Tuesday, October 31, 2006

FTD...Harvesting the Flowers to Grow the Weeds?

Founded in 1910, FTD Group (FTD) is the largest floral company in the world.FTD, originally known as “Florists Telegraph Delivery” connects 20,000 North American florists as well as about 50,000 florists in 174 countries worldwide.

The business divides itself into two segments, the Consumer Segment and the Florist Segment. The Consumer Segment is an Internet and telephone marketer of flowers and specialty gift items to consumers, operating primarily through its www.ftd.com Web site and the 1-800-SEND-FTD toll-free telephone number. The Consumer segment does not own or operate any retail locations. The Consumer Segment is a particularly interesting business to me with very low working capital requirements because FTD-member florists and specialty gift providers maintain all physical inventory and bear the cost of warehousing and distribution. The Florist Segment provides a comprehensive suite of products and services to enable florists to send and deliver floral orders.The largest sub-segment within the Florist Segment is Member Services which is the primary provider of business services to FTD-member florists to promote their revenue growth and operating efficiencies. This includes national advertising and “clearinghouse services” which eliminate counterparty credit risks between sending and receiving florists.

The company was taken private in February of 2004 in a leveraged buyout by Leonard Green & Partners. It was taken public again in February of 2005. An interesting pass for Leonard Green et al. For its initial investment of $185 million, mostly in preferred but including $40 million in equity, the IPO brought total proceeds of $208.4 million, paying off the preferred, providing $14 million in management fees for the “experience” and providing investment bankers with $7 million in transaction and closing fees. The Green firm retains about 55% of the equity for what appears to be at this point, a zero investment at this point. Like I say, nice pass! Get ready for more...Green filed a shelf registration S-3 on October 13th. More about that a little later.

The company did report decent numbers this morning for the first quarter, reporting 18 cents versus 11 cents a year ago. The CEO was very enthusiastic about the quarter in the conference call, not often that you hear a CEO describe the quarter as “For those of you who have had a chance to get through the release, you’ll see we had just an amazing quarter...really great on all fronts....just kind of an across the board homerun.” It appears that about 4 cents of the increase came from tax rate and forex changes.

Revenues were up about 27% including the Interflora acquisition...ex that, up about 9%. The Consumer Segment had revenue growth of 14% with Internet orders constituting 88.1% of total.The domestic Florist Segment had revenues down 1.1% but that included a comparison against a greeting cards business that FTD no longer owns...on a comp basis, revenues were up only about 4%. Advertising and selling expenses in florist had averaged about $13.3 million per quarter last year...now suddenly, they are running at $10.47 million. That $11.3 million in savings would represent about 40 cents per share pre-tax in savings or 24 cents after tax. This is substantial, but is it sustainable?

Historically, the company has announced the number of florists in the network. The last year and a half has seen a decline in the number of florists from 20,000 florists to somewhere around 19,000. FTD management has decided that analysts no longer need to know about this. It seems that 1-800-FLOWER’s Bloomnet may be taking some share.

The balance sheet has been impacted by the Interflora acquisition with total debt of about $348 million versus the June 2006 FYE of about $220 million and the prior fiscal of $238 million.

The market seems to have liked today’s earnings report. Reduction of advertising and selling expenses especially this drastically has provided some decent leverage, but how is this addressing the shrinkage in the number of florists? If part of the package of services that the firm sells to its members is national advertising, will the network members be content to receive fewer benefits for the same membership fee? Will the number of florists in the network continue its decline?

Could the cost reductions be temporary to perhaps “grease the skids” for another offering? Excuse my cynicism.

Some years ago, Peter Lynch described the practice of selling one’s winners and keeping one’s losers as harvesting the flowers to grow the weeds. Ironically, FTD management, in my opinion, is doing exactly that. Slashing of unnecessary expenses is a good thing, but cutting important expenses on a distribution system that drives your business seems foolhardy.

Disclaimer: Neither I, my family, or clients has a current position in any of the securities mentioned in this post. And no, I am not a florist.


Friday, October 27, 2006

Further on Yankee Candle

David Phillips at 10-Q Detective is an excellent equity analyst who provides consistently diligent and thorough reviews of corporate events and governance matters. He has just written up in this post a recent 8-K for Yankee Candle (YCC.)

As I had suggested yesterday, the conflicts that exist between management serving its own interests in a takeover and the minority shareholders that have hired them can result in a sense of unfairness. Just as the business is hitting on all cylinders, it becomes someone elses' vehicle to ride.

As David points out, management has provided itself with substantial severance packages so long as the Change in Control event occurs by April 1, 2007. David is quite correct in his suggestion that this puts a very high probability on the successful closing of this deal in the first quarter of 2007.

Thursday, October 26, 2006

Yankee Candle...Darn, It's Going Away

Yankee Candle (YCC) announced yesterday that it had agreed to be acquired for $34.75 per share in cash. Quoting the release:

The Yankee Candle Company, Inc. ("Yankee" or the "Company"; NYSE:YCC) today announced that it has entered into a definitive merger agreement under which an affiliate of Madison Dearborn Partners, LLC ("MDP"), a leading private equity investment firm, will acquire all of the outstanding shares of Yankee for approximately $1.4 billion in cash. The total value of the transaction, including assumed debt, is approximately $1.7 billion. The Board of Directors of Yankee has approved the merger agreement and has resolved to recommend that Yankee's shareholders adopt the agreement. The transaction, which is expected to close in the first quarter of 2007, is subject to approval by Yankee's shareholders, as well as other customary closing conditions, including the expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.

It is interesting to note that this is its second equity buyout...the company was acquired by Forstmann Little back in 1998 before being taken public in 1999.

Readers may remember our previous post on Yankee Candle where we highlighted our positive views on the company.

Results have been gratifying since that time, largely a function of the aggressive buyback of shares that the company has pursued. As of the end of the quarter, the weighted average of fully diluted shares was 40.08 million shares as compared to 44.22 million shares a year ago and about 54.5 million shares back in 1999 upon initial IPO.

The company appears to be firing on all cylinders with retail sales (including the Illuminations acquisition) up 25%. Yankee retail stores appear to have turned the corner with same store sales up 8%, the third consecutive quarter of improvement. Wholesale sales were up about 11%, well above expectations. The only rain on the parade that I could discern was a build in inventories, up about 27% in line with sales. Bank debt was up about $103 million.

On a TTM basis, the business is “smoking” with an ROE of 106% and a return on invested capital of about 25%. Pity that management and Madison Dearborn will be reaping the results! It is important to remind you and myself that the takeover is still subject to various approvals by regulators and shareholders. But the likelihood seems strong.

Not an idle backhanded comment from yours truly. For those who purchased at the IPO back in 1999 at $18, you have earned a compound return of merely 8.75% as of yesterday, demonstrating the dangers of investment bankers bearing initial offerings. For those who have looked for Mr. Market to provide them better entry points, the stock is up 57% from the day prior to the announcement July 25th, 2006 that the company was reviewing its strategic alternatives.

As one shareholder observed in yesterday’s conference call, “Good luck. Dearborn is probably getting a good deal. I think the worst times are behind you and you’ve got good times ahead.”

As I have observed before, takeovers may be short term gratification but long term, are a pain in the butt. Just when you get to know the business and returns are accelerating, it gets taken away and you have to look for another idea. There are worse problems admittedly, for example when you really don’t have a handle and management is absconding with the cash flow, but this company was a little jewel.

Disclaimer: I, my family, and many clients currently own a position in Yankee Candle.

Monday, October 16, 2006

Round Table Discussion on Wednesday!

ModernGraham.com is hosting a round table discussion on Wednesday October 18th at 2:00 pm Central time.

Ben Clark and Jon Ritchie have put together an excellent value investing blog which espouses the ageless virtues of Ben Graham and Warren Buffett. Weekly, they present portfolios based on Graham’s Intelligent Investor.

Ben Graham described two kinds of investors, the enterprising and the defensive investor. To Graham, the basic characteristics of an investment portfolio were determined by the position and characteristics of the owner or owners, as he put it, “...there has developed the general notion that the rate of return to which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task.”

"The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor."

For those of you who are willing to exert this extra intelligent effort, may I commend the discussion on Wednesday!

Ben and Jon will be hosting Geoff Gannon of Gannon on Investing and Doug McIntyre of 24/7 Wall Street as well as yours truly, Rick Konrad.

Here is Modern Graham’s description of the festivities planned:

How this works:
Readers may submit questions via comments left on this post or the contributor’s blogs, or by email to ben@moderngraham.com. Jon and I will compile the questions and moderate the discussion. Please submit as many questions as you can think of. This discussion can only be as interesting as the questions are.

The actual discussion will be held in this thread of our forum. The thread will be open to the public to read, but only the participants will be allowed to post.
We are excited to have the following people contribute to the discussion:

Rick – Value Discipline
Rick has been a portfolio manager of institutional portfolios for over 25 years. He is currently working with individuals rather than institutions and finds this much more satisfying and rewarding. His greatest joy outside of his family is training young people to become better research analysts.

Geoff Gannon – Gannon On Investing
Geoff leads Gannon On Investing, a value investing blog and value investing podcast influenced by Benjamin Graham, Joel Greenblatt, and Warren Buffett's value investing model. Built upon the value investor insights of intrinsic value, margin of safety, competitive advantage, and protection of principal.

Doug McIntyre – 24/7 Wall St.
Douglas A. McIntyre is the former Editor-in-Chief and Publisher of Financial World Magazine. He is also the former president of Switchboard.com, which was the 10th most visited site in the world at the time, according to MediaMetrix. He has been chief executive of FutureSource LLC and On2 Technologies, Inc. and has served on the boards of TheStreet.com and Edgar Online. He does not own securities in companies he writes about.

I am proud to be associated with such terrific people!! Look forward to participating with you in this discussion!

Saturday, October 14, 2006

Trees and Paper-The Rodney Dangerfield of Commodity Stocks

Rodney Dangerfield (may he rest in peace) was known for his line, “I don’t get no respect.” He drifted from job to job doing everything from working as a singing waiter to selling aluminum siding. He later said that he was so little known then that, "When I quit, I was the only one who knew that I quit!" His headstone reflects the no respect persona...it reads, "Rodney Dangerfield - There goes the neighborhood."

It seems that forest products or trees are treated this way by the market nowadays. It seems nobody wants to own them.

Little wonder...profitability sucks, capacity is being shut down, balance sheets in some cases are precarious, and the housing outlook, a major driver of lumber demand, is iffy and uncertain.The Canadian industry, which has generally been quite efficient, suffers from the high valuation of the Canadian dollar.

In an interview in The Wall Street Transcript (subscription required,) Paul Quinn, of Canadian broker Salman Partners describes the need to reduce capacity:

“I talk to all of the companies on a pretty regular basis, and they are all definitely going to get pretty sharp with the pencil come fourth quarter. I am expecting a flurry of announcements, at least on the Canadian side, and you see drips and drops on the US side where even producers in the US are losing money with the way things are going. The housing market has come off so strong and there is so much negative sentiment around it. People have the expectation, which I think is correct, that there is still a good 12 to 18 months of hurt coming in front of these companies. In terms of the buyers of lumber and panel products, there’s just no rush to buy any product. They know there is excess capacity out there and they know that mills can feed them just in time. So the inventories are low in the pipeline, but they are low for a reason, and that’s the demand slowdown.”

But there is some hope at the end of the tunnel. The long US/Canadian dispute over soft lumber has come to an end. Some 80% of the duties collected by the US government during the multi-year dispute will be refunded to the Canadian producers. These duties have been collected since 2002. For some of these companies, this amounts to a fairly substantial injection of capital. For example Canfor (CFP-Toronto) will be receiving some $3.80 per share after-tax according to Mr. Quinn, or about 33% of its current price. The company has earned a paltry ROIC of about 2% over the trailing twelve months. The company has realized some value by spinning off 80% of its pulp subsidiary as an income trust.

This past week, we have seen some rumblings in the housing stocks that suggest a turnaround. I think it is far too early and premature to start to get involved in the homebuilders.However, some really smart investors are seeing the clouds part and seeing valuation opportunities.

Amit Wadwhany, a fellow Canadian, was one of the best Wall Street (or at least its Canadian version Bay Street) paper and forest products analysts. He earns an honest living now...and deservedly, a very good one, with Marty Whitman’s Third Avenue Funds where he presides as the portfolio manager of the Third Avenue Global Value Fund as well as the Third Avenue International Value Fund. His interview with TWST can be found here. Amit is getting excited about the newsprint producers, a view that should be respected by its uniqueness and stark contrast to the consensus viewpoint. The jaundiced, condescending view that the consensus casts on the newspaper publishing business with its significant cash flow is only magnified when newsprint suppliers are mentioned. But, Amit observes:

“One of the things that we found quite exciting actually is the area of paper and forest products companies worldwide. Producers of paper, in particular newsprint producers, have become very cheap around the world. And necessarily, this is something that finds a very sizable, and potentially increasing, representation in our portfolio.”

He adds:

“Something that we find very exciting today, as I mentioned before, are newsprint companies. Not newspapers, but the companies that make the paper that newspaper companies use — the newsprint producers. Forest products companies generally are fascinating; they have so completely fallen out of favor that you can buy them at fractions of replacement cost. When I talk of fractions, in some cases it is $0.20 and $0.30 on the dollar, and that I think is quite exciting. Now, the reason why we think that is exciting is because it is not easy to find mature stands of trees, or sources of fiber, or cheap electricity, or to get the government permits in place to build these large operations which are extremely capital intensive.”

Be careful...there are lots of balance sheets that should cause trepidation and should be avoided. Abitibi Consolidated (ABY) has some terrific assets but, as a result of acquisitions in happier times, has a stretched balance sheet. They have just shut down 4 Quebec based sawmills cutting 20% of their output. Bowater (BOW) also has a rather stretched balance sheet. Both Abi and Bowater are single B+ credits. If such a credit rating has you nervous, it is difficult to justify owning the residual equity beneath it!

As always, great values abound when the industry situation is difficult. Patience is always required for such cyclical and controversial ideas. A pick-up in housing would help a lot...after five years of great housing stats, it seems a little too much to hope for. Weakness in oil may make the Canadian dollar a lot less exalted as a petro-currency. That would help both trees and papers. The asset values are there as Amit surmises. Takeovers may become a factor in the forest products producers as Paul Quinn surmises. These deep cyclicals are getting very interesting in my opinion.

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

Friday, October 13, 2006

Value Investing News

George at Fat Pitch Financials has a new innovation to bring to the blogosphere called Value Investing News. It is a fabulous repository of information drawn from your submissions of blog postings and is ranked according to your voting.

The ability to vote down a ranking exists as well as the much more common practice of voting up. Imagine an election where your vote could withdraw votes from the candidate that you least wanted to see in office! What a concept!

Value investing rarely infers newsmaking stories nor does it connote excitement for many people. After all, the predictable, franchise-like qualities of many of our favorite companies remain somewhat immutable over a long period of competitive advantage. No news tends to be good news. Bad news for value investors tends to be better news, especially if decent businesses are being battered by short term events. A good example of this was Sherwin Williams earlier this year. Value Investing News will gather the fresh posts of some of my favorites such as George and Fat Pitch Financials, Geoff Gannon of Gannon on Investing, and Steven of ValueBlogReview all of whom focus on news that may provide similar opportunities. Contrary to popular thinking, which is often an attribute of the great value investors, value investment ideas are exciting, are refreshing, and the notion of buying something for less than intrinsic value seems far more rational than those methods that rely on finding a greater fool upon whom to unload.

I encourage you to participate. The insights are worthwhile and entertaining. The constant innovation that George brings to the blogosphere should keep this site at the forefront of development. The world of active value bloggers should keep the site at the forefront of value thinking.

Thursday, October 12, 2006

Legg Mason-Is it Time to Start Looking?

Legg Mason (LM) dropped 17% yesterday losing about $2.5 billion in market capitalization. It seems like this ought to trigger some value “snooping” if not concerted buying, but let’s look at a few fundamentals.

LM transformed itself completely in June of 2005 with a deal with Citicorp that closed in December of last year.Legg became a pure asset manager, in fact, the fifth largest money manager in the States,one of the largest fund-of-fund hedge fund managers, and the largest fixed income manager.The firm became the #1 supplier of separately managed accounts in the States. The deal extendeded the reach of the firm globally with operations in Japan, Hong Kong, Latin America and Australia.All good things! In fact, enthusiasm for the deal and for the broadened distribution capabilities of the business brought the stock to $140 at its peak.

Now, reality is setting in.Bill Miller will not beat the S&P this year and is 1168 basis points behind as of yesterday. Yes, the great record has a tiny blemish, but hardly a disconcerting negative to long term investors. It appears that the performance of the former Citicorp Asset Management funds have also been somewhat disappointing. Western, the institutional fixed income management business is doing much better than most of the equity businesses.Consequently, LM finds itself gaining assets in lower margin fixed income and money market areas rather than the higher margin equity products.

The pre-release of earnings that caused yesterday’s crop suggests that the equity flows are probably of the order of about $5 billion in the most recent quarter, not horrific, but I wonder about redemption issues for Bill Miller’s Value Trust potentially accelerating as headlines loom about the disruption in the record. Believe me, I think redeeming this fund after one bad year is an incredibly stupid idea. I hope investors hang in but who can predict the likely behavior?

Do the rest of us buy the stock? Legg Mason is currently trading at only 1.3% of Assets under Management, well below the industry which is trading at about 3%. As of the June quarter, equities represented about 37% of the assets with fixed income and “liquidity” meaning money market representing the balance. Contrast this with Federated Investors (FII) which as the most heavily fixed income oriented public money manager (with only 14% equities) trading at 1.7% of assets under management.

Integration issues remain and the earnings accretion that was anticipated when the deal was first announced has not been as readily attained. Operating margins should be much higher than the current 24.5% over time.

Looking at ROIC, the company can do much better than its current 9% as well. The benefits of scale, of diversification, and what historically has been a very well run organization I believe will once again come to the fore.With an EV/EBIT of 17 times, the stock is not exactly a bargain at first brush, but more normalized levels of profitability likely, I think the stock at least deserves to be on the radar screen.

How significant is the Bill Miller risk? Not very...the massive Value Trust represents about $19.4 billion of total equities of $311 billion or 6.2%. Compared to total managed assets of $855 billion, the Value Trust is about 2.3%. The chances of a mass redemption seem small given the tremendous goodwill and performance that Bill Miller has attained.

Historically, this quiet, somewhat understated management team has under-promised and over-delivered. Near term integration issues have disappointed the Street, have hurt profitability, but have created an opportunity in my view. There is always market risk in asset management companies both from equity risk and interest rate risk. The company has an excellent record of integrating its previous acquisitions which have included names such as Brandywine and Royce. Existing management teams persevere and thrive under the new regime. Contrast that with some of the horror stories of the brokerage industry...how many Advest brokers have stayed with Merrill?

Bottomline, many analysts are disappointed, many estimates remain somewhat high. However, yesterday’s move took the stock down to the bottom of the valuation pile as far as assets under management. It does not deserve to be there in my view.

Disclaimer: Neither I, my family, or clients have a current position in Legg Mason or any of the other securities mentioned in this post except I, and some clients have a current position in Federated Investors.

Wednesday, October 11, 2006

Money for Nothing...Are Discount Brokers in Dire Straits?

The discount brokers are reeling this morning with the news that Bank of America is offering free commission trading for customers with more than $25,000 in deposits. This follows a recent announcement by Zecco.com that it was also offering zero commissions to its clients. The BAC announcement is limited to its Northeast customer base at this point.

Bank of America Zecco

What are the implications of “giving it away” to the online brokers. In my view, less than you would think.Discounting of brokerage commissions was the initial raison d’etre for the online industry and pricing competition has always existed. The “average” customer generates little more than $100 in commissions per year. For those traders who are more active than this, pricing is NOT the only consideration, I would think.

Execution is an important factor in differentiating discount brokers. The ease of use and functionality of the portal is critical to many traders. Those who choose to be very active traders are already getting substantial “deals” below the “suggested retail price.” Check out Barron’s Electronic Investor for other parameters by which these discount brokers are judged.

Access to research can be another important factor in selecting an on-line broker and Schwab appears to be unique in providing much of its own in-house expertise. A recent Barron’s article (subscription required) highlighted Schwab’s very good long term record which is largely quantitatively based.

This is not a radical move for Bank of America. It already was offering $5-$10 commissions well below the average rates of $12.23 at ET, $12.52 at AMTD, and $13.47 at SCHW. There are more streams of income than just commissions.

E-Trade, for example, offers a 3.20% rate on deposits between $5 grand and $50 grand compared to BAC’s 2.28%. Consequently, for the average customer who will be saving $100 in commissions to get the zero commissions at BAC, he is giving up an annual interest income of $230. Doesn’t sound like a very rational decision to me.

Many of the online brokers are encouraging fee-based advisory business rather than transactional business. Hence, management fees as well as substantial interest spread income can be generated. AMTD is selling at less than 15 times EV/EBIT on TTM EBIT for a business that generated about 18.5% ROIC. E-Trade sells at less than 12 times EV/EBIT with a ROIC that is quite modest at 1.5%. Schwab sells at 14.4 times EV/EBIT with a ROIC of 18% as well.

Don’t over-react as it appears many on the Street have.

As of noon,

Ameritrade (AMTD) is down 10.5%, E-Trade (ET) is down 9.5%, and Schwab (SCHW) is down about 5%.

Disclaimer: I, and my family do not own any of the securities mentioned above. Certain clients own a current position in Schwab.

Sunday, October 08, 2006

Festival of Stocks Edition #5

Welcome everyone to the fifth edition of the Festival of Stocks. Thank you to all who have submitted a post. I am ecstatic about the high quality of posts and the variety of opinion. And thank you to the new guests that have arrived at Value Discipline. Welcome and look around.

It has been a most interesting week with the Dow Jones establishing new highs adding 1.5% hitting 11,850. The S&P 500 trailed the DJIA and small cap indices rising only about 1%. The Russell 2000 was up a full 2%.

I have attempted to add my own commentary and spin that hopefully will not detract from the underlying wisdom and insight of the original post. Onto the Festival!


Gold Stock Bull reviews Silver Wheaton Corporation, a Vancouver based silver mining company, in fact, the only pure play silver mining company. Its unique operating structure is intriguing…operating strictly as a royalty company with current royalties drawn from production at three geographically diverse mines. Its relationship to Goldcorp provides it a great deal of management acumen. The royalty structure affords it a high ROIC at about 14% for the TTM.

Silver Wheaton (SLW)

Goldcorp (GG)

Inelegant Investor reviews the environment of video rental in Blockbusted. What can a company do when its business model is made obsolescent by the next new thing? Investor reviews the rapidly changing world of video rentals as well as the ominous potential impact of cable's pay-per-view. Seeking refuge in offering retail DVD sales, Blockbuster does not have the scale or cost advantage of other retailers such as WalMart or Costco.The company appears to be burdened with $1 billion in debt plus $2 billion in lease obligations. If that weren't enough, operating margins appear to be negative for the TTM. Yet, Carl Icahn has established an 11.5 million share position in the stock.Be sure to read both the post and the interesting comments that are attached!

Blockbuster (BBI)

Netflix (NFLX)

Another interesting look at the economics of DVD rentals appeared this week in The Long Tail. Though not a submission to the Carnival per se, I thought the post contained a lot of pertinent information regarding the economics of the DVD business, especially the economics of "seasoned" DVD's versus new releases.

Kevin Kelly at ValueBlogger reviews iPass, a company which provides remote access to companies through its software-enabled enterprise connectivity services. At first brush, it appears to be a successful business model with over 300 corporate relationships and networks in over 160 companies. Despite the recurring revenue model, the financial characteristics appear to have deteriorated with excessive spending, poor deployment of capital, a series of acquisitions, and issues of corporate governance. ValueBlogger believes that the business is trading at less than 50% of its intrinsic value, an assertion that may well be shared by activist shareholder Shamrock Partners that now controls some 14% of the stock. Who knows…where there's smoke there may well be fire…the stock was up 8.5% on Friday in a weak market.

iPass (IPAS)

David Phillips of 10Q Detective has another tale of corporate greed in his review of Estee Lauder. The company has a return on capital of about 14% at an EV/EBIT of about 14 times. It appears that the insider stake is about 8.6% of the outstanding stock yet multi-generational family members are interspersed throughout senior levels of management with senior level compensations. Biology teaches the dangers of in-breeding and I suspect management successions that refuse to look beyond the family tree suffer similar fates.

Estee Lauder (EL)

StreetInsider reviews interesting 13D filings and this week has a look at Midwood Capital's increasing stake in Factory Card and Party Outlet. This tiny company has a market cap of only about $27 million. Putting things into perspective, insiders own a 3.9% of the company, about $1 million of value with the CEO owning merely a $440,000 of stock….a modest stake indeed given compensation last year that represented some $600,000 plus. Of course, along the way, stock option issuance has provided management a gratuitous sidebet on the market as I like to call it, with options providing fully diluted insider ownership of 15.8% of the stock. It seems like a disproportionately generous reward for a company with an operating margin of 0.05% for the last twelve months. Despite $75 in revenue per share, the company shows in a loss per share of 17 cents for the last twelve months. No wonder, the frustration and the activism!

Factory Card and Party Outlet (FCPO)

Markets, Macros, and Miscellany

Mr. Market at the Margin of Safety provides some terrific insight into what he labels The Deficient Market Hypothesis, a cleverly labeled post that pokes holes and fun at the efficient market hypothesis (EMH,) the subject of value investors’ scorn and contempt. The conclusions read like a value investor's mantra:

1) Welcome volatility, it brings cheap prices.

2) Markets are inherently inefficient

3) Risk and return relationships do not hold in extremis.

4) Doing nothing is also a strategy…wait for the fat pitch!

5) Today may not be the time to buy…don't succumb to ready, fire, aim strategies!

6) Concentrate your ideas…diversification is an antidote for not knowing your stocks.

7) Value=Growth=Value…

Controlled Greed has a great post on How to Research Foreign Stocks. This is a good follow-up to an article he had written some weeks earlier on how to trade foreign stocks. In my opinion, most investors in North America are under-invested internationally. Though segmented markets are rare and correlations with more traditional markets are getting higher all the time, the benefit of accessing a larger opportunity set of companies is substantial. Valuation jewels can be found if one digs and certainly, Controlled Greed has uncovered some fabulous jewels in his work internationally.

In a similar vane, the what I would argue is the inaccurately named Confused Capitalist examines Emerging Markets. Jay Walker has often addressed these markets in his posts…have you done so in your portfolio? He argues effectively that some 25% of World GDP lives in emerging markets, yet few of us have more than a smattering of representation here.

Fat Pitch Financials adopts the crisp, concise, and clear communication skills of that well-known writing coach Warren Buffett!

Another non-submitted submission that I propose for your reading this week is Seed, which examines a biological reason for the bravado of serial acquirers and investment bankers. Pitting the desire for personal gain against the desire to punish someone else seems to be the basis for more than a few acquisitions. Makes you think, is this why there was a battle for Guidant?

Hedge Funds

Size, Strategy, and Swagger from Abnormal Returns is another terrific read on what likely will be declining returns and increased financial risks in the private equity hedge fund world. It all comes down to hubris.

Book Reviews

Enough Wealth has adopted Joel Greenblatt's Little Book methodologies from his/her Australian base but agonizes over the lack of foreign content in Greenblatt's database. I suspect that there are some uniquely profitable businesses in Australia that might meet Greenblatt screens, unfortunately many of them are commodity based and the sustainability of that profitability comes into question. I found a $Aus 700 million mining company called Aquarius Platinum that appears to have a 26% ROIC for the TTM with a low EV/EBIT of about 6.5 times. Credit Corp Group is in the collection agency business that appears to buy troubled receivables for pennies on the dollar and earns about 17.5% on its capital with an EV/EBIT of about 15 times. Can anybody think of other Greenblatt qualifiers in Australia?

Finally, Geoff Gannon has a book review of the newest "Little Book" the Little Book of Value Investing. The post, written by Steven Rosales, recommends the book written by Christopher Browne of Tweedy Browne, a firm that had the privilege of having several important clients over the years, Ben Graham, Warren Buffett, and Walter Schloss! The evolution of brokerage firm into investment management firm is discussed as well as many insights into bringing common sense into common stock selection. Buy when they're cheap! Buy international in order to double your opportunity set from which to select bargains!

Thank you everyone for your submissions! I am pleased by the quality of what has been brought forward and I hope that my commentary doesn't diminish the fine work that you have presented.

Prior editions of Festival of Stocks can be found on its homepage link.

Next week, look for the Festival of Stocks #6 at Stock Market Beat.

Wednesday, October 04, 2006

Festival of Stocks- Please Submit your Posts!

I will be hosting this week's Festival of Stocks. I would appreciate your sending in your submissions via this easy to use form.

George over at Fat Pitch Financials has put in a great effort to establish this carnival.

You can catch prior editions of the Festival at the Festival of Stocks' homepage.

I have a very tough series of acts to follow.

Prior hosts have included:

George at Fat Pitch Financials
Geoff at Gannon on Investing
Mike at Value Investing, and a Few Cigar Butts
and Frugal at My 1st Million at 33

All of these blogs bring a great deal of insight and effort to such issues as asset allocation, corporate governance, as well as individual stock commentary. I look forward to hearing from as many of you as possible, whatever your style or investment philosophy.

As Buffett said, there are many ways to get to heaven...I am looking forward to a wide variety of submissions from our Festival of Stocks contributors.

If you haven't participated before, here is a great opportunity to have your post recognized. If you have participated in the past, here is a great way to reinforce your message or to demonstrate the breadth of your talents.

Don't wait till the last minute! A number of submissions have already come in and I'd love to see more!

Thank you for your participation!

Tuesday, October 03, 2006

Political Gridlock ...Is Impasse Good for Capital Market Returns?

Some years ago, I was a partner in a firm where one of my other partners did political analysis. Though he had impeccable credentials and a strong and vital interest in the area, I always questioned the validity and the utility of this kind of analysis in making judgments about capital markets. I may have short-shrifted my former partner Bill.

Political economy, a rather old and somewhat antiquated term was superseded by economics. Yet, the interdisciplinary study of both subjects helps garner understanding of the political institutions, the political environment, and capitalism and how these influence one another.

As November mid-term elections approach in the States, there appears to be some concern developing that political gridlock could develop in Washington. Far be it for me to attempt to make any political forecast or show favoritism...at heart, I am libertarian and prefer as little government as possible. Yet gridlock, the condition of the U.S. House of Representatives, the Senate and the Presidency NOT being controlled by the same political party, seems to be a possibility that one should consider.

What influence does political gridlock have on capital market returns?

There is a widespread belief that gridlock is positive for the stock market. The most recent Financial Analysts Journal (Sept/Oct 2006) (sub required) addresses this fallacy. The origin of this belief is that gridlock reduces economic uncertainty because it lessens the chances for significant legislative changes.Rebecca Byrne in "Fear of a United Government" in theStreet.com published this article in November of 2004. She suggested, "investors ...like a government where power is more evenly split, because the chances of a legislative curveball are vastly reduced."

Kevin Hassett at The American Enterprise, back in March of 2000 wrote about the Clinton years:
" Back in 1992 when Clinton took office, visions of economic catastrophe danced in the heads of Republicans. The Democrats controlled the House, and liberals' cleverest schemes were about to become the law of the land. It was a critical break when Hillary's grandiose health care plan failed. But tax rates were raised significantly. Other interventionist policies--such as higher minimum wages--were introduced. Yet fast-forward seven years, and we find ourselves amidst one of the economic golden ages of U.S. history. What gives?"
He adds:

"There is some truth to all of these arguments, but they neglect an important fact. If liberal Democrats had been able to have their way with the economy over the past seven years, they surely would have contrived horrific enough policies to overpower even these potent economic positives. So we are left with just one conclusion: The '90s have not been an era of economic foolishness in Washington. Whether he intended it or not, the Clinton presidency has been a fairly good time for government-keep-your-hands-off economics."
He concludes:

"We will be studying that question for years, but my hunch is that the golden key was precisely what media pundits complained most bitterly about over the last few years: The national government's inability to do anything significant since the Contract with America. Precisely because government was so paralyzed by gridlock that it could not possibly impose its will on our fast-moving, radically changing economy, unprecedented innovation and economic growth became possible."
The FAJ study, written by Scott Beyer, Gerald Jensen, and Robert Johnson investigated the relationship between political gridlock and investment returns from 1949 to 2004...a divided government, representing gridlock occurred froughly two thirds of the time. The findings are quite interesting and in stark contrast to what is generally believed.

During gridlock periods, the small-company premium (outperformance) is absent. Returns achieved by the largest cap companies exceeded the return to the smallest companies by more than 3 percentage points.

Here by decile, are the annual equity returns under gridlock:

Decile I (largest)...8.27%

During periods of political gridlock, returns were fairly consistent across the range of market caps (essentially market cap agnostic) with a range of 4.65%-8.76%.

Political harmony produced returns that were quite different:

Decile I (largest).....8.78%










It appears that most of the small-cap effect must have occurred during times of political harmony. For the bottom half of market caps, the return differences between gridlock and harmony exceeded 10 percentage points, very statistically significant.

It was also found that equity returns were more volatile in gridlock periods than in harmony periods.

As the article concludes (my emphasis):

"The results reported for equities... run strongly counter to the view that equity markets prosper during periods of political gridlock. Instead, we found that equities performed better during periods of harmony; more specifically, small-capitalization equities thrived during periods of political harmony. This evidence contradicts the commonly advanced view that equity investors benefit from the lack of legislation enacted during periods of political gridlock. The findings are consistent with the view that the increased incidence of legislative action during periods of political harmony is advantageous to equities—particularly small-cap stocks."
The impact of political gridlock on bonds appears to be quite different, more like the result one would expect. Bond markets prosper during times of legislative gridlock. The lack of legislative action dampens government spending, inflation, and deficits. Investors' inflationary concerns tend to increase during periods of political harmony.

So there you go...a few very surprising conclusions.
  1. "Gridlock is good" appears to be a myth. Equity returns are higher and less volatile during political harmony.
  2. Large companies produced higher returns than small companies during gridlock periods..the small cap effect occurs only during political harmony.
  3. Bond investors develop inflationary fears during periods of political harmony.
  4. Finally, political conditions may be an important consideration for both equity and fixed-income investors. Sorry Libertarians and especially sorry to you, Bill!

Monday, October 02, 2006

Bank Regulators and Negative Am Loans

Negative amortization occurs when the monthly payments on a loan are insufficient to pay the interest accruing on the principal. The additional interest expense is added to the loan balance...the increased loan balance results in higher interest expense and again, an increasing loan balance. The homeowner essentially digs himself in deeper and deeper to cover the interest on the loan.

If the loan term ends without sufficient amortization, the remaining mortgage owned can be larger than the original mortgage.

Financial institution regulators just announced on September 29th the final guidance for non-traditional mortgages to clarify their stance on guidelines originally issued in December 2005. The goal to ensure more prudent underwriting standards is noble. The effect may considerably reduce volumes of such non-traditional mortgages issued. The guidelines will make it more difficult to originate loans to subprime borrowers, flippers, and borrowers who are stretching to afford a larger house. The offset is that credit quality for banks will improve.

A major change in the quality of mortgage underwriting is proposed. Before the guidance, some lenders underwrote loans assuming they would be outstanding a short period of time, but with loans having 30-year terms. The lender was assuming the property would be sold or the mortgage refinanced before the payment shock would occur. That game has just ended. The new guidelines now indicate the loan must be underwritten to assume collectibility over the life of the loan and a sale or refinance cannot enter into the decision making.

The new guidelines indicate that all or some portion of the negative amortization must be included in the initial calculation of loan to value. The amount of negative amortization included will depend on the spread between the payment rate and the accrue rate and how much negative amortization would be generated over the first payment period (usually five years). Again, this should discourage the more aggressive lenders and restrict their assumptions and enhance overall credit quality.

Finally, regulators want consumers to understand both the positives and negatives of nontraditional mortgages. Lenders are now required to make more balanced presentations regarding nontraditional mortgages and monthly statements will clearly indicate what each payment option will have on the loan balance. Good news for consumers...bad news for flippers and gamers who wanted to maximize cash flow.

It is encouraging to see a higher standard of underwriting, a higher standard of risk management and a higher standard of consumer disclosure. Unfortunately, it seems to me to be locking the barn door after the horse has bolted. After some years of overheated housing market activity and questionable loan practice, what took so long?

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