Monday, April 30, 2007

Stock Market Prognosticator and Festival of Stocks

The 34th edition of the Festival of Stocks appears today in Stock Market Prognosticator, a blog written by Eric J. Fox.

Eric has done a great job in highlighting some interesting posts of the past week covering a wide range of topics from uranium stocks to opening a zero commission brokerage account. Eric has been kind enough to include one of our posts last week, Private Equity Envy.

Eric is a hedge fund manager who seems to focus on deep value, somewhat obscure stocks. A terrific universe that can result in some outstanding returns. Managements frequently forget that they still have a public constituency. Read Eric's post on Biloxi Marsh Land. The financials may be intriguing, the assets may appear interesting, but management clearly does not want to divulge, let alone disclose anything based on Eric's experience.

Years ago, I went through a similar experience with International Speedway (ISCA) while it still lived as a pink-sheet company. Similarly, St. Joe Paper, now known as St. Joe Company (JOE) hardly gave outside investors much disclosure when it lived in the "pink."

Both ISCA and JOE turned into real goldmines as their management discovered that open disclosure and a broadened sharebase actually could help others recognize the intrinsic value. I am sure there are many pink sheet names that also gained "legitimacy" or at least broader recognition as they were launched on more more actively traded platforms and developed fuller disclosure requirements and standards. The Detroit and Canada Tunnel Company for years was OTC-pink and for years, the true value seemed unattainable. After being taken over some years ago, the tunnel is now owned by a fund of Macquarie Bank of Australia.

Enjoy Eric's version of the Festival of Stocks and have a look around his website. In my view, Eric has a great handle on value.

Disclaimer: I, my family, and clients do not currently own any of the securities mentioned in this post.

Friday, April 27, 2007

Making Sense of Deborah's World

Deborah is a teacher on call out in the unbelievably beautiful city of Vancouver, British Columbia. Education, she claims, is her primary calling.

However, she has an excellent blog called, "Making Sense of My World" a very thoughtful and fundamentally based view of mining stocks.

Many blogs which espouse mining stocks tend to be written by inflationistas or crazies who view every upward jiggle in the yellow metal as portending the death spiral of the US dollar. Having no trust whatsoever in paper currency, their blogs tend to be rantings about Argentine and German inflationary experiences. Every financial crisis takes on epic proportions as a struggle between good and evil. Deborah avoids these histrionics.

Instead, she provides level-headed, soundly reasoned analysis of mining stocks. I value her analysis and recommend it to you!

Please find her link in the right hand column.

Economic Worries and Marathon Running

It is easy to take a dim view of equity markets when we read today's economic report showing US GDP slowing to a lethargic 1.3% pace for the first quarter, well below the expectations of most economists at 1.7%.

It's a good time to remind people of what I view as truism, the economy per se has nothing to do with the stock market, the biggest factor is what price you pay and what level of profitability you are attaching yourself to. You will find I refer to this truism quite frequently, most recently here.

It's easy to get bogged down in the noise, to get spooked by the media's fear-mongering. or news creation Sub-prime mortgage failures prompt curiosity much like rubber-necking a car accident. For the individuals or families, they represent a financial train-wreck and a horrible event. In aggregate however, even with one quarter of last year's originations being sub-prime, and even with defaults potentially hitting 20% rates, we are still looking at only 5% of mortgages that are afflicted. It is also easy to forget about the number of homes that are actually owned "free and clear" a figure that encompasses most of the baby boom generation.

As a value investor, I have little regard or time for most economic forecasts. Avoiding trouble (aka preserving capital) is first and foremost on my agenda. Some of my friends are far better at developing an aggregate stock market view. Let me cite a couple of them that I recommend highly. They have been kind enough to allow me to write occasional guest commentary for them.

Henry To of views markets as somewhat overbought, but remains bullish on a market that remains well-supported by private equity buyouts and insider buying as well as numerous other factors that he provides his faithful subscribers.

Another friend, David Korn of remains bullish as well citing bullish insiders, as well as a host of evidence from sentiment indicators. I recommend both of these subscriptions as ways to improve your financial acumen from writers who are far better equipped than I to provide aggregate viewpoints.

Elsewhere in the blogosphere, I have found Interactive Investor Blog's recent post to be quite interesting.Q In a well-balanced post that cites bears such as Barry Ritholz in "The wall of worry now looks like the Great Wall of China " he also cites the very optimistic Ken Fisher, the Forbes columnist, money manager, and yes, Forbes 400 list.

Fisher's optimism is predicated on the spread between earnings yield and government bond yields in markets around the world. In what sounds like a physics argument relating to potential energy, he writes:

" At the beginning of the year the forward earnings yield was 2% higher than the 10 year government bond yield in the US and over 3% in the UK, France, Germany and Japan, yet over long periods the spread between the two has been close to zero. The theory is that when one asset pays more than another, money will flow to it and prices will rise."

Fisher continues,

“This is the beginning of a process that no-one has ever seen before,” says Ken, “In the past, when the earnings yield has been above the bond yield it’s either been in a single country… Or it happened for a very short time. This is the first time in modern history when the earnings yield has been above the bond yield all around the world.”

I am not sure that I am quite this optimistic. Nevertheless, I find it very odd that corporate balance sheets in general have failed to adequately respond to continued low rate opportunities. In a recent screen of S&P 500 non-financial names that I did, fully 30% of the companies had cash plus cash equivalents in excess of total debt. A year ago, the result was similar at about one-third. Looking at all North American companies covered by Reuters, there were 4,334 companies that passed this very far from robust screen. Financial leverage is only appropriate for companies that generate returns on investment above the cost of debt and can do so through cyclical ebbs and flows. Like the fellow who has discovered a hammer and thinks the world is covered in nails, financial engineering by blindly buying back stock willy-nilly can be a prescription for disaster.

Bottom-line, don't let economic aggregate numbers influence your investment thinking. The upside to any turbulence created by such releases is that fear or conversely, bravado creates opportunities.

In looking back at a week of earnings releases, (and remember it is only looking forward that makes you money) I am gratified by results at companies we hold such as 3M (MMM), Aetna (AET) , Harman (HAR), NCR (NCR), National Instruments (NATI), Microsoft (MSFT).

What a strange hodgepodge of businesses, you may think, but several characteristics define attention to return on invested capital, a discipline in running the franchise, and a return of capital to the shareholder.

Some years ago, I trained and completed the New York marathon. Though distance running is portrayed as being very solitary, successful training was easiest when you ran with a partner. The same is true for successful investing. Don't let the short-term economic stats worry you, find yourself some decent businesses to partner with for the long run.

Disclaimer: Either I, my family, or clients own a current position in the securities mentioned in this post.

Thursday, April 26, 2007

Harman International-Sidney, You're My Hero!

Last May 21st, I did a post on Harman International (HAR)-An Auto Parts Growth Story.

The company announced today that it has entered an agreement to be acquired by KKR and Goldman Sachs Capital Partners for $8 billion. The unique structure of this transaction will allow current Harman shareholders to participate in the newly structured company.

Shareholders can elect to receive cash of $120 or alternatively, may exchange some or all of their stock for the new corporation. Up to $1 billion of HAR stock may elect to participate in the new Corporation. Here is the press release.

Dr. Sidney Harman, the 88 year old founder and Executive Chairman of Harman will remain as Executive Chairman of the new company. His passion for creativity and integrity has shaped a great business. Of note, he is selling only half of his stock into the $120 offer and will tender the balance, together with the rest of the shareholders, on no special basis, to participate in the newly capitalized company.

Much like one of Berkshire Hathaway's managers, Dr. Harman's love of his business supersedes almost everything else. The ability to participate in the newly leveraged Harman International demonstrates a strong alliance with all shareholders. As Buffett describes the relationship with shareholders as a sense of partnership, Dr. Harman has demonstrated a similar responsibility.

And, by the way, record results for the second quarter and first half of the year. A remarkable result for a company that is 70% auto industry related.

Not often that you see an 88 year old executive step up to the plate for the next iteration of his company. Sidney, you are my hero!

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

Wednesday, April 25, 2007

Private Equity Envy??

The world of private equity hedge funds is a fairly rarefied world. The vast majority of these funds are organized as limited partnerships (LP) where the investors are principally institutional investors such as pension funds, banks, and high net worth individuals.The general partner (GP) identifies the opportunity, calls money from its lLP's (also called a drawdown or takedown) up to the amount committed and can do so at any point until the fund is liquidated. When an investment is liquidated, the GP distributes proceeds to the LP's in kind or in cash. The compensation from LPs to GP's consists of a management fee, plus a fraction of the profits called the carried interest.

This is a league of very big money and very big players. Most of us don't have the wherewithal to play this game. How envious should we be?

According to a just-released paper by the Research Foundation of the CFA Institute, it ain't quite as rosy as it looks. This literature review by Ludovic Phalippou of the University of Amsterdam shows that the average investor has obtained very poor returns from investments in private equity funds, largely because of excessive fees.

Much of the original work on private equity fund performance comes from seminal work of Steve Kaplan and Antoinette Schoar who reported that the performance of 746 private equity funds in their sample was close to that of the S&P 500, net of fees. Subsequent work by Phalippou and Gottschalg (PG)found the performance of private equity funds was below that of public stock markets.

Given the illiquidity of such investments and the leverage risk that they entail, the result is unattractive.

PG also noted that a number of the funds reported high values for their non-exited investments. The residual value of "living deads"- those companies that had not changed their residual values for some years were not yet ready to be taken public again, may in fact be considerably less than the book value stated. If these residual values were properly written off, then the performance of these private equity funds would decrease even further.

After making the appropriate adjustments, PG estimate that on average, private equity funds under-perform the S&P 500 by more than 3% a year. Despite these adjustments, PG believe that their estimate is still optimistic because additional costs incurred by investors were not measured.

An interesting fact is that the performance gross of fees was substantial.The typical 2 and 20 cost structure seems innocuous at first, but results in fees that can be very high in practice, according to Swenson at Yale, about 12 percent a year, according to PG about 7 percent.

Much like John Bogle of Vanguard or Charlie Ellis have opined. fee structures have a lot to do with performance. As PG conclude, the total rent (i.e. fees) captured by private equity funds is probably excessive and is probably behind the counterintuitive result of low net-of-fees performance.

The data of the industry leaves much to be desired as it contains extraordinary survivorship bias...there is an overwhelming mention of successful investments compared to reality. Only completed transactions get mentioned...less successful deals stay in buyout portfolios for years.

PG also report that the correlation between fund performance and duration is highly negative...the funds with longer duration perform worse, a function of the residual values of the non-exited deals.

Be aware of the real agenda , it may not be to maximize your returns. One study reports that investments were made in private equity funds to establish a commercial relationship with increase the likelihood that the funds will purchase services that the LP's corporate parent has to offer.

There are many risks inherent in being an LP. Selling stakes in the partnership is sometimes forbidden, and when it is not, can be sold only at deep discounts and only with the authorization of the GP. Past performance is often top secret. LPs have limited rights to influence or direct funds' activities. The problem of information asymmetry arises in this hyper-secret world.

Fees are typically charged on the amount of capital committed at inception, again typically only 16% of committed capital actually is invested by the end of the first year, after five years, only 80% of the capital committed is invested. A n extraordinarily high tariff in my view.

Intermediate valuations are described in this paper as "sluggish." There is a reluctance to write-off unsuccessful investments and a propensity to mark-to-"market"upwards those investments that are panning out. But "market" is ill-defined, it can be an arbitrary multiple of EBITDA or stock market comparables.

Overall, the article is well worth reading. In general returns have been less than that of an index fund after fees. Governance structures are poor, risks are high, disclosure is barebones. There is no reason to be envious of many of these private equity operators.

Some of the trade unions have been quite envious of the wealth building that is transforming the ownership structure for the companies that employ their members. A new study was brought out yesterday by the Service Employees International that is quite interesting as well. Please see SEIU Behind the Buyouts

We have ranted about the unfairness of some of the deals that we have seen on numerous occasions. Here is a set of recent Value Discipline links:
Falling out the First Storey Window
Observations on Risk
Yankee Candle Darn It's Going Away
A delicious Irony:Lots of Dollars Little Sense
Private Equity, Hedge Funds and the Struggle to Spend Cash

A few other interesting links apropos to the topic:

Financial Services Authority UK Risk Outlook


IMF Warns of Private Equity Boom

Monday, April 23, 2007

Lou Simpson article

There is an interesting article in today's New York Times which describes the career of Lou Simpson, the chief investment officer of Geico.

NY Times (subscription may be required) A Maestro of Investments in the Style of Buffett

The basic principles should be familiar to all of us who study the value driven superinvestors. These were outlined in a blog back in February, RetireRichBlog. :

  1. Think independently
  2. Invest in high-return businesses that are fun for the shareholders
  3. Pay only a reasonable price, even for an excellent business
  4. Invest for the long term
  5. Do not diversify excessively
The RetireRichBlog has featured some outstanding investors in its posts as well as some useful screens.

Disclaimer: I, my family, and clients have a current position in Berkshire Hathaway the parent company of Geico.

The Good Weather Bonus

At least Buffett in his annual commentary on Berkshire gave credit where credit was due..."Our most important business, insurance, benefited from a large dose of luck: Mother Nature, bless her heart, went on vacation. After hammering us with hurricanes in 2004 and 2005-storms that caused us to lose a bundle on super-cat insurance-she just vanished."

Contrast that with an article in today's International Herald Tribune, "Insurance chiefs get big bonuses thanks to good weather."

According to the article, annual bonuses for CEOs at the 21 companies in the S&P insurance index rose by 30 percent. The weather-related swing in earnings obviously benefited all shareholders. Nevertheless, since so much of what created the impetus for better earnings was beyond the control of management, it seems ridiculous to reward CEOs for Mother Nature's doing. As Buffett indicated, "This is not due to managerial brilliance but rather to good luck."

An interesting aside that is mentioned in the article is the compensation philosophy of the Hartford (HIG) which adjusts earnings to provide a more reasonable assessment of earnings "ex-Mother Nature."

In assessing financial performance for compensation purposes, the Compensation Committee has approved an adjusted core earnings definition that is intended to minimize or eliminate the effect—either favorable or unfavorable—of certain items. The adjustments pursuant to the definition are intended to ensure that award payments represent the results achieved in the underlying business and are not unduly inflated or deflated due to the effect of items that do not directly reflect Company or management performance.

In its definition of Adjusted Core Earnings:

Adjusted for After−tax:
1.Net realized capital gains and/or losses, except for those net realized capital gains and/or losses resulting from net periodic settlements on credit derivatives and net periodic settlements on fixed annuity cross−currency swaps;

2. Income/losses associated with the cumulative effect of accounting changes, and accounting extraordinary items;

3. Total catastrophe losses, including reinstatement premiums, state catastrophe fund assessments and terrorism losses, that are above 130% or below 70% of budgeted catastrophe losses;

4. The estimated earnings gained or lost associated with the S&P 500 index weighted average daily value during the performance period being above 105% or below 95% of the level budgeted in the Plan. For purposes of any adjustments pursuant to this section, earnings will be reduced/increased by $4.1 million for each percentage point the S&P 500 index weighted average daily value is above/below the Plan level;

5. Entire amount (or such percentage of the loss as determined by the Compensation Committee) of any other individual non−catastrophe loss associated with any unusual or non−recurring item, including but not limited to reserve development, litigation and regulatory settlement charges and restructuring charges;

6.Prior year non−recurring tax benefits or charges;

Disclaimer: Neither I, my family, or clients have a current position in Hartford Financial Services

Wednesday, April 18, 2007

Sallie Mae does not mean Others Will

Speculators seem to be herding around underperforming financial services stocks since the announcement of the Sallie Mae proposed takeover. The $25 billion takeover orchestrated by J Christopher Flowers is a unique offer for a unique set of assets.

Sallie (SLM), despite the existing leverage ($112 billion in debt currently with a $4.4 billion equity base) can afford the leverage with its gold-plated assets consisting primarily (about 85%) of government guaranteed student loans. Despite the bad rap that student loans carry regarding their default rates, this is not Sallie's problem...defaults are essentially Uncle Sam's problem.A federal student loan goes into default when it is 270 days delinquent, at which point a government guarantee agent purchases the loan from SLM and is reimbursed by the Department of Education.

The management team which has been in place since 1995 has done a sterling job in reducing the capital intensity of the business by increased securitization of these high quality loans and reduction of the equity base by a concerted effort to buyback stock. Previous management, in my view, luxuriated under the GSE banner, and spent its well-compensated time operating in fear of Congressional intervention with little appreciation of the securitization markets.

JP Morgan and Bankamerica will achieve better economics for their student lending operations than were feasible under their existing bank capital requirements. As well, they will pick up substantial income from the fees derived from arranging securitizations.

The financing facility of $200 billion (almost twice the loan portfolio) should assure credit agencies that SLM will have ample liquidity from two of the biggest banks in the land to backstop any potential crisis .

The terms for this LBO are very aggressive with interest coverage of only about 1.6 times.Debt will be over 8 times EBITDA. That is huge and scary. But don't forget about the backstop funding that $200 billion brings.

Sallie is no longer a GSE (government sponsored enterprise,) courtesy of the forethought of the existing management team. This flexibility has worked out in ways that are unimaginable. Had this remained a GSE, this deal could never have been contemplated.

The FFELP lending program operates very efficiently and effectively and at remarkably low cost. Under the Clinton administration, the direct lending competitor operated as one would expect any government agency high cost, and ineffectively. Snarled application processes left financial aid offices at colleges around the country wondering when they were going to get paid.

Will government allow this deal? Politically, student lending has always been an easy target, but remember this is no longer a GSE. Theoretically, this should be no more difficult than allowing a Bankone, JP Morgan merger which united two of the largest student loan originators in the country.

But because Sallie Mae does not mean others will. In my opinion, this should not open the floodgates to widespread LBO's of financial services companies. Deposit taking banks have a lot of hoops to pass through for a takeover, and the equity cushion is very important to people that offer deposit insurance, namely the FDIC. Freddie and Fannie (and I like them both) are ensconced as GSE's and will not have the flexibility to do this kind of a deal. CIT has a loan portfolio that is much more complex and less fungible than that of Sallie. It is possible but it won't be easy.

Needless to say, I like the Sallie deal from the perspective of a long time shareholder. Bondholders may feel more than a little chagrined.

Disclaimer: I, my family, or clients own a current position in SLM , BAC, JPM, and FRE, but do not own a position in any of the other securities mentioned.

Sunday, April 15, 2007

Festival of Stocks-Edition #32

Welcome to the 32nd edition of Festival of Stocks! As always, thank you George for allowing Value Discipline to host. This is our third time to be given the privilege to host.

To our old friends, welcome new ones, welcome...have a look around!

Thank you especially to all of you who have been kind enough to submit your blog postings for consideration and commentary. I truly appreciate it!

In an attempt to add my personal imprint, I do try to incorporate some additional materials that I find interesting and hopefully, will prove so to you as well.

Markets this week continued to advance this week with the broad-based Wilshire 5000 up 0.66%, about the same as the large cap S&P 500’s advance of 0.63%. Year-to-date, the largest 50 market cap stocks has finally moved into positive territory, but just barely, being up 0.31%. Contrast this with the 2.97% advance of the S&P 500 or the 4.03% advance of the Russell 2000. Wasn’t this supposed to be the year that large cap was to win the performance tables? As Barron’s (subscription required) points out in this weekend’s edition, “Big has become synonymous with poor stock market showings. This could very well continue unless the giants give back more to investors through dividends and buybacks.”

Sure, makes a contrarian feel pretty good about his large cap selections.

1) Kicking off this week’s Festival, we introduce Vladimir Kuznetsov, an investment banker in Moscow who offers great perspective on the Russian emerging market. His post, “Russian State-Capitalistic Model-Is This Right for Us?” comments on some recent articles that describe the stormy backdrop out of which emerging markets frequently evolve. Vladimir concludes that “these articles are too pessimistic, that Russia is still a ‘kid’ in market economy, and of course the birth and growth of this kid goes on with a lot of ‘strange and unusual’ actions.” In my view, the expropriation of Yukos under what I believe were trumped up taxation charges, underline the meager property rights that are accorded investors in Russia. Most would agree that this was a politically motivated campaign to bring down the company and its billionaire founder, Mikhail Khodorkovsky. In my view, this is a market where return of my capital is more important than return on capital. Please convince me otherwise. Your optimism is encouraging! To keep up with this market, please bookmark Equity Financing in Russia.

2) For gold bugs, TJP at Investor Trip features a post on DRD Gold (DROOY), a gold mining company which holds interests in the Porgera gold mine located in the Enga province in the highlands of Papua New Guinea; the Tolukuma mine located about 100 km north of the capital of Port Moresby in Papua New Guinea; and the Vatukoula gold mine located on the island of Viti Levu in Fiji in the South Pacific. The company also owns interests in the Blyvooruitzicht mine located near Carletonville approximately 70 km south-west of Johannesburg; the East Rand proprietary mines located approximately 25 km to the east of Johannesburg; and the Argonaut project. The company has a market cap of $241 million (US) but also carries debt of $157 million and cash of $55 million for an EV of $344 million. Here’s a link to Reuters Ratios and Analytics for DROOY.. TJP’s blog is It would be a very interesting trip indeed to visit DRD’s facilities around the world!

3) Media attention seems to be focused on the IMF’s president, Paul Wolfowitz and his battle to keep his job as a result of his securing a huge pay increase for a close female friend. However, is paying attention to some of the important deliberations and documents that have come from the IMF.

In his post, there is an excellent view of the risks of the private equity buyout craze. To quote:

"With allocations to private equity funds continuing to rise, it appears likely that in the future, more funds will be chasing fewer attractive deals. Already, rating agencies have warned that the number of viable targets has diminished. The strong demand for all elements of the capital structure of these deals means that prices are often bid up to levels that represent high multiples of earnings."

The IMF recognizes that the current economic situation remains relatively benign, but adverse changes could create a domino effect on these deals and on markets n general:

"If one of these factors changes, deals that looked promising in a benign environment could suddenly appear much less attractive. It is therefore likely that some private equity deals will fail to live up to expectations. The risk from a financial stability viewpoint is that the collapse of several large and high-profile deals during the syndication stage would trigger a wider re-appraisal across a broader range of products.''

4) Back to metals for a moment and particularly zinc. Years ago, when base metals were not politely discussed because the overwhelming supply and seemingly modest demand indicated a lifetime of low prices, portfolio managers and analysts used to joke that “lead’s dead and zinc stinks.” Perhaps my built in biases against paying for commodities that trade at such a premium to production costs have caused me to avoid most mining stocks at this stage. However, here is some compelling work by Deborah, a teacher in British Columbia. Her blog, “Making Sense of My World” has an excellent post on zinc this week with some great charts. If you are wondering, “What’s Up with Zinc?” the answer is everything except inventories. Thank you Deborah!

5) Bryan, over at has a fascinating blog which investigates many currency related trades effected through options and derivatives strategies. There is some really terrific work here. He has submitted a post which describes an interesting strategy to utilize leveraged ETF’s (Ultra’s) in combination with a bond ETF or a money market instrument. As Bryan indicates, the leveraged products available today provide an opportunity for average investors to engage in a greater amount of diversification while adding to returns and reducing the risk associated with market cycles.

6) Trent at The Simple Dollar has submitted a book review post of Burton Malkiel’s classic, “A Random Walk Down Wall Street.”The Simple Dollar » Review: A Random Walk Down Wall Street This is an excellent chapter by chapter review of this classic and highly readable discussion of CAPM and market efficiency. There is a lot of sage and practical advice provided in this blog! Market efficiency is presumed when well-informed investors act in a rational fashion. There is quite a difference between information and knowledge. Rational behavior is sometimes not the prevailing attitude. I refer to a Nietzsche quote, “Insanity in individuals is something rare but in groups, nations, and epochs it is the rule.”

7) Babak provides a glimpse the Solar Power Industry and associated stocks in this post at Trader’s Narrative. His interest in the sector is based on technical analysis. He mentions the following stocks:

Ascent Solar (ASTI)
Amtech Systems (ASYS)
Evergreen Solar (ESLR)
First Solar (FSLR)
Scientific (HOKU)
MEMC Electronic (WFR)
Solarfun Power (SOLF)
Suntech Power (STP)
Sunpower (SPWR)
Trina (TSL)
World Water & Power (WWAT.OB)

My thoughts....Be careful out there! Most of these companies are trading near all time highs and have very steep valuations. Investigate before you invest.

8) Endless Gibberish provides a post on Montpelier Re (MRH) the reinsurance company. Mother Nature was kind last year and the winds failed to blow. Returns on equity hit the mid-30’s. Here is a link that provides some ratios and analytics courtesy of Reuters.

9) George of Fat Pitch Financials, the mothership of the Festival of Stocks has submitted a post on Broadridge Financial Solutions (BR), the ADP spin-off. I stirred up a lot of controversy and comment when I published a note on BR, the night before it opened for regular trading on the NYSE. Haste makes waste! Though my cash flow work was good, my division of EV/EBIT was horrid...I am still not sure exactly where I made my error but to all of you, I humbly apologize. Mea culpa, mea culpa, mea maxima culpa! George provides some wonderful additional competitive analysis as well as a P/E based valuation analysis. Nice work George!

10) Finally, Tom Hanna has provided us a roadmap for next week. For our American friends, top priority is filing your income taxes. Like you didn’t know!! The week will be data heavy with financial/economic data including information on the supply side of the new homes market, industrial production and manufacturing, retail sales, inventories, the leading index, investor confidence and retail price inflation. Earnings season is under way with some of the big money center banks reporting in the early part of the week.

Thanks again to everyone for your readership and for submitting your Festival of Stock posts to Value Discipline.

Next week’s festival will take place at Money Walks, presided over by Andy.

If you wish to submit an article, here is the link: Blog Carnival - Submit an Article to a Carnival. Your help is much appreciated!

To review any of the prior Festivals, please check out this link.

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

Friday, April 13, 2007

Festival of Stocks

As you may know, I am hosting the upcoming Festival of Stocks. This is the third time that Value Discipline has hosted this important overview of recent investing blogs.

Just a reminder to please "hit me with your best shot!" Please submit your best recently posted stock market related article to be included in the Festival of Stocks.

Please use the following submission form: Submit your Post

I appreciate your submissions, your interest and your readership!

Monday, April 02, 2007

Broadridge and First Data

Of note, one of BR's major competitors in Investor Communications is First Data (FDC) which is being taken over in a going private transaction by KKR.

Presumably, this buyout will leave FDC's capital structure significantly burdened with debt.

Clearly, the risks that I cited with respect to BR's business model such as business concentration and potential loss of business due to SEC mandated changes re proxies are risks that KKR has assessed in its decision to buy the First Data business.

Sunday, April 01, 2007

Broadridge Financial Solutions, Inc (BR)

ADP has just spun off its Brokerage Services Group into a separately traded company called Broadridge Financial Solutions (BR.) The basis of the spin off was a tax free dividend of 1 BR share for every 4 ADP shares leaving about 139 million shares outstanding.The distribution was completed on March 30th, just this Friday.

The company has a 40 year history and is an outsource solution to the financial services industry. It provides integrated systems and services include investor communications solutions, securities processing solutions, and securities clearing and operations outsourcing solutions.

The company enjoys some long-standing relationships with its clients and some 70% of its revenues are recurring. Some parts of its securities processing solutions are used by 7 of the top 10 US broker dealers so there is tremendous market share. On average, the firm processes $2 trillion in fixed income trades daily.

These are large markets. Globally, investor communications is a $3-5 billion market with revenues at Broadridge last year constituting $1.4 billion of BR's almost $2 billion revenues. The Investor Communication Solutions business involves the processing and distribution of proxy materials to investors in equity securities and mutual funds, as well as the facilitation of related vote processing. ProxyEdge, their electronic proxy delivery and voting solution for institutional investors, helps ensure the participation of many companies’ largest stockholders. This is important from a corporate regulatory standpoint in that it provides regulatory reporting, tax reporting and corporate actions/reorganization processing solutions for its clients. In addition. this division provides financial information distribution and transaction reporting services to both financial institutions and securities issuers.In this business, the company gets a fee for each item processed and/or distributed.

This has been a decent growth segment for the business with YOY growth in revenues for the June 06/05 period of 15.6% and growth for the first half of 07 fiscal versus corresponding 06 of 14.5%. Earnings from continuing operations for the year were up 16.2% reflecting slight margin expansion to 14.7% from the prior year's 14.5% but mostly revenue growth.

Proxy communication represents about 65% of this segment and there is a cloud on the horizon. Let me quote from their recent filing:

"Prior to recent amendments, SEC rules required affirmative written consent from a stockholder before proxy materials could be delivered electronically to that stockholder. On December 13, 2006, the SEC adopted amendments to its proxy rules that will allow public companies an option to follow a “notice and access” model of proxy material delivery. The new rules go into effect on July 1, 2007 ."

What does this mean?

"Under the new rules, public companies may furnish proxy materials to stockholders by posting them on an Internet website and providing stockholders with notice of the Internet availability of the proxy materials. "

As the company indicates:
"The adopted changes, and the proposed changes, if adopted, will have a significant effect on our business. For those companies that choose the notice and access option, we will continue to mail notices to those stockholders who have not elected to receive proxy materials electronically. Therefore, the volume of items to be mailed will most likely remain unchanged. However, the weight of the packages will be less, resulting in lower revenues per distribution. At the same time, some stockholders may elect to continue to receive paper copies of proxy materials. Certain of these mailings may not receive the benefit of volume discounts, resulting in higher revenues per distribution. We also anticipate deriving additional revenue from the fulfillment services that we expect to provide for individually ordered paper proxy materials and for the establishment of procedures such as toll−free numbers and websites to accommodate the requests of stockholders to receive paper proxy materials for up to one year after the conclusion of the meeting or corporate action to which the materials relate. Additionally, we may derive revenue from new services such as the creation of access notices and the creation and maintenance of a new database of stockholders requesting paper proxy materials. We do not at this time know how many companies will choose the notice and access option, nor do we know how many stockholders will elect to continue to receive paper copies of proxy materials. As a result, we cannot at this time predict the net effect of the SEC’s new electronic access rules on our Investor Communication Solutions business."

My guess, at least for the foreseeable future, revenues should stay intact. Growth is driven by increasing levels of share ownership. High levels of activism and merger activity provide incremental revenue opportunities.Delivering of trade confirms, account statements, prospectus information, etc is another important aspect of this business. This aspect of the communications business integrates well with the securities processing business.

Securities processing is another decent revenue recurring business which operates under long term contracts. It is a scalable business where many firms choose to outsource their clearing systems. Brokerage industry consolidation provides both challenges and opportunities to be the platform onto which to consolidate. Pricing is a struggle. Securities processing solutions represents about 25% of the total revenues and generates pre-tax margins of almost 27%. Pure clearing operations for correspondent brokers at this point is a smallish business, less than 5% of revenues and generates a loss.

This is a very international business. BR has securities processing capabilities for more than 50 countries and voting platforms available for over 90 countries.

There is some concentration risk. The top 5 accounts represent about 25% of revenues. Hence, consolidation trends can hurt as clients merge.

The cash flows of this business are quite interesting. CFFO was $426 million last year, well above net income, and representing some 22% of revenues. Since capex has been about $34 million for the last several years, considerable free cash flow was generated, in fact, well in excess of net income. The 2006 CFFO was augmented by the liquidation of a "required regulatory deposit reserve" of $176.8 million in the the Clearing and Outsourcing Solutions segment. Hence, a more sustainable and realistic CFFO would have been about $250 million. Given the burden of interest expense, going forward CFFO, somewhere around $225. FCF should be around $180-$200 million

The equity market cap is about $2.7 billion, hence a FCF yield of almost 7%...seems quite cheap to me at least initially.

There is considerable debt, a good slug of which was paid out as a dividend upstreamed to ADP of $690 million. With about $85 million in cash, this works out to an EV of $3.3 billion. On an EV/EBIT basis this is a valuation of a modest 5 times trailing EBIT.

There is an excellent roadshow document that the company has provided here.

Disclaimer: Neither I, my family, nor clients have a current position in ADP or BR.

Large Cap-Small Cap- All Cap???

In today's New York Times there is an interesting article on the topic of investment style. Mark Hulbert, founder of the Hulbert Financial Digest, the terrific monitoring service of newsletter recommendations, wrote the article. Hulbert does a great public service in examining the investing record of newsletters, most of under-perform the market over time.

He quotes a new article by Fama and French which appears here.

Fama and French are known for their conclusions in a 1992 Journal of Finance study which examined the capital asset pricing model, CAPM. Their main result is that two easily measured variables, size and book to-market equity (BE/ME), the inverse of price to book value, seem to describe the cross-section of average stock returns. Based on this finding, they conclude that beta is insufficient in explaining average return. In more direct terms, beta really had very little to do in explaining returns on stocks. Much better explanations were provided by market cap (smaller stocks outperform larger) and price to book (the lower the price to book relationship, the higher the likely return on a stock.) This was viewed as a particularly revolutionary paper by some academics because it represented a formerly very strong proponent of CAPM (Eugene Fama) relinquishing that belief and adopting a more fundamental view. Fama and French later wrote a paper on "Value versus Growth, the International Evidence" which demonstrated that value stocks( as defined by price/book) had outperformed growth in 12 of 13 markets for twenty years and that the average returns between high and low price to book stocks was 7.68% a year!

In the most recent paper, Fama and French study migration, that is value stocks that earn high returns and migrate to neutral or growth portfolios; growth stocks that earn low returns and move down to neutral or value portfolios; and finally, slightly higher returns earned on value stocks that do not migrate compared to growth stocks that do not migrate.

A few conclusions: The higher average returns of small stocks are due primarily to one type of migration: small stocks that become big – specifically, price appreciation moves a stock’s market cap from below to above the NYSE median from one year to the next. Big stocks that become small have strong negative average excess returns, but they contribute little to the size premium. This perhaps surprising result arises because, unlike stocks that move from small to big, stocks that become small account for tiny fractions of the market cap of big stock portfolios. the size premium in average returns for 1927-2006 traces almost entirely to the high average excess returns (more than 50%) earned by the 8-12% of small stock market cap that moves to a big portfolio from one year to the next.

In contrast, differences in transition frequencies for value and growth stocks largely drive the contributions of Plus and Minus migration to value premiums. Without changing size groups, there is little room for growth stocks to improve in type or for value stocks to deteriorate. Thus, Plus transitions are common for value stocks, but they are rare for growth stocks, and Minus transitions are common for growth stocks, but they are rare for value stocks. As a result, Plus transitions, which are accompanied by high returns, contribute about 3.5% (3.5 percentage points) more per year to the excess returns of small and big value portfolios than they do to the matching growth portfolios. Similarly, Minus transitions and their low returns are a bigger drag on the excess returns of growth portfolios.

There is more migration from small to big than vice versa. There is more competition for companies earning high returns, therefore over time, their returns and their size diminish. Small stocks disappear in mergers much more often than large stocks.

The migration effects are very important. Over the last 80 years, small cap value stocks returned a spectacular 22.5% versus 13.3% for the overall market. But had the stocks which shifted to the growth camp the following year not been kept in the value classification, the small cap value index would have actually under-performed the average stock with an annualized gain of only 13.1%. Bottom-line...great performance from small cap value stocks occurs because they become larger cap growth companies.

Think about this the next time you look at a Morningstar box for your mutual fund, or read an investment strategist who is encouraging you to now emphasize value versus growth or large cap versus small cap.

The stock doesn't know what box it lives in. Ideally, the management of that company doesn't know where it is classified either. All they should care about is creating value for the shareholders. Ultimately, the performance of the stock depends on the performance of the business. Your return depends on what you paid for the stock initially. Whether growth stocks are soaring or otherwise, the inherent growth attributable to your company is far more important than the characteristics of its peers. High returns attract competition. Returns falter, expectations shrivel, and your growth stock may fail to grow. These conclusions are almost biblical, "But many that are first shall be last; and the last shall be first."

The consultants who descend upon portfolios now that another quarter has passed love to pigeon hole investment managers into a box. I hate it. It is a stupid waste of time in my view. As Buffett so wisely stated, "Growth and value investing are joined at the hip." Growth investing sees value in finding companies that have strong growth characteristics that the market may not fully appreciate yet. Value investors seek companies that trade for less than intrinsic value.

One of life's great experiences is watching a single digit midget grow into a significant business. This, thank goodness, has occurred a few times in my career. It didn't happen because I was looking for a small cap value nor because I was looking for a growth stock. It happened because I was free to roam, because I was independent. Most of all, it happened because I was looking for a good business, not a stock that fit a classification.

Professional investors report not only to their clients but they toe a line created by the consultants. As I have said numerous times, every really good decision I have made in my career almost resulted in my being fired because of doing something controversial. Exercising freedom, exercising independent judgment is so very important. Unfortunately, consultants frequently do get in the way of decent portfolio managers. For me, the consultants came, qvetched and left. The clients who understood, stayed. As individual investors, I encourage you to use that freedom, the only one you have to satisfy is yourself. Don't own a large cap growth portfolio because you "need that exposure." Find a great business that you like and that has winning characteristics.Don't own a small cap value portfolio because you think it's going to "move." Own some great small cap company that has the wherewithal to be a great business. Think all-cap, but mostly, just think!

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