Thursday, August 31, 2006

Radio Shack - Pink Slips and Reputation Slips

Apparently, 400 Radio Shack employees got pink slips in their e-mail this week saying,"Unfortunately, your position is one that has been eliminated."

What does this tell you about the business?

With about 5,000 stores and another 777 kiosks, this has been a business that historically generated a great deal of free cash flow (year to date CFFO is -$91 million before capex of $47 million.) It has historically bought back a great deal of stock, last year buying back(net of issuance) almost $600 million. Return on invested capital has been over 20% for the last three years.

So, to some degree, at least from a very superficial analytical standpoint, RSH may be worth a peek.

But there's a lot more to portfolio management or business management than just the numbers. Reputation and integrity count. Management does count. Despite the popular depiction of many managements as greedy, or Scrooge-like, there are many that are not.

Apparently, RSH management seems to lack class. Management claims that it was important to notify people as quickly as possible. Employees had 30 minutes to collect their thoughts, make phone calls, and say goodbye to fellow employees. But how dehumanizing! Not even a few minutes of management time for the exit interview, an opportunity to thank you for years of service, a chance to personalize the process and to wish the faithful employee good luck!

Contrast this with the send-off received by former Chairman and CEO Len Roberts who was getting $41 grand a month to provide "advice" for 31 months plus office space and an assistant at $100 grand a year. What about the credibility that was lost when it was discovered that former CEO David Edmondson had fabricated his educational credentials and had claimed that the college from which he had "graduated"  had misplaced his records not to mention that his diploma had burned in a fire. What about the hurried resignation of the Chief Operating Officer announced Aug 18th and effective today?

The motto of this company has been: "You've got questions...we've got answers?"

My question is, "Do you know anything about reputation management?"

Reputation and integrity count and it seems that the further down that RSH reputation gets, someone in management finds a way to dig even deeper. Problems seem to turn into crises very quickly at RSH whether media or blog driven!

Reputation must be managed as aggressively as any other aspect of management. Reputation influences a lot of things: customer loyalty, attracting good employees, getting a multiple on the stock. Bad things happen to good companies which provide opportunities for investors who have confidence in management's ability to turn things around. So far, the preponderance of evidence has yet to build a case for confidence.

Poor handling of employee dismissals given the difficult times that this business has recently seen provides little excuse for potential shareholders to even bother studying the financials.

So I haven't!

Disclaimer: Neither I, my family, nor clients have a current position in Radio Shack.

Do Mutual Funds Perform When it Matters Most?

I appreciate your patience with me as I have taken a bit of a break from blogging to catch up on some administrative necessities.

However, having read a fascinating article, I could not wait to bring it to your attention.

The combined assets of U.S. mutual funds totals some $9.4 trillion of which about $5.2 trillion is stock funds. Year to date cash flows have been about $110 billion of inflows into stock mutual funds.

Mutual fund underperformance has been widely documented by both the popular press and academic research. Though historically much of the underperformance has been attributed to poor stock-picking by professional money managers, more recent research has attributed the phenomenon to poor portfolio composition and excessive portfolio turnover. The high portfolio churn leads to after-tax performance that further reduces returns.

Noted thinkers such as Charlie Ellis argue that it is exceedingly difficult for institutionalal investors to outperform the market when, in aggregate, they actually are the market. John Bogle, of Vanguard fame, has similar thoughts, essentially that all investors, in aggregate earn precisely the market return before the costs of investment are subtracted. And management fees, transaction costs, distriubtion costs are substantial, particularly given current relatively low rates of return.

But this paper counters some of the negatave arguments that have long been attributed to the industry. The study, written by Robert Kosowski of INSEAD covers the U.S. domestic equity
industry for the period 1962-2005.

The paper demonstrates that indeed, during periods of expansion, the mutual fund industry, in general, fails to generate alpha...the risk-adjusted return is less than the benchmark index return. However, in periods of recession, the industry on balance achieves positive alpha, a risk-adjusted return greater than the benchmark.

During recessions, investors' marginal utility of wealth is other words, there is much greater sensitivity about loss of wealth. At such a time, the mutual fund industry is more likely to show positive alpha and enhanced returns.

The difference in alpha between expansionary and recessionary years is very significant amounting to 3 to 5% a year. The sudy also addressed the performance differences between aggressive growthm growth, growth and income, and balance or income fund classifications.

Please review the numbers in the spreadsheet posted prior to this post. The numbers are quite astounding.

During recessionary periods, balanced mutual funds in aggregate generated over 500 basis points of alpha on a risk-adjusted basis! Quite impressive! Aggressive growth mutual funds generated the least positive alpha as a category, but nevertheless, on a risk-adjusted basis, they did generate 82 basis points of alpha in aggregate. However, in every category, over the long run, managers fail to generate alpha.

Once again, the evidence is strong...most mutual funds subtract rather than add value over the long run. Clearly, there are exceptions to this, generally from low-turnover, disciplined funds. The real surprise is that most of the industry adds value when you need it most! Hence, it is possible to exploit business cycle predictability to achieve positive risk-adjusted returns from mutual funds.

The evidence is somewhat encouraging for recessions...but a quandary remains. How good is the investor at forecasting recessions?

Alpha Generation

Here is a spreadsheet of the alphas generated by mutual funds during expansion versus recessionary time periods.

Click POWER VIEW You can see the document in an applet mode when clicking 'POWER VIEW'.It could be an enriching experience.

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Wednesday, August 23, 2006

Tesco Seems Tasty...Returns on Capital plus Real Estate

As you know, Berkshire Hathaway recently stepped up its investment in Tesco, tripling its position that it had established in the first quarter.

Berkshire Triples Stake in Tesco

Tesco may not be as well known on this side of the pond as it is in the UK, but it has dominated UK food retailing since the early 1990’s. The company has a rich history having been founded in 1924 by Sir Jack Cohen who used his gratuity from the First World War to fund an inventory of groceries in London in 1919. Tesco opened the first self-service grocery store in the UK in 1948, well after their introduction in the States. The first supermarket was opened in 1956.

Tesco had a Wal-Mart or Costco kind of a philosophy…it buys in bulk and keeps costs down in order to offer low pricing. Expressed simply, “Pile it high and sell it cheap.” But regulation in Britain allowed suppliers to insist that retailers charge a set price to all customers in order to protect small stores. Tesco introduced trading stamps in order to bring better value and effectively lower prices to consumers. Retail price maintenance or fixed pricing was abolished in 1964, largely through the urging of Jack Cohen.

Tesco in the late 1970’s decided to become a superstore concept, close its inefficient “High Street” locations and move to the suburbs. It broadened its inventory beyond groceries . During the 80’s, it became Britain’s largest independent gasoline retailer. It was early in recognizing the importance of nutrition by introducing in 1985 its “Healthy Eating” initiative. In 1992, it introduced “Tesco Express,” a gas station combination with a convenience store. In 1995, it introduced the first customer loyalty card in the grocery industry in the UK, the same year that it introduced the “Would I Buy It?” quality initiative. By 1997, Tesco formed a joint venture with the Royal Bank of Scotland to offer financial services as well as its own branded Visa card.

In non-food items, Tesco sells electrical appliances, televisions and home entertainment, as well as branded clothing.

The company is a global retailer, in fact, more global than British, with 54% of its total selling space outside the UK, but representing only about 24% of total revenues. About two-thirds of its non-UK stores are less than five years old and still growing rapidly. Its international territory includes Ireland, Poland, Hungary, the Czech Republic, Slovakia, Turkey, South Korea, China, Malaysia, and Japan. The company is the market leader in many of these countries.

The company has been a financial powerhouse with a target for ROIC of 14.8% and a current 12.8% ROIC. Contrast this with Safeway (SWY) at 5.8%, Kroger (KR) at 7.0% and Wal-Mart (WMT) at 14.6%.

EBITDA margins also provide an interesting study in contrasts. Tesco exhibits EBITDA margins of 7.89%, versus SWY at 5.69%, KR at 5.36%, and WMT at 7.41%.

The balance sheet is relatively underleveraged compared to the EBITDA that Tesco generates. The company could pay off all net debt in only 1.3 years. On a net debt to total assets basis, Tesco also appears underleveraged at 18% compared to SWY at 38%, KR at 34.3%, and WMT at 23.5%.

Working capital management and inventory management capabilities are also superior to most others in the business, critical skills in retailing. The only shortcoming appears to be in terms of total assets turnover, because of the preponderance of real estate that is owned. Sales to total assets are about 1.75X versus 4.3X for SWY and 5.3X for KR. WMT is at 2.26 X.

The real estate intensity though a disadvantage in terms of capital efficiency does provide hidden value. Tesco is the largest property company in the UK with a book value of some ₤ 16 billion. According to Tim Attenborough, who has completed an outstanding and thorough report on the company at Exane Paribas, the current value of the portfolio may well be 50% higher representing a hidden value of almost 75% of the current market price of the stock. The CFO at the annual analyst’s review meeting indicated that the real estate value was at least 50% above book. Please check note 12 of the annual report which supports this valuation…hats off to the IFRS disclosure standards here!

There is a pension liability which despite being fully funded in actuarial actuality, appears as a liability under the peculiarities of International Accounting Standards. Ah, the wonders of GAAP! At the CFO’s review of the year 2005, he noted that in a two week period in January, a 20 basis point drop in bond yields increased the pension deficit by ₤200 million!

The company has undertaken a massive capex program which has funded its international expansion. Though generating CFFO of about ₤10.7 billion in the last five years, capex was about ₤11.2 billion for the period. Over ₤2 billion was returned to shareholders, primarily through dividends of ₤1.8 billion over the period. The five year dividend growth rate has been 11.6% CAGR. The company has indicated that at least 1.5 billion will be spent on share buybacks, some of it funded by the sale of real estate

The UK competitive environment is tough with Wal-Mart proving to be successful (unlike its foray in Germany which it recently abandoned.) But unlike its weaker brethren, Morrisons (which is overleveraged post Safeway UK purchase) and Asda, Tesco is gaining market share in groceries.

Politically, there is some risk as the UK has initiated an investigation of the industry by the Competition Commission. This is the third inquiry in six years…such inquiries have given the industry a clean bill of health declaring it to be competitive. The investigation will target the interaction between retailers and their suppliers, competition within convenience stores, and land acquisition practices. Perhaps the only gray area will be the third, where Tesco’s real estate success has allowed it to build a considerable land bank for future development. However, since the land bank is primarily skewed toward non-grocery retailing, it seems unlikely that the company should find itself in the Commission’s crosshairs.

Finally, let’s focus on valuation. The company trades at a current EV/EBITDA based on TTM EBITDA of 10.7 times versus about 9 times for WMT which trades roughly in line with SWY at 8.7 times and above KR at 7 times.

On an EV/EBIT basis Tesco is 14.6 times versus WMT at 11.3 times. SWY is at 15 times and KR is at 11.3 times.

Tesco is quite transparent in its disclosure and in my view, treats its shareholders as partners in the enterprise.

There is a great deal of growth that remains in this internationally focused food retailer, in my opinion, probably better positioned than Wal-Mart in emerging economies. Of these names, only WMT comes close in the quality of its operations or the returns on capital. The operating profitability and working capital management are superior to most of its peers. The cushion of its vast real estate holdings also provide hidden asset value.

Disclaimer: Neither I, my family, or clients have a current position in Tesco or Kroger. I, my family and some clients do have a current position in Wal-Mart and Berkshire Hathaway. Some clients do own a current position in Safeway.

Tesco Cash Flows 1998-2006

Here is a look at the Statement of Cash Flows (using Reuters data) from 1998-2006. Note that the CFFO has exceeded net income consistently. Capex has been expansionary in the last five years resulting in capex greater than CFFO. However, assuming that maintenance capex would approximate depreciation, the business would have generated free cash flow through this period.

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Tuesday, August 22, 2006

Corporate Activism and Governance-How Can You File a Proposal?

Shareholder activists frequently submit proposals for the annual proxy to effect changes in corporate governance. Only rarely are these binding on the board...shareholders, for the most part, do not have the power to initiate corporate governance changes...proxies are essentially non-binding polls.

However, according to CFO magazine, more and more companies have made changes in their corporate governance practices after receiving majority, or strong minority support for certain shareholder proposals.

Institutional Shareholder Services (ISS) completed its analysis of the 2006 proxy voting results. Investors are becoing more "vocal" or active. Eight of 11 different measures received more support for change this year compared to last year.

Two of these measures received more than two-thirds support on average among shareholders:
  1. Repeal of classified boards
  2. Elimination of supermajority voting
Classified boards represent a structure in which only about one-third of all directors are elected each year. Consequently, there is at least two-thirds representation of the "old" team which consequently retains its majority control. Supermajority voting is a system whereby a big majority of the votes of shareholders is required to effect change, consequently making such change unlikely, or improbable.

Among the 40 proposals that called for repeal of classified boards, the support was 68%. Of the 19 proposals to eliminate supermajority voting, 69% voted for elimination. These are strong signs of dissatisfaction to a board which ignores them at their peril.

In total there were 35 proposals that got over 50% support. Contrast this with just two years ago where, on average, support for shareholder proposals was less than 12%.

Always vote the proxy. Express yourself. The sands are shifting and corporate governance is becoming slightly democratized. If you don't vote, you are getting exactly what you deserve...more of the same. In some cases, that is wonderful, but if you are dissatisfied, when you fail to vote, you have only yourself to blame.

Secondly, consider submitting a shareholder proposal for the next annual meeting. Obviously, the more serious the proposal, and the better factually supported, the higher the likelihood of its being supported by other shareholders. Every proxy statement contains language regarding the submission of a shareholder proposal. Be forewarned, company managements despise this and will fight you tooth and nail. However, if you are serious changing the direction of a company and bringing in some changes in corporate governance, it can be done, and done without bearing any legal costs. I encourage you to e-mail me if you need help in starting this process.

Here is an example of the language that you should look for in the proxy statement. To be clear, I am NOT advocating any change in the governance of Caterpillar, I have merely selected it as an example of a proxy with clearcut language. As well, I hold no position in CAT.

Stockholder Proposals for the 2007 Annual Meeting
If you would like to submit a proposal for possible inclusion in the company's 2007 Proxy Statement, our Corporate Secretary must receive it on or before December 29, 2006.
Under Caterpillar bylaws, a stockholder may bring a matter to vote upon at the annual meeting by giving adequate noticeto our Corporate Secretary. To be adequate, that notice must contain information specified in our bylaws and be received by us not less than 45 days nor more than 90 days prior to the annual meeting. If, however, less than 60 days notice of the meeting date is given to stockholders, notice of a matter to be brought before the annual meeting may be provided to us up to the 15th day following the date notice of the annual meeting was provided.

A company management serves at the pleasure of its shareholders who are the true owners of the enterprise. Act like an owner and protect your interests.

Disclaimer: Neither I, my family, or clients have a position in Caterpillar.

Friday, August 18, 2006

Henry Kravis on Private Equity

The Philadelphia Inquirer published an interesting Bloomberg News item regarding the leveraged buyout market in today's paper:

Leveraged Buyout Market Hot

Kravis is quoted, "We continue to be very active and optimistic about our ability to close large transactions...I have never seen a market with this much liquidity and capital available."

Back in May, KKR raised $5 billion in an IPO of KKR Private Equity Investors LP which has certain commitments for takeovers of HCA, the French yellow pages publisher PagesJaune Groupe, and Phillips Electronics semiconductor subsidiary.

The first financial statements of this public entity were released earlier this week. KKRPEI Link

As of June 30th, the quarter end of this initial stub period, the firm had invested only 3.2% of its net assets. Subsequent to the quarter through August 16th, KKR has invested another $818 million including $419.5 million in secondary purchases of limited partner interests in other KKR sponsored private equity funds. I find it interesting to note that when other "ground floor" private investors are looking for liquidity, this publicly traded ( on Euronext Amsterdam) entity is there as the "bank." Though representing less than 10% of the total assets, this action does bother me. After all, valuations of private companies have a lot of uncertainty associated with them and there appears to be little third party ratification of value.

Among the other investments that make up this $818 million, is "an opportunistic investment in a publicly traded security" of $194.6 million. Again, though clearly allowed within the mandate, I think most of us find it a little unusual that a public company find its way into the KKR Private Equity Investors LP.

But who can argue with success? According to Chief Executive magazine of March 06:

While pushing through these changes, KKR was helped by successful deals in its current fund. Launched in 2000, the $6.1 billion Millennium Fund has so far produced an unusually high gross return of 71 percent on investments that include PanAmSat, the satellite operator, and utility Texas Genco. These gains add to the staggering amounts KKR has generated: By last September, the firm had invested $22.5 billion, converting it into $61.3 billion. Of the resulting $38.8 billion gross profits (calculated before the billions that KKR partners have taken), $10.6 billion is unrealized, reflecting shareholdings in companies KKR still controls or part-owns. "The bottom line is that they have made a lot of money for us over a long period of time," says Joseph Dear, executive director at Washington State Investment Board, one of the world's biggest private-equity investors.
No argument with past success. But financing costs have risen, on virtually every currency one can imagine. LIBOR is close to its highest since 2001. Valuations, Kravis claims have come down sufficiently to offset these higher funding costs.

I remain skeptical. My guess is that the returns on private equity in aggregate, in the next five years will hug the returns on public equity. There is simply too much capital chasing these deals, and far too much belief in spreadsheets that extrapolate past returns into eternity.

As I said before, the smartest way to be involved in private equity investing at this point may well be as a seller.

Please check my previous post, Private Equity Hedge Funds and the Struggle to Spend Cash.

Disclaimer: Neither I, my family, or clients have a current position in any of the securities mentioned in this post.

Thursday, August 17, 2006

Berkshire Triples Stake in Tesco

Berkshire has increased its stake in Tesco, the UK based, but global food retailer.

According to Bloomberg News, Berkshire, which does not have to report to the SEC any of its holdings traded on foreign exchanges, now has a total of 177.8 million shares of Tesco, more than tripling its stake from the previously reported 57.6 million shares.

The shares were acquired, as per normal, through its insurance subsidiaries, Geico with 32.4 million shares, GenRe with 76.8 million shares, Medical Protective with 5.15 million shares, and United States Liability with 5.81 million shares.

I find this a very interesting move in a very interesting retailer. First of all, at present exchange rates and securities prices, Tesco is now a larger position than Wal-Mart representing almost $U.S. 1.2 billion (correction from original post) versus about $900 million in WalMart.

Tesco’s international exposure is relatively immature, representing about one quarter of sales but over half of selling space. There is considerable exposure to emerging markets with business in Hungary, Poland. the Czech Republic, Slovakia, Turkey, Malaysia and Thailand. There is also exposure to Ireland and Japan.

Tesco has well-above average ROIC, when measured against other foodretailers. The ROIC was 12.8% for its February 2006 fiscal. This figure has shown steady improvement over the last five years. The company has a goal of achieving an ROIC target of 14.8% down the road. The company enjoys strong cash flow generation. Were it to cease its expansionary capital spending, the company would be debt free in about two years.

There is also substantial real estate value in Tesco as it is the largest property company in the UK

The company has also treated its shareholders as partners with significant share buybacks in the last couple of years.

I will be doing a more complete review of Tesco and its operations in the next couple of days, but wanted to get at least the preliminary information out to you as soon as I could.

Disclaimer: I, my family, and some clients have a current position in Wal-Mart and Berkshire Hathaway. None of us have a current position inTesco.

Berkshire Buys Southern Energy Homes

We have commented in the past on Buffett’s interest in manufactured homes. In fact at the most recent annual meeting, Buffett had very strong positive commentary regarding Clayton Homes, Berkshire’s manufactured homes subsidiary. Berkshire, back in 2003, purchased Clayton Homes for $1.7 billion, for what in retrospect seems like a bargain price. In fact, at the time of the purchase, there was some controversy about whether there might be a follow-up bid by some other bidder.

Clayton Homes, in my view, even prior to Berkshire’s involvement, has been the class act of the industry with its conservative financing and fully integrated approach. Clayton has 36 manufacturing plants and about 450 of its own stores, plus a network of some 1400 independent dealers. It operates 71 manufactured housing communities and is completely integrated in offering financial, insurance, and mortgage services to its customers.

Yesterday, Clayton acquired Southern Energy Homes(SEHI.PK) a small manufactured homes builder based in Alabama. Southern Energy Homes, having a very small shareholder constituency, reduced its SEC filing costs by going Pink Sheet rather than full SEC registration. The company, which like most of the industry in 2001 had been over-leveraged, but has steadily improved to the point that last year, the company had no long term debt or bank debt. Sales last year were about $200 million, rising 27% over 2004’s results. Net income was $9 million.

Things have continued to improve this year. Revenues at SEHI were $144 versus last year’s $88 million. Net income was $7.1million versus $2.7 million.In the first half of this year, the company has generated $17 million in CFFO and spent about $1 million in capex for free cash flow of $16 million.

The company held about 3.5% share of the manufactured housing industry.It manufactures out of five facilities, four in Alabama, and one in Texas.It sells to about 200 independent dealers.

Total industry shipments last year were about 147,000 units. This was the first upturn in shipments since 1998, the last peak in manufactured homes which was 373,000 homes.

For further background on the industry, please see two prior posts:

Trading Down in the Housing Cycle

Berkshire on Manufactured Housing

Disclaimer: I, my family, and some clients have a current position in Berkshire Hathaway. None have a current position in any other security mentioned in this post.

Tuesday, August 15, 2006

Greenlight Capital gives Microsoft the Greenlight

David Einhorn, of Greenlight Capital is one of the most highly respected hedge fund managers around, known for his investment skill and his generous charitable giving. David is known for his bearish stance on Allied Capital (ALD) a business development corporation with assets of over $4 billion controls a significant number of portfolio companies in which it provides debt capital. The accounting and valuation of these companies has been called into question by David for some time...his questions continue to be reflected in the put position that he maintains in Allied Capital in his portfolio.

David was featured in Value Investor Insight, one of my favorite publications, back in March 2005 (subscription required.) He described his process in VII, “We take the traditional value investor’s process and just flip it around a little bit. The traditional value investor asks “Is this cheap?” and then “Why is it cheap?” We start by identifying a reason something might be mispriced, and then if we find a reason why something is likely mispriced, then we make a determination whether it’s cheap”. Greenlight also has a private equity side that was featured in TWST (subscription required.)

Greenlight Capital filed its 13-F last night, and it does make for some interesting reading. Please find a table in the following post which outlines changes that have been made between last night’s filing (pertaining to June 30th holdings) and the prior quarter’s holdings:

I have excluded the Allied Capital weighting as it represents a hedged bet of puts and calls.

Positions in Brunswick, Ipsco, Leap Wireless, and StreetTracks Gold Trust were eliminated. New positions in DR Horton and Microsoft were initiated. Significant reductions in weightings were made in American Home Mortgage and MDC Holdings. The position in Freescale continues to dominate the portfolio, but very large positions in Ameriprise, and MDC were maintained.

It is interesting to me to note the rather heavy position in Microsoft and the continued orientation to homebuilders and real estate with DR Horton, MDC, and MI Developments.

Disclaimer:I, my family, and some clients have a current position in Microsoft and Live Nation.

Berkshire Hathaway Filing

Yesterday, Berkshire Hathaway filed its 13-F outlining its holdings. I will be reviewing the holdings, and the changes for a number of institutional managers that I hold in high regard. A 13-F is a form that investment managers who are managing over $100 million must file on a quarterly basis. Remember that this can be somewhat stale information for some very active applies to holdings as of June 30th of this year

Berkshire bought two new positions,

Sanofi-Aventis (SNY) 448.5K

Johnson & Johnson (JNJ) 1.97 M

Berkshire increased its stake in:

Iron Mountain (IRM) +1.5M to 5M

Berkshire eliminated its position in:

Lexmark (LXK) previously 2.5 M

Gap Stores (GPS) previously 10M

Berkshire reduced its position in:

H&R Block (HRB) -4.7M to 11.4M

Sealed Air (SEE) -60.2K to 677.7K

ServiceMaster (SVM) -400K to 4M

Anheuser Busch (BUD) -32.6K to 43.5M

Unchanged positions:

American Express (AXP)

Ameriprise (AMP)

Coca-Cola (KO)

Comcast (CMCSA)

Comdisco (CDCO)

ConocoPhillips (COP)

Costco (COST)

First Data (FDC)

Gannett (GCI)

General Electric (GE)

Home Depot (HD)

Lowes (LOW)

M&T Bank (MTB)

Moody's (MCO)

Nike (NKE)

Outback Steakhouse (OSI)

PetroChina (PTR)

Pier One (PIR)

Procter & Gamble (PG)

SunTrust Banks (STI)

Torchmark (TMK)

Tyco International (TYC)


United Parcel (UPS)

WalMart (WMT)

Washington Post (WPO)

    Remember, whether in driving or portfolio management, there is danger in following too closely! Blind faith in even the greatest's stock picking can also be risky...witness Pier One . Remember, these changes are as of June 30th.Disclaimer: I, my family, and some clients have a current position in Berkshire, Lexmark, Gap, Comcast,Tyco, and WalMart. As well, some clients have positions in H&R Block, Anheuser Busch, ConocoPhillips, General Electric, and Home Depot.

Greenlight Capital Changes

As discussed in the previous post, here is a list of the holdings and their weightings for David Einhorn's Greenlight Capital.

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Sunday, August 13, 2006

A Buffett Quote du Jour

"It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds."

This quote is from the 1977 Berkshire annual.

Certainly, some of the biggest mistakes I have made in my investment career have been on the basis of being overly contrarian when the obvious was staring me in the face...I was looking at a failing industry, the one-puff cigar.

Making too many excuses for why a stock is cheap often flies in the face of all the contravening evidence, that perhaps one is investing in a very tough industry, or one that is seeing new competitive forces.

Many years ago (even before I was an analyst) stock research departments were known as statistics departments. But research is far more than statistics...understanding the competitive advantage for a business is far more important over the long run to investment success than buying a stock just because it is cheap.

For years, Bethlehem Steel appeared to be one of the cheapest stocks around, trading at a fraction of its stated book value. It didn't matter. That was the problem, book value was not a reflection of value...competition from imports, rising health cost and pension costs from its roster of retired workers was far more critical than valuation.

One of the worst investments I ever made was in a catalog retail business, Service Merchandise, a 42 year old business that had once been a top retailer in the nation, achieving over $4 billion in sales. A series of restructurings were to no avail. The obvious should not be an impediment, yet I resisted the obvious and inevitable fate. Turnarounds and contrarianism provide some bravado, but sometimes a false one.

Ponder what stocks you hold simply because they appear too cheap to sell. What are you missing? What new competitive factors are nipping at the heels of your holdings?

Be in a business where tailwinds prevail rather than headwinds!

Disclaimer: I. my family, and some clients currently have a position in Berkshire Hathaway

Saturday, August 12, 2006

Earnings Quality and the 10Q Detective

Careful readers will note that I have added a new link, "10Q Detective" which is published by David Phillips. As David describes it, "investors often overlook SEC filings and it is the job of the 10Q detective to dig through business' 8-K and 10-Q filings, looking for financial statement 'soft spots' such as depreciation policies, warranty reserves, and restructuring charges."

David does a fabulous job in tearing apart financials, but also examining compensation excesses, pump and dump stock frauds, and the reasonableness or illogic of growth expectations. In short, David's mission is to protect investors from the BS promulgated by some managements, their IR firms, and the deferential verbal obeisance of investment bankers. It is a blog worthy of your time and I recommend it highly.

David pursues one of the aspects of investment management that is I believe critical to investment success. As a young analyst, I was chided by a fellow analyst and brilliant CFA who said, "Nobody has really made any money by looking for good accounting." My counter of course was "Plenty have lost money from bad accounting." A large part of investment success is simply avoiding investment failure...avoiding trouble.

The reason this is so important stems from the asymmetry between gains and losses. If you have a 20% loss in a portfolio, you need a 25% gain from that level just to break even. The numbers look like this:

Percentage loss......Gain required to Break-even

Regrettably, as you can see, the arithmetic of this asymmetry makes it tough to overcome a "torpedo" hit. 

The frequency of these holes has been increasing with the increasing volatility of these markets. Relying on Reuters data for the last month, of 8892 US stocks in their database, there were 748 stocks which had dropped 20% or more in the last four weeks, almost 9% of all stocks. But surely, these companies will come back over time, right? Well, not exactly. This market takes no prisoners...using the same database but over a 26 week period, fully 2,294 companies of the 8892 or 25.8% were down over 20%. I daresay, 983 companies, or 11% are down over 40%...needing a 67% rally to breakeven. Scary!

The best way to avoid them or at least reduce them is to investigate before you invest. Never rely on a tip, a story, or the tout of some investment expert to get you into a stock.  Study David's blog, check out Michelle Leder's Footnoted, another excellent source. In some small way, perhaps even Value Discipline can provide some guidance. Please read my note on accruals. Ultimately, do your own research and satisfy yourself as to the earnings quality of what it is you are buying.

What exactly is "earnings quality?" It is very difficult to define per se. Not unlike the explanation of pornography," I know it when I see it" earnings quality presents a struggle to define with exactness. Yet, there are some real hallmarks or footprints to earnings quality.

The accountants tend to look at earnings quality as "representativeness"...does the measure of income correspond to the change in net economic assets pther than from transactions with owners? In other words, how much better off is a firm at the end of the accounting period than it was at the beginning from its "outside" transactions. Earnings quality is considered over there persistence in the earnings, is there predictive ability that is derived from the earnings?

I believe that a much more simplistic definition of earnings quality can be understood from "closeness to cash" and looking at the relationship between cash flow from operations and net income over time. Earnings quality tends to go down when accruals become a larger part of earnings. Earnings quality tends to go down with the greater proportion of estimates and forecasting that is required of management in preparing the financial statements. Companies with  percentage of completion revenue recognition for long term contracts (as GAAP requires) may have questionable earnings quality. As accounting becomes increasingly focused on "fair value" accounting, it seems to me that the number of management judgments will increase and the potential for poor earnings quality will increase correspondingly.

 Frequent earnings restatements is another yellow flag for poor earnings quality. An excellent academic article on this topic is "Predicting Earnings Management: The case of earnings restatements" by Richardson and Tuna at Wharton and Min Wu of Hong Kong University. As they conclude, " Information in accruals, specifically, operating and investing accruals, are key indicators of the earnings manipulation that lead to the restatement."

The capital markets have had far too many examples of firms whose earnings and income recognition policies have pushed the limits. By using some of the resources that I describe today, and careful thoughtful examination of your investment, I believe you can avoid much of the grief.

Capital preservation is rule one in this business. Performance comes from buying stocks that are undervalued. But before one can begin to assess value, one needs to understand the business, and its earnings stream. If earnings quality is poor or suspect, there is no need to even bother with valuation thinking.

Thursday, August 10, 2006

A Study in Contrasts

The gulf between continents at times seems so wide. Contrast:


General Motors

Sunset Over Detroit

Prospects for Automotive Suppliers

Auto Industry Consolidation: Is There a New Model on the Horizon? (free subscription required)

Ford Steps Up the Pace, Too Late


Automakers See Profits Jump 76% in First Half Year

Auto Parts: The New Kid in Town

Boomtime for India's Auto Parts Industry

A couple of quotes to contemplate:

"... shows that the United States and Germany are close to 100 times as saturated with automobile ownership as China and India. Japan is more than 75 times as saturated and even Thailand is about 7 times as saturated. ...consider that China has four and one-half times as many people of driving age as the U.S. and that India has more than three times as many as we do, you can understand both the limited growth potential of the U.S., Germany and Japan, which together account for a majority of global automotive ownership, and the vast potential of the developing nations, especially China and India. If each of these two expanded to just one-half of Thailand’s penetration, their automobile ownership would more than triple, from 12 million cars at present to 40 million. Yet, as you can see from Exhibit 4, India’s auto production now is half that of South Korea’s and China’s is less than twice Korea’s and less than one-third that of the U.S. As car production grows, so will the indigenous base of component suppliers."
source: Wilbur Ross speech April 18, 2006
"The Indian auto-component industry has grown at a cumulative average growth rate of 21% annually in the past five years, according to the Automotive Component Manufacturers Association (ACMA) of India. An ACMA/McKinsey & Co. study shows India has the potential to grow from US$8.7 billion in 2005 to US$45 billion by 2015."
source: Rediff India Abroad, June 6, 2006
Four comments about this industry:

One positive about China from a North American perspective...Shanghai General Motors ranked first in the automobile industry with profits growing by 21 percent.

There has been a trend by both Indian and Chinese companies to seek invest in North American auto parts businesses. Some of these businesses are so out of favor and cheap, that they may become takeover candidates by foreign interests for strategic purposes or private equity investors.

Third. from the Chinese perspective:
Shanghai General Motors ranked first in the automobile industry with profits growing by 21 percent.

Finally, don't forget that just because you may live in North America, you need not confine all your investment dollars here. Think global.

Currently, my only position in the autos/auto parts sectors is Harman International, which I have described in prior posts:

Harman International-An Auto Parts Growth Story

and Still Big on Small Stocks

Disclaimer: I, my family, and some clients have a current position in Harman International. None of us has a position in any of the other stocks mentioned in this post.

Private Equity, Hedge Funds and the Struggle to Spend Cash

Uncorrelated returns, perhaps two of the more dangerous words that you may hear. What this boils down to is essentially performance that has a low correlation (statistically measured) versus a benchmark index.

Low correlation means enhanced diversification, something that traditional hedge funds were designed to provide.But uncorrelated return does not equate to good returns. The Japanese equity market was beautifully uncorrelated with the S&P 500 through the 1990's. But the returns were not all that beautiful.

Affluent investors certainly gravitate toward hedge funds that access private equity and I must admit that I have utilized such funds myself. But do such deals always provide value? According to hedge-fund research firm, Greenwich-Van Advisors, hedge fund assets have grown to over $1.1 trillion from $480 billion back in 1999, a 15% CAGR versus an S&P market that provided -1% over that period!

Ultimately, this is not rocket science despite the brilliant minds that gravitate toward the area. Hedge funds do not necessarily represent a vehicle that is entirely separate from capital market returns, at least not the way many of them practise their craft. Capital markets' returns reflect the underlying wealth build or fall in the entire economy over time. In a 2001 study "Do Hedge Funds Hedge" by Krail, Asness, and Liew of AQR Capital Management,one of the conclusions was: "hedge funds seem to do a lot less hedging than simple estimates might suggest." Hedge funds as a group, at least according to this study, exhibited a beta of 0.85, that is 84% of the price movement could be explained by the S&P 500. For entry into this mystical rite, an investor pays 2% plus 20% incentive my view, a ridiculous toll. Nice work if you can find it, but is this sustainable?

At the last Berkshire Hathaway annual meeting, this was a topic that incited Charlie Munger to be much more vocal than usual: " Half the business school graduates at the elite Eastern schools say that they want to go into private equity or hedge funds. Their goal seems to be to keep up with their age cohort at Goldman Sachs. This can’t possibly end well."

Which brings me to private equity. According to the Financial Times, "Private equity is struggling to spend cash as fast as it is raising it."
There is an astonishing amount of capital that has come into the private equity arena. According to the artilce, about $300 billion in uncommitted, "un-called" capital is available to buy-out funds, representing core equity. Given the ability to finance at 4:1 debt, this represents about $1,500 billion in purchasing power, which equates to over 10% of the total market capitalization of the S&P.

This can be a very attractive proposition to the management of a company:

  1. Increased ability to make significant long term capital project investments with less shareholder quibbling and criticism.
  2. Set aside Sarbanes-Oxley compliance public investors, no SOX.
  3. Less scrutiny and criticism of executive compensation arrangements.
  4. Private ownership equates to overall privacy as to corporate strategy.
  5. No public owners equates to no SEC regulatory and legal risks.
In short, going private means less transparency, less visibility. Unfortunately, as a limited partner in a hedge fund per se, transparency is always an issue. This reminds me of John McMullen's quote regarding being a limited partner in the Yankees with George Steinbrenner, "Nothing is more limited than being George Steinbrenner's limited partner."

Transparency and disclosure is almost always a problem with hedge funds. Toss in a mix of private equity deals selected from a group of managers who crave privacy, and you have a rather uncertain fate. Oh yes, you also may be locked in for periods of five to ten years (or longer) waiting for the "Liquidity Event."

The public markets do not always recognize intrinsic value immediately, or in the short term. In the last seven days, my clients and I have benefitted from going private transactions in Aramark (RMK) (at too cheap a price) and Reynolds and Reynolds (REY) at a fair price. But private equity investors are lurking and their coffers are full of cash. Intrinsic value has a higher probability of being recognized more quickly, in my view with these characters around.

As FT points out, buy-outs are becoming less selective. Having too much un-utilized money makes a private equity manager appear slovenly and out of tune with the times. These guys are not incentivized to hold cash. "If less discriminating buy-outs are the future, it is best to be on their receiving end."

The smartest way to be involved in private equity investing at this point may well be as a seller.

Disclaimer: I,my family, and clients have a current position in Berkshire Hathaway, Aramark, and Reynolds and Reynolds.

Tuesday, August 08, 2006

Acco Brands

Historically, one of the interesting places to search for value is off the beaten path. Spin-offs, especially from large S&P 500 companies, tend to provide such opportunities. The rationale is straightforward...

  1. S&P 500 companies tend to be contained within index funds,
  2. A spun-off company must be sold by the index fund,
  3. Large cap funds will sell off small cap spin-offs
  4. Little analyst coverage. Too small a market capitalization, too different from parent company's focus, no underwriting relationship, etc
Because of these biases against such companies, the tendency historically has been for them to trade down due to a lot of selling pressure from the large number of initial sellers and to ultimately find a reasonable valuation level.

Acco Brands (ABD)
was spun off from Fortune Brands (FO) an S&P 500 company a year ago at this time, August 9th, 2005. Each holder of Fortune Brands received one share for every 4.255 shares of FO common held. Acco is one of the world's largest suppliers of branded office products with products marketed in over 100 countries. The company completed a merger with General Binding in August of 2005 as well. About 85% of its sales come from products in which it holds the #1 or #2 market position and with shares that are often twice or more than the next biggest competitor.

The office products market has been a beneficiary of the growth of the service economy. The large retailers that one would ordinarily associate with this sector (Staples, Office Depot, OfficeMax) have only about 10% of this market, which is very low compared to other destination retailers such as the building supplies or pet supply retailers. One can argue that this relatively low penetration by the mega-retailers should spell greater brand awareness and greater marketing of office products. One can also argue that the mega-retailers' propensity toward private label brands could also hamper margins.

As I mentioned, at the time of the ABD spin-off, the company took over General Binding (GBC). GBC had been under-managed in the past and had operating margins that were only about 7% versus ABD's historical 12%. There is a major opportunity for Acco to integrate operations and focus the product line and hence gain cost synergies.Many of the strategies that Acco has at its disposal for GBC are strategies that the company used in the past. GBC has provided Acco some scale opportunities and consequently some bargaining power. The company has a reputation as an innovator and historically has indicated that about one-third of sales in any year have come from products developed in the prior three years. Gross margins have show improvement at least quarterly, but operating margins remain to be disappointing, at least to me.

The stock has dropped off 5% today which has drawn my attention but is down 26% from its inception a year ago. On an EV/EBIT basis, the company is trading at 15.3 times.

There are about 53 million shares outstanding of which about 15% is held by Lane Industries, a former large minority holder of GBC. Lane has been a significant seller of the stock. Market cap is about $975 million and EV is about $1.80 billion with significant long term debt on the balance sheet as a result of the acquisition and the spin-off capital structure. Interest coverage is about 2.8 times.

The company has generated free cash flow in its very brief public history, last year generating $30.8 million in free cash flow and in the first quarter generating $19.2 million. Return on invested capital is still quite low at about 4.3%. Working capital management has improved slightly with Receivables Turnover at 6.5 times versus last year's 5.1 times and Inventory turnover improvements to 6.9 times versus last years 5.7 times.

In a recent Wall Street Transcript interview with Tim Reynolds of Mallard Capital, (subscription required) he outlines his rationale for selecting this stock.
"This is not an exciting top-line story, as they are a single-digit revenue grower, but they can deliver mid-teens earnings growth. With the stock trading below the market multiple of 16 times, it is a good bet with that kind of earnings growth.Finally, the stock is only covered by a couple of analysts ' another potential catalyst down the road."
I think this is an interesting stock but I await some operating margin improvement before I will use the stock. Debt leverage is high, but if free cash flow generation continues, a much cleaner balance sheet will develop. Earnings growth will come from balance sheet deleveraging as well as from operating margin improvement. I like their strong position in the industry as well as their ability to innovate. Still on the sidelines for now, but looking for a buying opportunity.

Disclaimer: Neither I, my family, or clients have a current position in any of the stocks mentioned above.

Wednesday, August 02, 2006

Pew Internet Survey

For broadband internet users, online news is part of the daily news diet, but interestingly, radio, TV, and local newspapers are remain a significant part of everyday activity.

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Tuesday, August 01, 2006

Newspapers and the Internet...No Obits for Papers Yet

A number of value investors, notably Bruce Sherman, of Florida based Private Capital Management love media stocks for their free cash flow characteristics.

Notably, as Buffett reminded us at this year's annual, every time you attend a funeral, you should be thinking, there goes another newspaper reader. The competition for the same two eyes over the same time span by all different kinds of media has become ever fiercer.

My only newspaper holding, the New York Times (NYT) is recumbent near its low. Recent earnings were flat following ongoing cost-cutting charges excitement here. Yet underneath it all, interesting trends are emerging.

Web sites in the NYT News Media Group showed revenue gains of 25%, showed revenue increases of 63%. Regrettably, these businesses represent a token, but at least a growing token at 7.7 % of total revenues. Total revenues for the firm were up but 1.6% on a slight 0.6% increase in circulation. The great shrink of shares outstanding continues...down to 144.6 million shares with $124 million left in repurchase authorization. Five years ago, this was 172 million shares.

More broadly speaking though, a report came out yesterday on The Use of the Internet by America's Newspapers by the Bivings Report.A survey of America's 100 largest newspapers (by circulation) was undertaken. To quote the report

"The results of our research clearly showed that America’s newspapers, unlike political candidates, are generally embracing the Internet and are using new and improving Web tools to their advantage. Here are some of our results:

* 80 of the nation’s top 100 newspapers offered reporter blogs. On 63 of these blogs, readers could comment on posts written by reporters.
* 76 of the nation’s top 100 newspapers offer RSS feeds on their websites. All of these feeds are partial feeds, and none included ads.
* Major Web tools, such as blogs and RSS penetrated both the most and least circulated newspapers.
* Video was the most common form of multimedia found on the websites, and was offered by 61 of the newspapers."

Consider this survey by the Pew organization

For broadband internet users, online news is a more regular part of the daily news diet than is the local paper; it is nearly as much of a daily habit as is getting news from national TV newscasts and radio. For home dial-up users, however, online news is not as much an everyday activity.

Note the fact that TV, radio and the paper retained significant aspects of the total audience.

Perhaps newspapers are not suffering as fast a demise as some believe.

Disclaimer: I, my family, and some clients have a current position in the New York Times.


Hot Topic (HOTT) reported its July comps this morning. Same store sales were down 7.2%.

Hot Topic is a retail chain that focuses on that most fickle of consumers, the teenager selling her/him apparel. accessories, music, and gifts. Women's apparel showed a positive comp whereas everything else continued to be negative.

What is disturbing is that comparisons really are getting quite easy, yet management seems to be unable to turn things around.

Check out these same-store-sales trends:

Jan -1%..........................-3%
Feb -8%..........................0%
Mar -13%.......................+5%
Apr -7%..........................-2%
May -6%........................-2%
June -3%........................-3%
July -7%.........................-5%
Aug .................................-7%

As an alte kacker, I am hardly the best judge of Hot Topic's stores or whether they understand today's teen. There does not appear to be anything in the assortment that is driving sales according to a couple of store managers I have contacted.

Sticking to my own circle of competence, I did a quick comparison of HOTT versus Claires (CLE) another retailer with significant teen sales but a much broader base and far more encouraging fundamentals.

Please see my prior write-up on Claire's Stores.


Gross Profit Margins (TTM)37.00%54.09%
Operating Profit Margin (TTM)0.04%17.71%
Gross Profit Margins (MRQ)36.70%54.10%
Operating Profit Margin (MRQ)-1.75%12.80%
Free cash Flow/ CFFO (TTM)-13.68%66.37%
EV/CFFO (TTM)10.5511.89
EV/EBIT (TTM)23.648.42
ROIC (TTM)7.90%19.80%
P/E 07 est (consensus)22.4413.14
Five Year Growth e.p.s.0.25%20.70%

As you can see, despite the turnaround possibilities that Hot Topic may present, even with today's 17% price collapse, the value is not yet compelling.

Please see an interesting interview with Marla Schaefer, co-CEO of CLE in The Wall Street Transcript (subscription required)

Disclaimer: Neither I, my family, or clients have a current position in Hot Topic. I, my family and some clients do own a current position in Claire's Stores.

Comparison of HOTT to CLE

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