction of a new corporate office building, and $88.5 million on a new poultry complex in South Georgia which began operations on August 22, 2005. Maintenance capex is generally only around $25 million. Long term debt to capital is a tiny 2%.

The stock is down roughly 25% for YTD, but is currently trading at only about 3.5 times Enterprise Value to EBITDA ratio.

The company has a long history of being shareholder friendly…dividend growth over the last five years has been 44%. The company has not bought back stock historically.

Chicken prices have fallen this year both domestically and internationally. Input costs have risen as well. Whether it is avian flu fears that have affected chicken demand or some other rationale, it is difficult to perceive this as a long term problem.

I believe the stock is very cheap.

Hedge Funds-Adapt or Die!

This article by Grail Partners, consultants based in Boston, provides some interesting thinking about the evolution of the hedge funds industry.

A three-fold increase in institutional investors' hedge fund investments over the next five years – to $950 billion – will double industry assets to $2.5 trillion.

However, the industry will be dominated by multi-strategy, multi-billion players rather than what is primarily a cottage industry today.

Corporate pension plans which have been struggling with low returns, aggressive return assumptions, and volatility will turn increasingly to fund of funds or multi-strategy hedge fund solutions. In the view of the author, this will represent a “climate change” for many hedge funds which will either adapt or die.

Creative Destruction is Healthy

A lot of my friends keep looking for an opportunity to buy General Motors or Ford because they are "down." Old friends of mine from Windsor and Detroit wonder if there is any future in the automotive industry.

Fortunately, as Buffett instructs us, we need not swing at every pitch. Fat pitches where we have a sense of value and a sense of competitive advantage are the only ones that are worthy of our attention.

The problems of both F and GM are well known and in the opinion of many, well-discounted in the stock price. Yet, when we begin to apply a discounted cash flow valuation methodology to the cash flows, we inherently are looking for an initial period of "excess" returns, that is, returns which are above the cost of capital. In the calculation of the terminal value, the excess returns collapse to a normal cost of capital...in other words, excess returns are zero.

As well, the calculation of the pension liability and the post-retirement health care liability is very dificult to nail down. In fact, reasonable estimates of these liabilities are at odds with the accounting definition and likely would eliminate for both companies, almost all of their shareholder equity. In my view, bond covenants would be severely challenged.

There is an economic justice in all of this. Creative destruction as Schumpeter espoused, drives out the old economic structure, but remember, it also creates a new one. Higher quality and more attractive Japanese and Korean imports, better assembly methods with lower labor input costs, and crisper, more adept managements that can accelerate the trip from concept to production are all Schumpeter forces of creative destruction that provide investable opportunities elsewhere.

The essence of my analysis on this matter is "why bother." There is no fat pitch here despite the beguiling prices.

An excellent article about creative destruction was published last weekend in "The Sunday Times." I think it is a worthwhile read!

Awash in Capital

The global wall of cash is driving down returns but increasing risk as investors seek higher return investment vehicles or utilize leverage. This article by William Bernstein of "The Efficient Frontier"addresses these issues.

Stock picking versus Indexation-Good News for Us!

An interesting study on stock picking has emerged from academe. Two profs at Indiana University, Utpal Bhattacharya and Neal Galpin did an investigation into the prevalence of indexing versus actual stock picking in global narkets. Notwithstanding Buffett’s comments on indexing, I have found another fabulous quote which precedes Buffett’s view:

“A small gamble in a large number of different companies where I have no information to reach a good judgment, as compared with a substantial stake in a company where one's information is adequate, strikes me as a travesty of investment policy”

This quote is from John Maynard Keynes. The authors conclude that indexing is prevalent worldwide. No surprise here. I believe that this is GREAT news for stock-pickers!

Other conclusions:

Our first big result is that, on an average, there is more stock picking in emerging markets than in developed markets...about 63% for emerging markets versus 45% in developed markets.

Our second big result is that, on an average, stock picking is declining around the world. Of the 43 countries under investigation, we record that for 38 countries, the maximum fraction of volume explained by stock picking is lower in the last five years (2000-2004) than in the previous five years (1995-1999).

In the United States, the maximum fraction of volume explained by stock picking has secularly declined from a high of 60% in the 1960s to a low of 24% in the 2000s.

We find that though stock picking is less in S&P 500 stocks than in non S&P stocks, the difference seems to have disappeared in recent times.

My conclusion...ultimately, even indexing depends on stock-picking. Efficient markets theory suggests that because there are so many equally informed investors, that no one can have an edge and therefore index. Should stock-pickers become less prevalent, the inherent assumptions of efficient markets no longer apply. The irony is that indexes which endorse capital markets efficiency cannot achieve it without the stock-pickers!

I strongly believe that disciplined investing will provide incremental returns over any benchmark index.

Freddie Mac (FRE)

Freddie (FRE) increased its dividend by 34% to $0.47, a surprise since the company generally doesn't increase its dividend until the March quarter. The dividend has increased 81% in the last two years!

My valuation on FRE "dead" that is basically stopping its business and letting its existing portfolio run off is $72. If FRE enjoys a modest amount of growth, say one third of what it had in the last decade, I believe the stock is worth closer to $100.

There remains $12 billion in excess capital above minimum levels and roughly $5 billion above the 30% capital standard. Management appears to be set in returning much of it to shareholders. This will occur when the company has brought its financials up to date and restored its relationship with its regulator. The excess capitalwould allow the company to buyback almost 10% of the outstanding assuming the 30% capital remains.

Remember that Freddie's sins were UNDER-stating of earnings versus Fannie's of OVER-stating earnings. Fannie has had to sell almost $200 billion in assets to meet its capital requirements.

Both GSE's are under considerable scrutiny by Congress as their role is being defined and legislated. In my view, this is not terribly unlike the opportunity that SLM and STU presented during the Clinton attack on student lending under the FFELP program.

It seems to me that FRE in particular should resume its growth quickly sometime in mid-2005 as the Congressional cloud lifts and the company gets current with the SEC filings.

The company has indicated that it will commence a $2 billion buyback and has now cranked up the dividend substantially. Clearly, the company is signalling its shareholder orientation. At 1.4 times book value versus an historical average of closer to 2.7 times, I find the stock quite cheap.