Value Discipline

Pantry Gets a Heads-Up from the Globe

2010-03-30T22:47:00.002-04:00

The Pantry just received a mention in a blog that is part of Toronto's Globe and Mail, essentially Canada's version of the Wall Street Journal.

The article, On the Hunt for 'the king of value factors' highlights price to sale ratios. At the top of the list is The Pantry.

Just a word about price to sales ratios. Be careful in using them. A company with very poor profitability but big time sales will appear attractive on these screens. If they can develop some operating margins that are respectable, then these companies can be huge winners. But if they can't, they merely churn through sales dollars without adding much value for shareholders.

Is "The Pantry" Bare?-Piotroski Says No

2010-03-29T17:14:00.004-04:00

"You can't buy what is popular and do well" is one of the great Warren Buffett quotes. Though over time, I have learned to be far more comfortable investing in quality businesses that throw off lots of free cash flow and earn superior returns on invested capital, many value investors start their search for cheap stocks with the new low list and those that are making news headlines that portray disappointment. Contrarianism does work, as Buffett says, there are many ways to get to "financial" heaven. As is obvious, the real challenge for us as investors is separating those businesses that have been unfairly beaten down because of Street overreaction from those that truly deserve to be disregarded and ignored. "Moribund and poorly run businesses deserve to languish" as the great mutual fund investor, John Neff once described.

So how do you separate these businesses? For many years, academics focused on low price to book value companies (or put another way, high book to market companies) as a place to seek superior returns. As it turns out, these companies demonstrated an anomaly to the prevailing capital assets pricing theory. Subsequent analysis showed that a low price to book value ratio implies that prices contain expectations of low ROE expectations. Such companies, at current prices are generally expected by the consensus to be poor performers and therefore considered risky.

In a Seeking Alpha article earlier this year, John Reese of Validea highlighted an enhancement of this value investing screening technique developed by Joseph Piotroski of the University of Chicago. These refinements focused on generation of operating cash flow (as opposed to earnings), improvements in liquidity or leverage, as well as some signs of improving profitability and turnover. As John described it earlier:

Piotroski thus applied a series of additional tests of financial strength to identify a set of criteria that did lead to market outperformance. I've listed the 10 criteria below.

Book/market ratio
Return on assets
Change in return on assets
Cash flow from operations
Cash compared to net income
Change in long-term debt/assets
Change in current ratio
Change in shares outstanding
Change in gross margin
Change in asset turnover

In essence, this is contrarian investing with a wrinkle, some sign of internal improvement, cheap but with some light at the end of the tunnel. Rather than seeking excellence, Piotroski looks for encouragement. Most investors tend to "over-extrapolate" past performance trends, as I like to say, extrapolate short term trends into the hereafter. Overly pessimistic extrapolations do tend to reverse as the reality of changing actual earnings hit the tape. Ditto for those companies with a positive bandwagon…overly optimistic extrapolations reverse as well.

Having done some recent work on retailing (Tiffany's Valuation Looks Too Rich), I thought it may be of interest to look at a retailer at the other end of the spectrum, one that was bumping its bottom in the new low list, and with apparently few friends, The Pantry Inc (PTRY) .

The Pantry operates a convenience store chain in the southeastern United States. Its merchandise products include tobacco products, packaged beverages, beer and wine, general merchandise, health and beauty care products, self-service fast foods and the usual snack and grocery items. As of December 2009, it operated 1,668 convenience stores in 11 states primarily under the banner, "Kangaroo Express."

Like most convenience chains, gasoline and fuel sales drive overall sales but contribute significantly less to gross profits (data per Gridstone Research)

Pantry Inc

	2005	2006	2007	2008	2009	CAGR
Gasoline Sales	3200.3	4576	5335.2	7358.9	4731.2	10.27%
COGS Gasoline	2986.5	4294.8	5110.5	7096	4417.5
Gross Profit -Gasoline	213.8	281.2	224.7	262.9	313.7	10.06%
GPMargin	6.68%	6.15%	4.21%	3.57%	6.63%

Merch Sales	1228.9	1385.7	1575.9	1636.7	1658.9	7.79%
COGS-Merch	779.6	867.7	989.9	1041.6	1071.8
Gross Profit-Merch	449.3	518	586	595.1	587.1	6.92%
GPMargin	36.56%	37.38%	37.19%	36.36%	35.39%
Gasoline as % of Total Sales	72.25%	76.76%	77.20%	81.81%	74.04%
Gasoline as % of Total Gross Profits	32.24%	35.19%	27.72%	30.64%	34.82%

In terms of some ratio analysis (again, per Gridstone), here is how the business has developed:

	FYE Sep-05	FYE Sep-06	FYE Sep-07	FYE Sep-08	FYE Sep-09
[ST] Gross margin	15.0%	13.4%	11.7%	9.5%	14.1%
[ST] Operating margin	3.4%	3.4%	1.7%	1.5%	2.7%
[ST] EBIT	148.5	204.9	121.2	141.1	176.6
[ST] EBIT margin	3.4%	3.4%	1.8%	1.6%	2.8%
[ST] EBITDA	212.9	280.9	217.1	249.4	286.2
[ST] EBITDA margin	4.8%	4.7%	3.1%	2.8%	4.5%
[ST] EBITDA (TTM)	212.9	280.9	217.1	249.4	286.2
[ST] EBITDA margin (TTM)	4.8%	4.7%	3.1%	2.8%	4.5%
[ST] Pretax margin	2.1%	2.5%	0.6%	0.6%	1.5%
[ST] Net margin	1.3%	1.5%	0.4%	0.4%	0.9%
[ST] Effective tax rate	39.3%	39.1%	38.8%	38.1%	36.8%
[ST] Return on equity	28.8%	30.3%	7.7%	8.5%	13.8%
[ST] Return on assets	4.4%	6.0%	1.5%	1.5%	2.7%
[ST] Return on invested capital	9.4%	11.2%	5.2%	5.2%	6.3%
[ST] Net operating profit after tax	90.2	123.1	71.9	85.3	107.7
[ST] Cash flow from operations to Sales	3.0%	2.6%	2.0%	1.8%	2.7%

Obviously, this is a business whose metrics are far less appealing at first brush to most investors having just salivated at the metrics of high end retailing.

Yet, there is some evidence of improvement in operating margins, in returns on assets and equity, and invested capital.

There are certainly some issues here that are disturbing, a lot of debt, for example, with $1.67 billion in total liabilities versus $440 million in equity. Interest coverage is about 2.7 times. Leverage has often been high in this consolidating industry, and in particular at PTRY where some heavy acquisition years of 2006-2007 impacted the balance sheet. Given the significant assets here and the relatively low equity base, the hunter may well turn into the "hunted."

Standard and Poors recently affirmed its corporate credit rating announcement of The Pantry as a "B+" and noted:

"Credit measures deteriorated, with total debt to EBITDA at 6.6x compared with 4.9x one year ago. Although we expect some improvement in fuel and merchandise margin through 2010, credit measures are not likely to improve to levels needed to support a higher rating. We revised our rating outlook to stable from positive, and affirmed our 'B+' corporate credit rating on Pantry Inc."

Of note, there is $180 million in cash on hand as compared to a market cap of only $278 million as well as availability of an additional $142 million through its revolver. The next tranche of debt that comes due is convertible debt due in November of 2012.

Book value is about $19.50, most of which consists of goodwill, hence, at current market prices, PTRY trades at about 60% of book, certainly "qualifying" it for Piotroski's scrutiny. Five years ago, this stock sold at almost four times book value at a time when ROE was near 30% and ROA was about 6%. These metrics seem impossible now.

Taking a somewhat more recent perspective, consensus earnings are now around the $1.27 area having dropped down from $1.66 some nine months ago. Certainly this represents a different trajectory for expectations than most retailers have had in the same period. Sales per share is enormous at over $300 per share…there is tremendous operating leverage…both ways primarily because of gasoline sales. Even looking at just the non-gasoline sales, these represent over $80 per share in sales.

Though not a perfect demonstration of Piotroski's criteria, (shares outstanding have increased YOY and asset turnover has yet to show improvement) most of the other parameters have been met.

Though not a name I would want to stake my retirement assets in, I think The Pantry is a worthwhile speculation at current levels. High risk but potentially high reward.

Please find an investor presentation by The Pantry management at the Bank of America Merril Lynch Consumer Conference of March 10th, 2010.

Disclaimer: I, my family and clients do not currently own a position in PTRY.

Tiffany & Co-Valuation Seems Generous to Me

2010-03-23T17:28:00.002-04:00

On Monday, Tiffany & Co reported what seemed to be somewhat disappointing earnings of $1.09 versus a street consensus of $1.13. TIF actually has had a fairly good history of positive earnings surprises in recent quarters (data courtesy of Reuters):

Quarter Ending	Percentage Surprise
01/2010	- 3.63%
10/2009	+40.43
07/2009	+18.74
04/2009	+ 0.42
01/2009	+ 6.61
10/2008	+42.19
07/2008	+14.74
04/2008	+24.22
01/2008	+ 5.09

As you can see, the negative surprise was not hugely negative either. What went right and what went wrong?

The fourth quarter was actually surprisingly strong on a sales basis. The breakdown by geographic segment looks strong across the board for the fourth quarter:

For the Americas:

+14% versus a drop of 29% the previous year

For the US+12% versus a drop of 33% the previous year

For Asia Pacific:

Sales were also strong throughout with exception of Japan, rising 14% in dollar terms. Outside Japan, sales were robust at +38% in constant currency. Japanese sales in the fourth quarter were down 9% in constant currency.

For Europe:

Particularly strong sales here +18% on a constant currency basis.

Tiffany was quite defensive through 2009, reducing headcount by 900 people and opening only 10 stores, taking capex down to $75 million from a more normal level of about $200 million. Ex one time items, it appears that SG&A positively leveraged by 140 basis points in the quarter to 35.7%. However, the dollar amount of SG&A was increased by 12.7%, as the company indicated, largely tied to incentive compensation. Strong cuts through through the year seem to have come somewhat unglued in the fourth quarter due to incentive payments.

Given a fairly aggressive plan for new store additions (adding 17 stores) and increased marketing spend, management is guiding for 10% SG&A growth in 2010. With marketing growing faster than sales, TIF is going for market share, perhaps not an unwise strategy when small independent competitors may be having difficulty securing financing for their expensive inventory.

Nevertheless, incentive compensation seems to be driving SG&A growth at Tiffany and I wonder about how well this will leverage into earnings per share. Consensus earnings per share estimates for Jan 2011 are already at $2.47 up 21.0 % from this year's $2.04. It is interesting to note that earnings estimates for the upcoming year were $2.01 just six months ago.

I have provided a spreadsheet compiled from Gridstone Research analysis at the following link:

http://tinyurl.com/yk6bye6

As the analysis indicates, return on equity has gone up to 15.3% from 13.5% in 2007 largely due to the use of higher financial leverage. Tiffany has purchased over $1 billion in common stock in the last three years (generally at higher prices than current.) About $400 million in new long term debt was issued last year. Asset turnover and operating margins worsened over this period.

Considering other benchmarks for management's performance, the return on invested capital remains lackluster despite what seemed to be a reasonable year. ROIC was 12.2% up from last year's 10.7% but not up to the 2008 and 2009 levels of 12.7% and 15.9%.

EBITDA margins have fallen to 16.3% in 2010 down significantly from last year. Surprising! Capital intensity (the amount of capital it takes to generate sales) has also moved up slightly from prior years. As well, one of the most important missions for a retailer is working capital management. In the quarter, strong inventory controls were very evident with inventory falling 10.8% versus last year relative to the 17% revenue gain. Yet, working capital management turnover was 1.65 times for 2010 down from levels generally better than 2 times in the past.

Tiffany at 19.3 times forward estimates which presume 21% growth seems expensive to me.

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

Traits of the Successful Investor and the Changing Nature of Brand Loyalty

2010-03-21T14:09:00.002-04:00

The year 2010 seems to be progressing as a positive experience following the shaky start in January. The subsequent rally that has transpired since that time has caught many people flat-footed, but that is the price of erratic trading. Most of us are bombarded with an onslaught of noise portraying itself as information. We are encouraged to make massive shifts from sector to sector, from stock to stock, even from currency to currency. Our exposure to information and communication technology in real time has advanced well beyond the advancement in our human judgment for most of us.

I think successful investors accept the rapid pace of trading with a great deal of humility. Many of our worst problems in investing stem from the hubris of imagining, if not actually believing that we are that super-brain that can predict short term fluctuations in the market. Most successful investors approach the market with a great deal of humility and a fundamental understanding that the short term is incredibly random. How many six sigma events do we need to endure in a decade to understand that the market can fluctuate completely unexpectedly? Expecting to catch every short term ripple can only lead to frustration and discouragement.

In order to profit from the market, we simply must be there at those times when the probabilities of success are on our side. Though having an eye for value is a key attribute of success, there are many places where investors gain an edge.

Cheapness, in and of itself is not a sufficient condition for investing. Think of the disastrous results of many value investors in the last couple of years who bought book value “bargains” in the financial services sector. I think great investors are extremely conscious of the quality of balance sheets, both from the quality of the asset side as well as the nature of the liabilities and especially the off-balance sheet liabilities. How often have I been approached by a young analyst who insisted that some retailer was debt-free without regard for its heavy schedule of operating leases? How often do we forget the impact of assumptions in the pension plan liability or the retirement health care benefits? How little attention or regard did some analysts have for the obligations of banks as issuers of securitized assets? The truly great investors recognize "iceberg" risk, that is, those risks that are not obvious to initial scrutiny but lie beneath the surface. Understanding these sorts of obligations, such as the domino impact of a drop in credit rating on securitization differentiated the most successful investors in financial services from the book value bargain shoppers.

Great investors have a strange capacity to suffer. And the best returns develop from those times when you suffer the most. There is rarely a bell-ringing moment that tells you are looking at a bottom. Fight the complacency that we succumb to in bear markets, that feeling of why bothering to do anything, because next month the price will probably be cheaper. Whether it is dollar-cost averaging in getting a lower basis cost for a position, or just a commitment to maintain equity weighting at a higher than average level when bargains seem to abound, great investors have an ability to drage their guts through the gravel and maintain commitment to an investment plan regardless of the popular "wisdom."

In strong markets, stay disciplined and don’t try to be too creative. Unusual takeover activity in a sector should encourage you to sell investments in that sector rather than seek “the next target.” We were fortunate to have a position in Pall Corp (PLL) which reacted strongly to the announcement of the Millipore (MIL) takeover. Pall hit our target price and in our determination was fully valued unless some strategic buyer chose to pay the same sort of multiple as Millipore enjoyed. Possible, but I choose not to roll the dice and play a game of hope. Pall is sold and gone from our portfolios. Maybe I’ll look stupid in the coming weeks, a chance I am willing to take. A corollary of risk control is always leaving something on the table, both at the bottom and the top.

Taking a bit of a 30,000 foot view, what is the source of a successful investor’s edge? Can this apply to the average “home-gamer” as Cramer refers to the retail investor? I divide edges into four types:

Informational Edge- Do you have information that nobody else has? As a rule of thumb, having insider information and acting on it will get you into prison. Rule FD leveled the playing field so that analysts with long standing relationships (but not ethics abiding CFAs) could not receive special insight. Information had to be disseminated democratically.

Analytical Edge- I view this as coming to a different conclusion than the consensus viewpoint based on the information that is there. For example, John A. Paulson made a fortune in betting against residential real estate and the mortgage markets based on his understanding of the sub-prime markets and the exposure of various banks to this market. Sometimes an analytical edge can be garnered by using the same inputs everyone else has but weighting them differently. For example, a great business run by capable managers may extend its franchise to other geographies where markets are under-penetrated. This incremental growth might not be priced into the current price of the stock. A problem subdivision which represents a sideshow or a distraction, at worst a short term problem can become an overwhelming distraction for Wall Street and hence, most investors.

Behavioral Edge- As Buffett described it, be fearful when others are greedy and greedy when others are fearful. This is an incredibly difficult attribute to develop because for most of us, we are falsely comforted by a consensus viewpoint. We often ask for advice from people who will affirm our own views. The frenetic investment in bond funds last year seemed to be more of a movement to avoid the pain of stocks rather than an endorsement of the fixed income markets. Another example, Administaff (ASF) announced a dreadful fourth quarter on February 11 which clocked the stock from $23 to $16 and change in the next two days. It appears at least superficially to be based on a non-recurring one-time issue. In decent times this has been a mid 20’s return on invested capital, but in two days, almost 30% of the company’s shares outstanding traded hands, dismissing the past entirely. Currently, the stock is back to level of $21 plus once again. An important part of the behavioral edge is the ability to actually execute, not merely to theorize and wait. When the "fat pitch" crosses the plate, be sure you are ready to swing for it. If it ain’t on the tape, it ain’t in the portfolio and no one has gotten rich on paper profits.

Time Horizon Edge- Having the ability to take a longer term perspective, having the comfort of waiting for the fat pitch, having the ability to avoid the misinformation is another important edge that some value investors enjoy. Great ideas deserve a disproportionate part of your capital, but make sure you are safe. Too short a time horizon and you’re in danger of not letting your thesis unfold. But look at and stress test your portfolio all the time. Being married to too big a view can be dangerous however. Being too dogmatic and inflexible can be dangerous. For example, one of my former partners was married to a view that the S&P 500 could not possibly trade at more than twice book value because historically this represented dangerous ground. Needless to say, as share buybacks became prevalent, and write-downs eroded the value of equity, his dogma became nonsensical.

Though it is difficult for the average retail investor to develop an informational edge, I believe that it is certainly feasible for this person to develop and utilize any of the others. It is vital to develop this edge in my view. If you approach the markets without a model or a philosophy, your odds of being doomed are very high. If you don’t have a framework anchored on objective measurements (in other words not just a gut feel) you will be ground down by the uncertainty of markets. As individuals, it is tough but not impossible…we are neurologically not wired to make rational decisions, with emotional decisions anchored in animalistic “fight or flight” wiring. If you think like an owner, you will remember that the investment is locked up in the business rather than the stock price.

Someone once said that successful portfolio management was a little like taking friends and family out on a fishing boat. The paramount responsibility is everyone’s safety. Cluttering and overloading the boat is a dangerous practice in boating just as it is in portfolio management. Heading out into an oncoming storm can be disastrous for the boater and investor alike but storms pass and smooth sailing will follow.

I have been giving a lot of thought to Berkshire Hathaway as the annual meeting approaches. Buffett’s annual letter reads like a value investing primer, much of which is knowledge that has already been presented in prior letters. Buffett's investment approach over these many years has evolved from Graham and Dodd net working capital exercises to the purchase of incontrovertible brand name franchises that have long periods of competitive advantage. I think the last few years of investment involve some new thinking and a different perspective: especially the regulated utilities and Burlington Northern investments , and how it seems that Buffett is showing less and less interest in brands. I sense some changes in brand loyalty are occurring. Is this driving Buffett's seeming lack of interest in buying additional brands? Why is this?

The common ground for consumer brands and his forays into the railroad and utility worlds is recurring revenue. Though cyclicality is present in every aspect of business, it strikes me that over the long run, all of these chosen industries enjoy a competitive advantage. Certainly rails and utilities are unlikely to be displaced by substitutes and the amount of capital for a new entrant to achieve share is enormous. But are brands becoming less valuable over time?

It seems that a number of factors have proliferated which have governed brand loyalty are getting more difficult to attain. These new, and developing, challenges include:

The recession has caused a significant and perhaps more than a temporary change in shoppers’ behavior. The consumer seems to be making her choices using different criteria than in the past. Though recently, we seem to be going through a period of frugality fatigue as shoppers have perhaps started to step up slightly from the bargain counter, it seems that for many of us, the need to cope with less discretionary spending is putting many brands through an ongoing review, scrutiny and re-evaluation.
Consumers seem to be more willing than ever to try new brands. This movement toward experimentation seems to have diminished historical fierce brand loyalty and has encouraged switching between brands. Some people refer to this as brand promiscuity.
Private labels are starting to emerge as brands in their own right, and offer a strong incentive to switch to a retailer’s products. Some years ago, President's Choice became a branded generic product (in Canada as well as migrating into the States) that achieved favor through offering consistently high quality than what consumers expected. The strategy for competing against a retailer controlled brand (especially with Wal-Mart and Target) is likely quite different from competing against other national brands. Target has been especially successful in developing identifiable women’s brands that offer style at a reasonable price.
Are brand lives shortening? Is the consumer’s tolerance for quality mistakes dropping? It seems that consumer expectations of their branded products have risen. It is not just a matter of quality or value that today’s consumer expects; how does the brand resonate with the consumer in terms of its reputation? What is the corporate ethic of the company behind the brand? As we look at Toyota, some would argue that the brand has been diminished by the reduced quality perception of cars out of control. Yet, on the other hand, no other auto manufacturer has ever shut down production in order to search for an answer to an engineering problem. All these factors mean that it is easier for a brand not to deliver against consumer expectations. Our expectations are higher, and ergo so must the brand’s standards improve. Brands which do not continually improve their standards will be dropped. Consequently, brand lives may be shortening and importantly, the spending to support a brand may be increasing.
Brand image is no longer passed around by word-of-mouth or by traditional advertising. Twitter, Facebook, and social media is changing the brand management landscape. Good experiences as well as bad experiences impact reputation quickly by virtue of social media.

Don’t get me wrong. Traditional brands still are worth a great deal. A look at Nike’s (NKE) results the other night are telling. Great numbers, better than expected, great brand, lots of momentum. But SG&A was 33.0% as compared to the previous year’s 30.4%. Sales were up 6.6%, so there was no leverage in the SG&A line. Nike is still a great brand, largely because it carries a lifestyle image to its consumers. In short, Nike is cool! Proctor and Gamble (PG), the quintessential consumer brand company reported in February that fourth quarter sales had grown 5% in line with revenues, but SG&A was up 170 basis points. Again, no sales leverage in SG&A. I suspect that care and feeding of brand companies will continue to require more upkeep (= dollars) and consume more margins over time.

Perhaps the paragon of today’s brand is Apple (AAPL). In early days of cell phones, brand loyalty was essentially non-existent. Before the iPhone, loyalty was low for both handset manufacturers and for network providers. In the past, consumers often switched handsets repeatedly, and often tried handsets from a variety of different manufacturers as a result. Before the iPhone, cell phones were very much commodity items, competing on price largely based on the number of functions that were offered. Reliability was not a particularly relevant consideration since phones came and went based on the length of the network’s contract. Nokia (NOK) had some edge and loyalty largely because of functionality considerations, not because Nokia was a “lifestyle brand” which helped consumers have more fun from their phones. Networks were a very secondary consideration for most of us who stayed within close geographic proximity. In fact, networks were often viewed negatively as the high cost, recurring part of cell phone ownership with not especially reliable functionality.

The tons of apps that are offered for the iPhone have changed everything. Consumers accessed a highly functional service which is both fun, allowing them to use the products in new ways (remote access to turning off the lights at home) and all sorts of practical and not so practical experiences. Powerful stuff!

Even more powerful is Apple has captured the heart and soul of its consumer by engaging with him/her. Ongoing development of apps (generally by someone other than Apple) increases its interaction with the consumer and modifies and improves the brand with every interaction. For most products, our interaction is established at time of purchase, but with Apple, the interaction is not limited to the retailer, the manufacturer can still build an ongoing relationship with the customer for more than simply providing information (or doing recalls!).

So it seems that brand loyalty in the future will be derived largely by the post-purchase interaction. This is quite different than the traditional consumer brand development of “new and improved.” Social media ensures that the consumers’ views and experiences will be monitored by all of us, and especially the owner of the brand. Online transparency will force brands to ensure that their credentials stand up to scrutiny.

Social media opens up a two-way communication with the consumer…the basis for post-purchase engagement. This means that transparency is a key watchword for brands when developing post-consumer engagement – by inviting consumers to be more involved with your brand they are likely to take a longer, deeper scrutiny of what the brand is doing and what it represents.

Brand loyalty is still something to look for in investments. However, both capturing it and maintaining it has become a new discipline. However, many brands with a long heritage and consumer trust have survived the recession better than middle brands, and have invested to ensure that they come out of this period in a stronger position to continue growing. But just as the consumer is constantly assessing and re-evaluating these brands, so must we as investors.

Disclaimer: I, my family, and or clients have equity or fixed income positions in Berkshire Hathaway, Apple, Nokia, and Toyota.

The Developing Compensation Philosophy of the Treasury Department

2009-06-11T12:50:00.001-04:00

Here is a link to Gene Sperling's opening statement: http://www.treas.gov/press/releases/tg166.htm#_ftnref3

There are some very interesting quotes that help to frame Treasury's philosophy re systematic risk and executive compensation in this statement.

Compensation structures that permitted key executives and other financial actors to avoid the potential long-term downsides of their actions discouraged a focus on determining long-term risk and underlying economic value, while reducing the number of financial market participants with an incentive to be a "canary in the coal mine."

The testimony describes one investment bank which acknowledged the skew in its incentive structures:

Simply measuring bonuses against gross revenue after personnel costs with "no formal account taken of the quality or sustainability of those earnings."

It is clear that Treasury intends to broaden itself beyond its initial focus on financial services:

But what is important for our economy at large is the topic of this hearing: understanding how compensation practices contributed to this financial crisis and what steps we can take to ensure they do not cause excessive risk-taking in the future. And while the financial sector has been at the center of this issues, we believe that compensation practices must be better aligned with long-term value and prudent risk management at all firms, and not just for the financial services industry.

Here are the principles that were outlined in the "way forward":

Compensation plans should properly measure and reward performance.
- In other words, performance metrics should not just be based on stock prices but also relative performance and adherence to risk measurement. "Don't confuse brains for a bull market."

Compensation should be structured in line with the time horizon of the risks.
- The testimony discussed the trade-off of large short term gains that presented a "tail-risk" of large losses. Hence, the notion of stock compensation that is required to be retained for a long period of time, even beyond retirement, is being introduced. Also suggested that bonuses could be "at risk" and withdrawn if a poor year follows a good year.
Here is an abstract regarding executive pensions and their role in long term compensation.

Compensation practices should be aligned with sound risk management.
- The testimony refers to The Financial Stability Forum's Principles for Sound Compensation Practices. The authority and independence of risk managers is "all the more important in times of excessive optimism when consistent -though unsustainable -asset appreciation can temporarily make the reckless look wise and the prudent look risk-averse." The context of risk management is broadened to include all employees, not just executives, that may be incentivized for excessive and imprudent risks.

We should reexamine whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders.
-The testimony describes that golden parachutes were in place at over 80 percent of the largest firms as of 2006.

We should promote transparency and accountability in setting compensation.
-According to one Congressional Investigation, the median CEO salary of Fortune 250 companies in 2006 that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use consultants with such conflicts of interest.
House Committee Report on Executive Pay Also see blog for additional discussion.
Also please see Ferri and Maber abstract which describes the change that "say on pay" has made in making CEO compensation in the UK more responsive to negative results.
Also please see the CFA Institute survey's response to "say on pay"
Also please see "Shareholder Say on Pay:Ten Points of Confusion"

Executive Compensation-Government is Not Going Away

2009-06-11T09:34:00.002-04:00

Corporate governance is a topic that many of us tend to ignore, leaving it to the institutions or corporate raiders that are looking to influence the strategic direction, the capital allocation, the corporate structures or the compensation structures of business.

Yet, the way business is run should matter to us all. We need the goods and services it produces, or the employment it provides. As shareholders, whether directly or through our 401-Ks or pension plans, the long term wealth that corporations create is important for our old age dignity and in fact, the national prosperity. Hence, the governance of corporations affects us all whether customer, employee, citizen or shareholder. The effectiveness of corporate governance is indeed a factor in determining whether companies survive and prosper or stumble and fail.

Some years ago, Jonathan Charkham noted in his book, Keeping Good Company :

“It is difficult to escape the conclusion that government has a role here as it is the only power in any land which can strike a balance between the conflicting wishes of competing interests. Furthermore, the framework within which these interests compete is one of government’s own making. Everywhere the corporation is a creature of statue not nature, designed to encourage the continuity of power that the sophistication of modern economies require. It is not government’s role to double-guess individual commercial decisions-but to ensure as best it can, that the structure it creates for companies contains checks and balances that are effective in resolving the tensions between differing legitimate claims.”

One does not undermine one’s dedication to capitalism by believing that companies are more than just engines to maximize return on capital. After all, one could repeal child labor laws, ignore plant safety, ignore anti-trust and thereby maximize profitability, but at what cost to society?

Playing for very high stakes has been an ongoing theme in American capitalism probably since Alfred Sloan of GM declared that “The business of business is business.” Excessive and sometimes fraudulent risks, competition, and the increasing size and complexity of organizations: these three factors have been at the heart of every corporate breakdown and crash and burn. The call for greater regulation and greater scrutiny has followed every scandal, for example, the salad oil scandal of the mid-1960’s resulted in more stringent commodity trading regulation after nearly taking down American Express and causing significant loan losses in the banking system.

So it is little wonder that the Obama administration has begun to scrutinize certain aspects of corporate governance, in particular, an effort to rein in executive compensation. Though far from setting executive pay ceilings at all corporations, the new compensation czar – lawyer and mediator Kenneth Feinberg – will have broad discretion to set the pay for roughly 175 top executives at seven of the country's largest companies, which received billions in government loans. He will set the salaries and bonuses of some of the top financiers and industrialists in the United States including Fritz Henderson (GM), Vikram Pandit (Citigroup), and Ken Lewis (B 0f A).

The Obama administration argues that poorly designed compensation packages encouraged some Wall Street executives to take on excess risk in the mortgage market and elsewhere, which in turn helped trigger the financial crisis and a global recession. As Barney Frank, chairman of the House Committee on Financial Services observed (bolded words are my emphasis):

“It is not the role of government to set policy regarding the amounts that are paid in compensation to top executives, nor to deal with the question of how that compensation is allocated among salary, bonuses, retirement packages, etc. But as Secretary Geithner’s remarks recognized, there are two very important points that we should address.”

“First, shareholders must be empowered to have a major role in the process of setting overall compensation. While it is not the government’s role to say that a certain amount is too much, it is very much the right of the people who own the company to speak out if they think excessive compensation is being proposed. The system of say-on-pay that was piloted in England is a reasonable way to do this, and I was proud that the House adopted the bill that came from the Financial Services Committee to institute this in 2007. Unfortunately, the bill did not go forward in the Senate, but I am optimistic that with the support of the President, we will be able to enact this important principle into law. Recent evidence in England shows that when shareholders are in fact troubled by excessive compensation, say-on-pay is an effective tool for them.”

“I also agree with Secretary Geithner’s annunciation of the principles that should guide the structure of compensation – not the amount. But I differ with his view that this can be accomplished by strengthening the independence of compensation committees. Given the inherently close relationship that exists between CEOs and other top executives on the one hand, and boards of directors on the other, it is very unlikely that you will ever get the degree of independence that will allow the boards of directors to be left completely on their own to set compensation. That is part of the reason for say-on-pay. But it is also the reason why legislation should be adopted that instructs the Securities and Exchange Commission to set principles which prevent boards from providing compensation systems that lead to excessive risk taking.”

Many proxy statements this year contained “say on pay” shareholder proposals, almost all of which were opposed by managements. I am strongly in favor of such proposals which now appear to become the law of the land. Though these proposals are not enforceable per se, they do provide moral suasion and have had influence in European countries that have adopted the practice for example, Royal Dutch Shell. See also the recent impact in some UK retailers.

Proxy statements frequently contain a report from the compensation committee which generally outlines the company’s philosophy of compensation, what it uses as its peer group for a model of compensation, and what sorts of behavior are being rewarded both short and long term. In general, the compensation committee charter suggests that compensation should align managers’ interests with those of shareholders. An excellent template for what should be part of the compensation committee’s report was recently produced by the California State Teachers Retirement System. Among the points that CSTRS suggests is some specificity regarding the role of risk in incentive compensation:

“The role of risk in the context of the executive compensation program, which should include both a defensive perspective (how the committee ensures potential compensation does not incentivize excessive risk), and an offensive perspective (how the program is designed to incentivize appropriate risk and aligns the interests of management with those of long-term owners)”

Our summer intern, Drew Levine, recently completed a study of proxies that we have voted at our firm and run some statistics on components of executive compensation trends versus share price performance. If shareholder and management interests are truly aligned, one would expect some degree of correlation between comp and share performance. Sadly, that has not been the case. Here are some of Drew’s observations:

After conducting analysis of executive compensation data, it is safe to say that there is little to no correlation between stock price performance and compensation. The data compiled is from a tumultuous time in the stock market where nearly all of the companies we voted on stocks were down. One would think that because the company's stock performed so poorly the executives pay would subsequently suffer, but that was certainly not the case in some instances. The strongest correlation in the data was the percentage increase or decrease in bonus compensation in relation to stock price performance. However that measure of correlation was still extremely low at .21 for the CEO and .16 for the CFO. It's shocking to see that there really is no correlation between pay and performance because one would think that would be the most basic and truest basis for compensation. What I found most surprising was the average salary and total compensation growth from 2006-2008. It is amazing to see that although the majority of these companies were struggling with the economic downturn, the average salary growth for the CEO in 2008 was 74.9% and their total compensation growth for 2008 was 25.7%. What this indicates is that executives are increasingly taking more base pay with the knowledge that because their company's stock won't perform well, they will not get the oversized bonuses that they were used to receiving just a few years ago. Although, when looking through the data, it was relieving to see that in most of the companies the executives did not receive bonuses for 2007 and 2008.

In 2007 and 2008, we surveyed 79 and 92 CEO's respectively, and 55 and 81 CFO's respectively. This was due to new hires and fires at the executive positions. From year end 2006 to year end 2007, the average stock price of the company's surveyed was up 26.7%. From year end 2007 to year end 2008, the average stock price was down 40%. The average salary for the CEO in 2007 and 2008 was just over $1,000,000 and the average salary for the CFO during the same time frame was around $600,000. The average bonus for the CEO and CFO in 2007 was over $1,000,000 each with that number decreasing to about $450,000 for the CEO and $300,000 for the CFO in 2008.

For the 2009 proxies we voted, we emphasized voting for "best practices" such as shareholder's votes on executive compensation (say-on-pay) and shareholder's ability to call special meetings. Many people forget that the shareholders are the real owners of the company and that management is working for us. For that reason we find it important to vote every proxy for companies which our clients hold shares and not just throw them away like many shareholders do.

Looking at total compensation for the CEOs rather than just bonuses, the correlation to share price performance is non-existent at -0.03. Apparently, CFO total comp has a somewhat stronger link to share price performance at a still rather weak 0.19. Here is a spreadsheet of our compensation study and the statistical correlations that we observed.

Last year, the CATO Institute published a paper on Executive Pay Regulation versus Market Competition by Ira Kay and Steven van Putten which argues that: “The misperceptions that drive regulatory efforts are grounded in the idea that the market for executives is not competitive and that pay levels do not reflect supply and demand for talent” (pg. 1). Kay and Van Putten argue that the “myth of managerial power”, executives control over the board which sets their compensation, leads to greater regulation because lawmakers believe that the market is rigged as they put it. The authors present evidence to the contrary that says that the market is actually competitive and that the appropriate level of executive compensation tracks performance.

This may well have been the case but we face a new reality. We had better become accustomed to the idea of big government as regulations to restore financial order come into force. Jeff Immelt, in a recent address to the International Economic Forum in Montreal stated it most succinctly, “The government has moved in next door and it ain’t leaving. You could fight it if you want but society wants change. And government is not going away.”

A Report from Today's Citigroup Meeting re Governance

2009-04-21T17:20:00.002-04:00

Corporate governance has always been an important part of value investing. Obviously, most of us hate waste when precious company resources are squandered to build executive dreams rather than shareholder capital. Misallocation of capital and failure to optimize returns on capital have led me at times to conduct activist campaigns with some managements. This can lead to stormy verbal exchanges, but occasionally, has led to real change in management strategy, abandonment of some projects, and greater focus.

Though managements can ignore shareholders for a period of time, the annual meeting of shareholders allows investors an opportunity to vent, to express opinions, and to make suggestions.

Today, I attended the Citigroup annual meeting, as you can imagine, a very raucous affair.

I thought readers may find it helpful to see a question that I posed to Richard (Dick) Parsons, the chairman of Citi. Much of the board of Citigroup has been in place for many years, and though management has started to slowly bring in some new board members (with actual banking experience) some of the "deadwood" remains.

Mr Chairman, my question relates to the effectiveness and qualifications of our Audit and Risk Management Committee.

On page 35 of our proxy, we have the Report of our Audit Committee which indicates that the Committees meetings facilitate communication among members of the Committee, management, independent risk managers, internal auditors, and Citi's independent auditors.

On page B-3, Annex B of the proxy, the Committee is charged to review and discuss with management, at least annually:

"Developments and issues with respect to reserves" and "Off balance sheet structures and their effect on Citigroups consolidated financial statements." as well as

"Effectiveness of the bank's advanced systems for the calculation of risk-based capital requirements"

Under the section regarding the "Oversight of Risk Management", the audit committee is charged with responsibility to review with management the categories of risk the company faces including financial, operational, reputational risk AND

Review the risk policies and procedures adopted by management.

No one can deny that risk management at Citi has been an abysmal failure. It seems that the mission of this company was a Star Trek mission..."To boldly go where no man has gone before."

This company lived under an illusion of prosperity...an illusion that has been endorsed by the lack of oversight and ability of the Audit Committee to fulfill its responsibilities.
Over the last five years, the Chairman of our Audit Committee was Mike Armstrong, who at the same time served on the Executive Committee. That same committee was chaired by none other than Bob Rubin whose hypocrisy and denial of the risks that have taken this company down, all shareholders are suffering for.

I am at a loss to understand how someone who was on an Executive Committee, supposedly steering this lumbering ship, could maintain independent judgment by chairing the Audit Committee. Obviously, someone here, most likely the Nominating Committee agrees since:

Mr. Armstrong, who has been a director since 1989 is no longer part of the Audit Committee, as of this year, continues his "service" to our Company on the Nomination as well as the Compensation Committee. Much as this company has suffered under an illusion of prosperity, it appears to continue to suffer under an illusion of competence.

During Mr. Armstrong's tenure as the Audit Committee chairman, the incalculable loss in shareholder value due to his failure, and the Committee's failure to properly manage risk has led to some of the spirited discussion that you are experiencing today. I applaud Mr. Armstrong's removal but wonder about how much more damage is feasible after his 20 years on this board.

I see we have now appointed John Deutch to chair the Audit and Risk Committee.

John has been part of the board for two tenures, initially between 1987 and 1993 and currently since 1996. John is a brilliant scientist who has served this nation with distinction as an Undersecretary in the Department of Energy as well as the Director of Central Intelligence. It seems that one of the things most lacking at Citi is central intelligence.

John apparently did a BA in History and Economics back in 1961, presumably he may have studied some accounting back then, perhaps Accounting 100, though unlikely to have studied anything about risk management or auditing.

John has served on the Audit Committee of our Company since 1997 and hence, likely drank the Kool-Aid as to the Illusion of Prosperity.

John has served on other boards, mostly as a member of the nominating committee or technology committee but I see that he has served on the Finance Committee of Cummins Engine.

The last time that Citi had a Finance Committee, it was chaired by Jamie Dimon in the mid-90's...I hear he's done pretty well since.

John's only other service on an audit committee was at CMS Energy where while under his tenure, where:
-the Company had to restate its financials for its energy trading business a la Enron
-it had inflated its revenues by $5.3 Billion
-had to engage in major asset sales in order to survive, selling off most of its foreign operations in India, Brazil, Australia...unusual for a funny little utility in Midland Michigan
-and presided over the CMS stock falling to an 18 year low and down some 90% peak to trough.

I suppose that in some ways, John may be imminently qualified to add value given his experience, nevertheless, it does seem odd to offer an audit committee post to someone who presided over disaster in his only prior "at bat."

It is surprising to look at the current board, outside the new additions, and see so many characters,who though they may have a lot of management experience and executive expereince, seem to lack accounting or audit or even finance credentials. As Buffett has said, there are many banks but few bankers. It appears that none of our existing audit committee members have any prior financial services experience!

I note that the audit and risk management committee has many members who, like Mr Deutch and MrArmstrong presided over this seemingly out of control disaster.

Andrew Liveris since 2005 on Audit

Ann Mulcahy since 2007 on Audit

Dr Judith Rodin since 2004 on both Executive and Audit Committees

Shareholders can no longer countenance the shameful incompetence of our Audit and risk committees financial expertise where it is clear that there is none.

Rather than your vote, they deserve a dressing down that would knock years off their lives. We have been victims of their steely eyed stare into nothingness.

Mr Chairman, is it not time that the same standard applies to our board as has been applied to some former members of management...the standard that sent our Chief Risk Officer in 2007 to the dugout to contemplate the meaning of "sub-prime"...the same standard that sent Chuck Prince into a glorious retirement at huge expense to shareholders...out presumably for dance lessons.

Mr. Chairman, I respectfully submit that it IS time for meaningful change in our Audit and Risk Management Committee.

...................................................................

Most of us investors tend to vote with our feet and simply sell the stock. I urge you to read the proxy statements and if there is something egregious that you see, to let the board know and to let it be known in a public forum. Stupidity needs to be aired out and benign neglect needs to be addressed.

Change, though glacial and slow can be achieved. I am more than happy to use this blog as a forum to bring some of these matters to readers attention.

Disclaimer: I, my family and clients may have a position in certain securities mentioned in this post.

NCR versus Diebold

2009-04-19T22:29:00.004-04:00

Courtesy of Seeking Alpha, I have been privileged to have been introduced to an exciting new research product called Gridstone Research. Gridstone is a new research platform that combines financial data, operational data, and unstructured textual information about a company into a structured useful form.

As I become more proficient with its use and application, I will be incorporating Gridstone into my financial models.

For now, a very basic look at NCR versus DBD's profitability over the last several years.

http://tinyurl.com/d2kjv8

Disclaimer: I, my clients and family may have a current position in securities mentioned in this blog post.

Techonomics and the ATM

2009-04-19T22:27:00.001-04:00

“By prevailing over all obstacles and distractions, one may unfailingly arrive at his chosen goal or destination.”- Christopher Columbus

Needless to say, it has been an incredibly tumultuous environment. The economic outlook, despite a few specks of light in a dark sky remains quite bleak. Despite this, I have been encouraged by valuations, by the tape action, and by the prevailing sentiment that continues to express doubt in the strength of this rally.

For today’s thoughts, I would like to focus on the tech sector. Tech stocks, in my view, are beginning to discount a recovery and unlike the tech bubble of the turn of the century, generally constitute reasonable business models. Many of these companies have substantially improved their manufacturing footprint to lower cost geographies. Many enjoy recurring revenue models. Many enjoy strong reputations and decent customer loyalty. However, in a climate of falling capital expenditures by their customers and the experience of building inventories, and falling prices for commodity products, the industry has generally been swift in its response by cutting employment and focusing on cost control.

Real tech spending fell at almost a 24% annualized rate in the fourth quarter (according to Ned Davis Research), the biggest drop since 1990 and in fact, much larger than the 18.6% drop in Q2 of 2001, when the tech bubble burst. As a percentage of GDP, tech spending fell to just 3.6% of GDP down 0.3% Q4/Q3 and down from a peak about two years ago of just over 5%. The quarter over quarter drop in tech spending to GDP exceeded the drop in the 1973-75 and 1981-82 recessions.

The industry responded by cutting production and employment. Capacity utilization in the industry went from just over 80% to 59.9%, a record low.

It is important to keep in mind that many of these trends are quite long in the tooth, in many cases having portended the industry recession. We may well be near the end of the downtrend in this industry. For example, new info tech orders declined for 28 months post tech bubble…currently, we are in the 34th month of decline in this metric. The semiconductor book-to-bill ratio declined for only 13 months post tech bubble…now, we are in the 31st month!

Earnings expectations have weakened substantially. The 2009 median expected growth rate has dropped to about -10% from expectations in early 2008 of about +20%. Though growth expectations post tech bubble bottomed at -26% in September of 2001, this coincided with the bottom in these stocks. From a valuation standpoint, price-to-book and price-to-sales ratios are below the 2002 troughs. The current price-to-book ratio is at 2.5 times as compared to the September 2001 trough of 3.3 times. The price-to-sales ratio is currently at 1.5 times as compared to the prior 2.1 times.

Here is a screen (courtesy of Cash Flow Analytics ) of high tech companies with revenues greater than $100 million that have produced free cash flow though the last twelve months.

http://tinyurl.com/c6zj3s

As you can see from the screen, there are many cheap stocks from which to select, in many cases with excellent balance sheets.

One subsector within technology that I believe has been ignored is the ATM sector. As one can imagine, at a time when banks are more concerned about retaining capital to ensure their solvency in a deteriorating credit environment, there should be little propensity to spend on ATMs. Investors remain concerned that increasing bank failures, potential nationalization, and general credit concerns will severely impact the operating performance of the ATM manufacturers. Yet, some of this concern may well be overblown. During the S&L crisis of the 1980s when almost 1500 banks failed, the ATM manufacturers experienced rising sales as new banks emerged and surviving banks increased their focus on efficiency and innovation to reduce their costs.

The global market is dominated by Diebold (DBD)and NCR (NCR). Demand for self-service solutions has been steady from the large national banks that have rolled out deposit automation and bulk checking products. Roughly two thirds of ATM demand is replacement driven. Replacements are driven by regulatory and technological changes as well as aging of the equipment which has a useful life of six to eight years.

In a recent broker conference, NCR’s CEO Bill Nuti described the recurring nature of his business:

“ I think we also have a fairly stable revenue stream inside the Company. When you look at our revenue stream, approximately 40% of it is services, annuity-based services maintenance, which has contracts that stem from a year to five years in length, and a fairly stable revenue stream.”

“Another 10% of our revenue is in consumables. That tends to be fairly stable. This would be purchasing of paper rolls for point of sale or two-sided thermal paper technologies and printers. Another 20% or so comes in the year vis-a -vis backlog. Backlog coming into the year that we expected to turn in the year.”

“So, you've got about 70% of the revenue stream that's relatively reliable, strong revenue stream. The rest, of course, comes from success within the year.”

“ I think large banks in the US will continue to roll out deposit automation at a fairly aggressive rate in 2009. We have a very good position in that particular segment of the banking market.”

One of the important technological developments in the ATM industry has been the direct deposit taking ATM where the money is deposited immediately as opposed to an envelope-taking ATM.

Nutti describes the advantages of this technology:

“A return on investment has been nothing short of outstanding for the banks that deploy deposit technology. In fact, today, the reason why in this environment you're seeing banks roll out deposit technology as aggressively, is because they're being, basically, the departments of the banks that are rolling this technology out are being told by the leadership of retail banking, we need to get X tens of millions of deposits out of the branch and automated onto a machine because of the cost savings.”

“So, the cost savings are phenomenal for a bank to take someone who was once depositing checks in a branch vis-a -vis a teller now onto a machine. And so you're seeing tremendous cost savings.”

“I've got one customer who recently was requested to move more rapidly with deposit automation because they need 60 million checks that were normally deposited in branches to now be deposited vis-a-vis deposit-taking ATMs. So, that's one customer. And you can imagine, you could put any number, any dollar savings you want against the 60 million checks and come up with a pretty good ROI given the cost difference.”

The difference is discernible to customers as well, spending only seconds rather than waiting inline in a branch for a teller. The bank would far rather employ a person as a salesperson, selling additional higher margin services and establishing customer relationships rather than depositing checks in a drawer.

For NCR,there is also exposure to the airline industry and its self-serving kiosks. NCR is the number one provider of these devices to the airlines with an 80% share. According to the company, to check in by waiting in a queue at the airport costs about $3.15 per transaction. Checking in by kiosk runs $0.14! That is a tremendous cost savings.

The company anticipates that it will generate free cash flow in 2009 despite needing $200-$250 million to fund its pension plans. Currently, the company has $403 million in cash and investments per share (roughly $2.50 per share) net of debt.

The company launched over 50 new products in 2008, the highest number in more than a dozen years, including the launch of the industry's newest and most innovative ATM family, NCR SelfServ.

In the retail industry wit introduced a next-generation self check-out solution, 5.0, and other point of sale solutions that have captured significant market share.NCR is gaining significant traction in expanding its self-service strategy into new industries including the entertainment industry that promise to open up future avenues of growth for NCR.

For Diebold, some 50% of its revenues are service oriented, consisting of annual maintenance, servicing and monitoring contracts. In North America alone, the company has over 120,000 annual contracts to service the installed ATM base with a renewal rate of well over 90%. The company has generated about $250 million- $300 million in EBITDA annually whereas capex has run around $40 million. A concern is that DBD has been the subject of an accounting investigation by the SEC relating to revenue recognition practices. From a corporate governance standpoint, last March United Technologies (UTX) offered to buy DBD for $40 per share which the company rejected as inadequate. Recently, the company allowed a poison pill provision to expire. Back in 2005, the board dismissed most of its senior management because of poor internal controls and controversy about its election systems division which represents about 5% of sales.

The company has made significant strides in cost reduction since the 2005 disaster. As per its most recent conference call:

“More than just squeeze cost out of the old process, they identified best practices that were new to Diebold and implemented them successfully. As a result of the success of this initiative in 2008, we expanded the effort to eliminate an additional $100 million of cost out of the Company by the end of 2011. Key to the next 100 million, we expanded our relationship with Minlo, our logistics partner in the supply chain area. They assisted us in reducing our finished goods warehousing footprint from 89 company operated facilities down to three Menlo operated logistics centers. One center located in Greensboro, North Carolina is a flexible delayed product configuration facility serving market in North America and Latin America. This helps us improve lead times to customers while reducing costs.”

“We also improved manufacturing footprint. We have 85% of our production in low-cost geographies. By increasing production in low-cost geographies, we are also manufacturing our ATM products closer to our key customers in growth regions in Asia and eastern Europe. In addition, we consolidated security manufacturing facility in Ohio, with existing facility in North Carolina. To further streamline our operations, we expanded our vendor managed inventory system. We continue to leverage our relationship with Ariba implementing best practices and direct indirect procurement processes.”

NCR trades at merely 2.6 times trailing EV/EBITDA reflecting $1.5 Billion in equity market cap, $333 million in debt and over $700 million in cash or an enterprise value of $1.1 Billion.

DBD trades at 7.6 times EV/EBITDA with $1.5 Billion in equity market cap as well, but $620 million in debt and $360 million in cash or an enterprise value of $1.7 Billion.

Here is a look at the quarterly progressions of working capital management, capital intensity, and ROIC for these companies:

http://tinyurl.com/cm7vc2

In conclusion, I believe that there are many opportunities within the tech sector that are worth further exploration and investigation. By prevailing over the many distractions, focusing on value, and relying on recurring revenue models, investors can earn significant long term returns with some patience. I believe that the ATM industry in particular represents an unappreciated sub-sector in tech.

Happy New Year!

2008-12-31T15:53:00.004-05:00

What can be said in New Year rhymes,
That's not been said a thousand times?
The new years come, the old years go,
We know we dream, we dream we know.
We rise up laughing with the light,
We lie down weeping with the night.
We hug the world until it stings,
We curse it then and sigh for wings.
We live, we love, we woo, we wed,
We wreathe our prides, we sheet our dead.
We laugh, we weep, we hope, we fear,
And that's the burden of a year. - Ella Wheeler Wilcox

What a tough and rugged year it has been for all of us in capital markets! Who could have imagined the volatility, the fear, the panic that we, our friends, clients and employees felt at times. To our friends at Lehman, the Bear, and many others in investment banking, losses are particularly deep as victims of the financial tsunami that washed through the financial system.

We think of all of you as the old year passes and the hopes for a new year are in our hearts. We thank you for your readership, your support, and your thoughts! We are looking forward to a regular dialog through this blog and through some new and exciting alternative channels that we are developing. We appreciate the ongoing support of friends like Henry To of marketthoughts.com and David Korn of The Retirement Advisor. Special thanks to Geoff Gannon who has one of the most insightful blogs in investing. I look forward to hearing more about Geoff's ongoing publishing projects. I would be remiss in not mentioning David (Dah Hui Lau) who is determined to dedicate his life to value investing as well as a fellow Ontarioan Nurse B who continues to Triage his Way to Financial Success.

Finally, the ongoing help of The Wall Street Transcript as well as Cash Flow Analytics have helped mold and shape many of our thoughts and theories. Our friends at Seeking Alpha have also provided great support in terms of distribution of ideas as well as access to conferences.

Best of the New Year!

Rick

Finally, an Irish toast:

In the New Year, may your right hand always be stretched out in friendship, never in want.

Fair Value, Mark-To-Market and Financial Reporting-Another Revision?

2008-12-29T17:05:00.003-05:00

Less than a week to go for 2008, and the Financial Accounting Standards Board (FASB) has a proposal which it has thrown into the arena to address the problem of fair value.

Mark to market accounting has stirred up a very ugly debate between its adversaries and its proponents. Mark Sunshine, in a Seeking Alpha post some months ago noted that: " Mark to market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse." Other prominent naysayers as far as the current accounting rules for mark-to-market include Steve Forbes and noted fund manager, Ron Muhlenkamp.Here is a recent interview where they discuss mark-to-market accounting.Forbes does not mince his words:

"Henry Paulson is the worst treasury secretary in living memory. But even though he's miserably mishandled this financial crisis there's still time for him to turn things around. He can--somewhat--repair his reputation. He simply needs to back away from the disastrous policies and practices that have defined his tenure."

"His first mistake was to support the weak-dollar policy that sparked and fed the crisis. Then he continued to enforce mark-to-market accounting rules. Mark to market destroyed bank balance sheets. Now insurance firms are faltering under its weight. But there's still time for common sense...And while mark to market is fine for publicly traded stocks, it makes no sense when you don't have a market, as with packages of subprime loans. And it also makes no sense for long-term insurance reserves. Paulson and the SEC can suspend this inane rule in a heartbeat, yet they refuse. Adhering to one position without regard to consequences and expecting a different result is the definition of insanity. It's time for Paulson to follow the path of reason."

Proponents of mark-to-market generally perceive greater transparency with its usage. For example, here is a part of a letter to FASB by Rebecca McEnally of the Investors Technical Advisory Committee (IATC):

"The ITAC believes that it is especially critical that fair value information be available to capital providers and other users of financial statements in periods of market turmoil accompanied by liquidity crunches such as we're now experiencing. In the absence of timely fair value information, uncertainty increases, further exacerbating market instability and causing investors to withhold investable funds or demand a hefty uncertainty premium. A cornerstone of the restoration of investor confidence must be to provide the information investors need to make risk-based decisions."

"Regulators recognize that fair value measurement is an essential tool in their oversight and monitoring of the risk management practices and risk profiles of financial institutions, and ensuring that the institutions' capital provisions are adequate to support the risks embedded in the financial instruments and other assets the institutions hold and the financing used to support those assets. Given this widely-recognized critical importance of providing relevant, high-quality financial information to the markets, the ITAC has been dismayed to learn that a few managers of major financial institutions, along with representatives of industry organizations representing some financial institutions, are now calling for a suspension of fair value reporting for financial instruments. They argue, in effect, for a return to the old financial reporting model for financial instruments in effect decades ago with its out- of-date historical cost reporting and lack of transparency, particularly for embedded financial risks."

The proponents credit the transparency they believe that mark-to-market has brought to capital markets with the market's improved understanding of the risks and consequent selling off of many financial services stocks.

"Recently, some have attempted to shift the blame for the current crisis from the poor business and investment decision-making, including the flawed underwriting, securitization, risk management, and disclosure practices in which they engaged, to fair value financial reporting, a "shoot the messenger" argument. This reasoning is both perplexing and misleading. In fact, the current requirement to report financial instruments at fair values was instrumental in the uncovering of the deep and widespread problems in the markets. The long-term solution to the problems relies heavily on the retention of the requirement to provide fair value information to investors and regulators: the higher the quality of fair value information that is provided, the faster will be the necessary market adjustments to the problems."

"What those making the argument fail to recognize is that these are not abnormal features of the measurements, per se, but rather characteristics of the normal functioning of markets as investors reassess risks and rewards and liquidity disappears for poor quality securities and investments with little transparency. Some downward price revisions will inevitably result in the triggering of covenants that the original purchasers of securities or lenders demanded as a condition of investing in the securities and agreeing to the terms upon which the capital was provided to issuers. Again, these triggers are a normal part of the contracting process and designed to protect the investors, including lenders. The fact that the triggers were activated is not an indictment of the measurement system but rather is a direct function of the poor or deteriorating quality of the investments. Arguing that by not recognizing the poor or deteriorating quality of the investments we will somehow solve the problem is not only inappropriate but is a variant of the "shoot the messenger" argument: Pull the covers over the problems and maybe they will just go away."

I certainly recognize that under most normal circumstances, there is great transparency in fair value as opposed to other methodologies. However, it is also very clear to me that a myopic and complete focus on fair value can in effect be liquidation or bankruptcy value in times of severe systemic stress. I would agree with Forbes that the triggering of covenants that has resulted from large and probably unnecessary write-downs has caused more panic than elucidation as far as asset values. As he said very colorfully:

"Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline."

A compromise of sorts appears to be coming. The FASB would like firms to include in their financial statements a table which provides a comparison of three different reporting measurements:

The reported carrying value
Fair Value
Incurred Loss Amount

These changes would allow managements to highlight future cash flows of securities that will be held to maturity and are available for sale. Though the near term "fair value" or "market value" in a very constrained and illiquid market may look dreadful, the majority of many of these assets will likely pay off over their long term maturity. Hence, the "incurred loss" category when it demonstrates that few losses have actually been incurred may create some substantiation of long term value that is more realistic in my opinion than what we have now.

This proposal labelled proposal FAS 107-a, if approved, would go into immediate effect for reporting periods after December 15th, 2008! That puts more than a little uncertainty into forecasts of fourth quarter financial services profit forecasts. But at least the uncertainty may be somewhat positively skewed in favor of less write-down in the recognition of "fair value."

Part of the backbone of accounting is what's known as the conceptual framework which describes the function and purpose of accounting. As the FASB and the global body, the IASC consider a new conceptual framework, they propose (italics are mine):

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. Capital providers are the primary users of financial reporting. To accomplish the objective, financial reports should communicate information about an entity’s economic resources, claims to those resources, and the transactions and other events and circumstances that change them. The degree to which that financial information is useful will depend on its qualitative characteristics.

Financial reporting information is a faithful representation if it depicts the substance of an economic phenomenon completely, neutrally, and without material error. It must also be relevant.

In my view, the substance of financial reporting should focus on the long term substance of the transaction rather than the strains of the current capital market. Perhaps the new proposal begins to address the situation. Perhaps what is sacrificed in terms of timeliness and verifiability is offset by improvements in comparability and relevance.

Unfortunately, forecasting results will become even more difficult as accounting rules may be modified at the worst possible time, the year-end for most companies. But, if implemented, these rules may provide a bit of sunshine and upside at long last to a sector that has been wrapped in uncertainty and fear if not deprived of common sense for some time.

Happy Holidays!

2008-12-24T17:20:00.002-05:00

A simple and sincere message to all. Here's wishing you the best of holidays in this blessed season.

Wishing all of you a Happy Hanukkah, a Merry Christmas, and peace!

Looking forward to 2009, a Happy, Healthy and Prosperous Year for all!

Rick

Stocking Stuffers

2008-12-21T18:51:00.002-05:00

It has been a remarkable year. It has been year that many of us would just as soon forget. The cascading effects of deleveraging have been rampant across all markets.

The financial turmoil of 2007-08-09? has deeply affected households as well as businesses in most parts of the world. The reduction in the target Fed Funds rate since September of 2007 has been dramatic going from 5.25% (it really was this high!) at the beginning of this period to its current range of 0 to 0.25%. As any borrower knows, reductions in Fed Funds do not result in immediate parallel movements in interest rates that you and I pay, nevertheless, interest rates are likely lower than they otherwise would have been.

After peaking at a multi-decade high of +9.8% in July, the US producer price index (PPI), inflation rate has completely collapsed to +0.4% in November.

Little wonder that investors are huddling for warmth, are seeking "guarantees," and are about as risk-averse as I have ever witnessed. I warn my analysts about turning into "life insurance company treasurers" seeking relative shelter rather than seeking capital appreciation. Strangely, for long term real returns what appears to be safest in the capital markets at the moment may well be the most dangerous investment you can make,treasury bonds.

In this weekend's Barron's (subscription required) Rob Arnott, the former editor of the Financial Analyst's Journal provides some very thoughtful discussion in this interview by Lawrence Strauss.

As he describes,

"What we saw in September and October was a take-no-prisoners market in which everything outside of Treasuries was savaged. Finally, in November, we saw the beginnings of a rationalization where some markets did begin to recover-but some markets had been hit beyond any rational valuation of the risks associated with those assets."

Arnott goes on to describe very aptly, the behavioral tendency of most investors to continue to bank on "winners" rather than looking for bargains.

So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors.

He describes the current environment as "the richest environment of low-hanging fruit I've seen in my career."

A further key point...

"This is not a time to be hunkering down in the safety and comfort of the Treasury curve." "There are tremendous opportunities right now."

This being the holiday season, I suspect that Mr. Market has provided us some gifts for the taking if we choose to partake. I will be putting together a number of screens of bargain or quality ideas that I think may contribute to a happy new year. As well, I will be providing a review of many of these names in the coming days and weeks.

I will start with a list of Stocking Stuffers, as you will see, not necessarily very high quality businesses with strong competitive advantages. This list was constructed using Reuters and the following assumptions:

Price under $10 per share...i.e. Stocking Stuffers
Operating margins on a Trailing Twelve Month (TTM) basis better than that of the respective industry and showing improvement versus last year or two years ago.
Company must be generating free cash flow in the most recent TTM period
PE multiple must be within 20% of the lowest PE in the last five years
Enterprise Value/EBITDA must be less than six times.

Here's a look at several reporting formats for this screen:

Stocking Stuffers-Operating Margins, PE's, FCF

Stocking Stuffers-ROI, ROE

Stocking Stuffers- Debt Leverage

Here is another screen but rather than considering operating margin improvement, this screen looks for the following attributes:

Price under $10 per share but above $1.
Stock price below book value per share
Cash exceeds debt
Interest coverage more than two times
Net earnings must be positive for the most recent twelve months.

Remember that frequently, book value can be a misleading metric for value investors. Companies which chronically earn below average returns on capital or equity may well have assets whose valuation needs to be written-down. Impairment of these overvalued assets can lead to too low a price to book ratio. It is also important to note that companies that have a history of buying back stock at prices above book value will drive down Book Value and hence increase P/BV. Consequently, excellent companies that have generated excess cash and treated shareholders well by returning capital through buybacks will be missed by P/BV screens.

Book Value Bargains?

The Barrons interview makes it clear that Arnott favors investment grade corporate bonds at this stage. Spreads against treasuries have widened to immense gaps, for investment grade about 6% over treasuries, for below investment grade, perhaps 15-20%. As Arnott suggests, even if defaults reach historic proportions, it would take several years of defaults to lose a 20% spread in the competition against treasuries.

As Arnott concludes, and I agree, the less you hold in Treasuries, the better you are likely to perform in 2009. Riskier assets are priced to provide some significant returns for the coming years.

We'll have a deeper look at a few of the names within these screens over the coming days and weeks.

The Commodity Investment World Conference-Some Observations on Commodities as a Diversifier

2008-12-07T21:32:00.004-05:00

For two days last week, it was my privilege to attend the Commodity Investment World conference through the courtesy of Seeking Alpha. A broad spectrum of commodities markets, their economics and approaches to these markets were discussed.

Commodities conferences historically have been the denizens of inflation hawks. Theories of Malthusian catastrophes as population and consumption growth outpace agricultural production have always suggested dwindling supplies with the development of shortages and hence,higher prices for commodities.

Beyond the Club of Rome disaster scenarios, come monetary arguments for inflation. If currencies have value because of scarcity, central banks around the world have spent the last several months creating fiat money by decree-simply put, when money becomes too plentiful, it loses its value. Even Ben Franklin observed some 230 years ago:

"The currency, as we manage it, is a wonderful machine. It performs its office when we issue it: it pays and clothes troops and provides victuals and ammunition, and when we are obliged to issue a quantity excessive, it pays itself off by depreciation."

Many commodities historically have functioned to offset the depreciation in the currency that Franklin described and have been storehouses of value and hence, inflation hedges.

This conference was much more realistic in its tone. Commodities, which generally serve portfolios as tremendous diversifiers because of their low or negative correlations to equities have unfortunately demonstrated near perfect positive correlation with equities recently. The English translation of this statistical notion is straightforward...stocks have been declining- and so have all commodities.

So why bother even thinking about commodities in what appears to be a deflationary environment? Two reasons:

As Marc Faber of GloomBoomDoom fame has cited, when the investment community is fascinated by a major theme (deflation), outstanding opportunities arise elsewhere. "The greater the mania in one sector of a market or in one stock market, the more likely that neglected asset classes elsewhere offer huge appreciation potential." I believe that commodities, as several panelists at the conference indicated, may bottom within a few quarters.
The sources of return for commodities relate not only to issues of supply and demand and economic fundamentals but also to the possible returns from long/short active management as well as what are termed, "roll yield" and "collateral yield."

Roll yields occur when the price of a commodity is higher for shorter delivery dates. The investor earns a positive roll yield by buying, waiting for the price to appreciate as the delivery date approaches, then selling and using the proceeds to reinvest at a cheaper price at a longer term future delivery date. Collateral yield is the return earned by margin held against a futures position (generally T-bills.) The significance of roll returns should not be ignored...for the 15 years between 1989-2004, crude oil returns averaged about 20% per annum of which 6% per annum consisted of pure spot price returns and 9% consisted of roll returns.

Under more normal circumstances, if any of us can remember what normal is anymore, commodities can be a terrific portfolio diversifier. Why?

Commodities tend to correlate positively with inflation whereas stocks and bonds tend to negatively correlate with inflation. In an article that Warren Buffett authored in Fortune in 1977, he explained the deterioration of securities under inflationary conditions.
Commodity prices and stock and bond prices react differently under different phases of the business cycle. As business cools, treasury bonds tend to rally, whereas stocks and commodities tend to skid. As business expands, stocks and commodities tend to be pro-cyclical whereas bonds will decline.
Commodity prices tend to be more affected by short-term expectations whereas stocks and bond prices tend to be more affected by long-term expectations...not necessarily true at the moment, but at least a "normal" expectation.

Hence, commodities can be very potent portfolio risk diversifiers.

Here are a few links which you may find useful:
The Benefits of Commodity Investment

Alpha, Beta, and Commodities: Can A commodities Investment be Both a High Risk-Adjusted Return Source and a Portfolio Hedge?

Perhaps, one of the most interesting presentations at the conference was Dan Sternoff of Medley Global Advisors whose primary research focus is China. Though much of the commodity boom prior to July related to a silly notion that Chinese and Asian economies had decoupled from North America, the slowing of the Chinese economy has become quite evident.

Disturbingly, the deceleration is more rapid than even the Chinese government had anticipated no doubt precipitating China's biggest interest-rate cut in 11 years with the 108 basis point cut in one-year lending rates. However, according to Sternoff, the slowdown so far has been domestically led and not yet linked to the global cycle, more a consequence of China's slowing property sector affecting industries such as cement, steel, cars, appliances, and furniture.

Residential construction represents a significant 12% of Chinese GDP. Though not a real estate bust per se, (there are no Mortgage backed securities or other forms of securitization and housing is purchased with 25-30% down payments) property prices are down probably 5-10% nationwide with higher end apartments in larger cities down markedly more. Real estate transaction volume has fallen off a cliff.

Though Sternof expects Chinese GDP growth of about 7-8% next year, the composition of Chinese GDP growth is shifting away from resource intensive activities. He expects that state owned enterprises may well become acquisitive overseas as global valuations provide opportunities.

Other presenters had rather bleak views of Europe suggesting that most European authorities did not have a pro-active view of stimulus programs and that no governments had the skills of a Larry Summers or Paul Volcker in handling crises. Their conclusion in short, it is wrong to think that despite the steepness of the price waterfall, it is wrong to think that commodities have bottomed.

Roger Kubarych of UniCredit and a former associate of Henry Kaufman suggested that a reasonable fiscal stimulus plan of perhaps $400 Billion for the new Obama regime could include 4 segments:

Low to middle income tax benefits
A business investment tax credit or R&D tax credit
A program to stop foreclosures or a plan to help states and municipal governments buy foreclosed properties
An infrastructure building plan

It seems that many commodity traders are perplexed by the rather tight correlation of commodities to one another, not just their price movement relative to securities. It is unusual for industrial commodities such as base metals or energy which are clearly sensitive to economic activity to correlate this well with agricultural products that generally have little sensitivity to the economy.

As well, most commodities tend to bottom at their marginal cost of production, yet many instances were cited where producers, starved for working capital in the credit crunch, are willing to produce under their full cost of production merely to access cash flow.

Another interesting presentation addressed timber as an uncorrelated commodity asset whose value creation is largely attributable to biological growth rather than inflation. Basically, value increases as tree diameter grows and if current prices for small diameter trees don't work for you, a tree will grow about 7% every year, so greater value should accrue over time.

A very broad spectrum of commodity topics was considered. My only complaint about the conference relates to no-shows-there were numerous no-shows among presenters who were scheduled to appear for some topic panels. Despite this annoyance, in my view, the conference was worth attending.

Historically, portfolio construction meant a split between stocks, bonds and cash. I believe that going forward, commodities will also be an important component for portfolio construction.

Opportunities exist for not only portfolio hedging because of their usual uncorrelated returns, but also for active management strategies that take advantage of unusual backwardation. Like capital markets, commodity markets are in disarray and bathed in horrible sentiment. Though highly volatile in physical or futures formats, structured products and commodity ETFs may offer individual investors better opportunities to participate. It is too important a market with too many unique characteristics to ignore.

Analysts in the Confessional

2008-12-02T15:11:00.001-05:00

So why the lag in taking earnings estimates down? NBER yesterday declared the existence of recession, yet analysts continue to be reluctant to fess up and mark down their numbers.

In an interesting article in Australia's Business Spectator this morning, two analysts confess why it is so hard to reduce their forecasts.

The confession was written by two Goldman Sachs JB Were analysts, Sam Ferraro and Matthew Rose, who, after meeting their buy side counterparts, detected some frustration. So even though their strategist was forecasting a decline in earnings of 15%, their own forecasts still pointed to higher earnings.

Here are the reasons they cite:

The analysts haven't seen anything like this before--hence, they tend to underestimate the effects of systematic or top-down developments.
Their researched companies and managements haven't seen anything like this before- A survey of analysts reveals that 25 per cent of companies that used to provide profit guidance no longer do (and guidance is all-important – see the next point, below). CEOs, they say, are chosen for their “left brain skills: optimism, ambition, hard work, focus and decisiveness. Patience and an appreciation of history are not considered virtues for these individuals"
Analysts seek to curry favor with management in order to preserve their information networks- Remember, that for most brokerage firms, the investment banking client is the "real" client...the individual client represents far less revenue, and hence, upsetting him/her is less onerous and career-threatening than upsetting the major client.
Analysts need to manage their "reputational risks" so they engage in herding behavior. There is comfort in numbers. The costs of being out in left field with a big call gone wrong far outweigh the benefits of getting the big call right.

As I said in my previous post, earnings estimates at this stage of the game may well be ignored by most participants,"I also believe that in a well-established and hopefully, late stage bear market, analysts are completely ignored and stocks will rally in the face of declining earnings estimates."

As portfolio managers, we do our own forecasts and tend to use Wall Street for idea generation rather than forecasts or recommendations. We have long recognized that many estimates are candy-coated to stroke the egos of the "real" clients rather than serve our needs. Similarly, there is a reluctance of research analysts to say "sell" or to couch it by calling a company a "hold" so as not to offend the investment banking client.

As in every part of investing, self-reliance and judgment are an important part of success.

Staying in the Game

2008-12-01T16:46:00.001-05:00

My sincere apologies to readers I have disappointed in my absence over the last several months. As our business has grown, time has certainly been at a premium and unfortunately, we have neglected our responsibilities to this blog. We hope to mend our ways with more regular postings of commentary regarding markets, economies, analyst upgrades and downgrades, as well as independent analysis of interesting companies.

Some of you may be aware of our regular monthly commentary to Marketthoughts, Henry To's excellent subscription service. Henry, who is currently working on his MBA at the UCLA Anderson School is a CFA charterholder as well as an actuary. Henry's thought provoking analysis and commentary is insightful and ruminative. His productivity in his subscription service despite his full time efforts as an MBA student is a real inspration to me. I hope to aspire to his level of publishing productivity! In Ocotober, I first published this commentary in Marketthoughts. I think most of this remains quite applicable:

Baffled? Frustrated? Worn out? Most of us have to answer yes to these questions. After over thirty years of investment management, I still try to stand up to my own sinking feelings and act professionally and as unemotionally as possible. A value discipline forces you to take notice, to battle your emotions, and to recognize value with at least a small order. Courage is in exceptionally short supply especially among newer clients who have never seen this before. But even when I visit some of the brokers who sell our products, many of whom have years in this business equal to or greater than mine, there is terror in their eyes and no activity in their books. It is never easy to battle feelings of inadequacy and powerlessness which overcome you in bear markets.

It's been over a year since housing issues triggered problems in mortgage markets which triggered problems in credit markets which triggered problems in the shadow banking system which triggered a bust in the commodity cycle, etc, etc, etc. The sequence of events reads much like the "begat" verses which describe generations in the Old Testament.

We have been through some twenty years of credit expansion...like most "topping" experiences, as we neared the peak, more and more credit was needed to produce less and less real economic growth. The credit experience of the last twenty years parallels most other addictions where greater amounts of the abused substance are needed to achieve the desired result. Not unlike substance abuse, too much will indeed kill you.

The widespread deflation of asset values, whether stock prices, housing prices, or commodity prices has exposed the excesses of borrowing and destroyed the creditworthiness of the debt that was secured by the price inflation of the underlying assets.

All business cycles are driven by some excess "thing" that needs to be corrected. Many bear markets of the past have been triggered by credit tightening...not this time. Others, such as the internet bubble burst were triggered by excessive valuation of a sector...not this time. Others, such as the 1974 bear were triggered by fears of earnings collapse in the face of a seemingly uncontrollable macro variable, at that time oil prices...to some degree, this had been an aggravating factor again.

Abrupt changes in the availability of credit lead to abrupt changes in liquidity and hence, asset prices. This turns into a self-fulfilling prophecy...fears that asset prices may fall, lead to falling if not cratering asset prices.

The downward spiral of the current crisis parallels the emerging markets crisis of 1997 and 1998 where Thailand, the Philippines, Indonesia, and Malaysia faced currency attacks that undermined investor confidence in foreign denominated debt. Asia lost access to foreign credit, currencies plummeted and creditors lost confidence that they would get their dough back, all rushing for the exits at the same time. The decisions of the credit markets ensured that the crisis deepened.

The global economic response this time is much more heartening with bank recapitalization, broadened limits on deposit insurance, guarantees of bank debt, coordinated interest rate cuts, and major increases in liquidity. I suspect that much more can be done in terms of encouraging increased lending into the rea leconomy from the newly recapitalized coffers of the "favored few" banks. In addition, in this deflationary time, interest cuts have only begun.

The somewhat haphazard and piecemeal initial response to the crisis, especially in Europe has done little to boost confidence. However, following the UK's massive bank recap plan, the world began to coordinate it activity.

I am encouraged by some signs of life in the commercial paper market and by recent moves in LIBOR (finally.) As well, perhaps whimsically, there is now a TED spread gadget to be monitored on your iGoogle homepage. In my view, more of a sign of the late innings of a crisis than the beginning. We have also survived the Lehman CDS episode with nary a whimper.

The very high probability of a long and deep recession has prompted considerable fear recently. Though quite clearly, cyclical stocks
have reacted quite negatively to this prospect, most analysts have yet to revise their estimates downward for next year. Of course, this is causing some trepidation that more disappointment will follow. Here's a look at S&P consensus estimates according to Bloomberg and Bank of America stats.

Of all estimates that are higher in 09 versus 09:

Consensus estimates for 406 (82%) in the S&P are higher for 09 over 08. The overall average increase is +19% with a median of +11%.

45 of 500 (9%) are up +30-200% averaging +64%
34 of 500 (7%) are up +20-29% averaging 23%
156 of 500 (31%) are +10-19% averaging +13%
120 of 500 (24%) are up +5-9% averaging +7%
48 0f 500 (10%) are up +0-4% averaging +2%

In my view, most investors/ speculators/ traders in this market are completely oblivious to Wall Street estimates in this environment. People are trading from the gut rather than from consensus estimates. I believe Roy Neuberger ( of Neuberger and Berman fame) once spoke of analysts quite disparagingly, " In a bull market, who needs 'em, in a bear market, they'll kill ya.) I also believe that in a well-established and hopefully, late stage bear market, analysts are completely ignored and stocks will rally in the face of declining earnings estimates.

Recently one street strategist described a complacency that given stocks are down 30%+ that earnings misses are reflected in the valuations. According to him,"Magnitude of surprises on the downside can still surprise the market despite significant downward moves in the stock price prior to earnings release." As an example, Alcoa which had already been down 54% YTD dropped another 12% on its recent negative earnings surprise, and then fell another 27% after the earnings date. similar fates awaited shareholders of EAT, RT, IR, MWV, PEP, DPZ, JNY, SVU, NVLS, EBAY and others.

I have attempted my own analysis of negative earnings surprises. According to Zacks data between September 1st and October 23rd, there have been 190 companies that reported a negative earnings surprise of 10% or more.I chose the first 50 names of their screen for further analysis. Companies selected were not necessarily part of an index and had market caps ranging from $30 million to $72 Billion.

The average earnings surprise was -129%, obviously a horrific miss! The reaction on the earnings miss was as high as -37% though it averaged about -7.2%, even in these hardened times, a significant reaction.

However, after the earnings miss, the performance from that date to October 23rd was hardly supportive of the strategist's conclusion. In 25 cases, the stock outperformed the broad Russell 3000 index. In the other 25 cases, the stock underperformed the Russell. Here is a spreadsheet link outlining the findings.

Wall Street frequently puts far greater emphasis on its ability to forecast earnings as a stock picking methodology than is warranted. Though I have enormous respect for the work that analysts do, having served as a research director for a sell side firm, there are tremendous lags in information flow that can result in very limited usefulness. As well, GAAP allows tremendous scope for a management to make choices or assumptions that are not captured in a single point E.P.S. number. My advice, look for confirmatory evidence of conservatism and focus on cash flow rather than earnings.

Some final thoughts for this month. The market abounds in very cheap stocks. Free cash flow yields exceeding 10% are relatively easy to find. This particular metric is always a standard that I find produces the first inkling of a decent business value. Naturally, all screening depends on observation of historical data, and it is dangerous to simply extrapolate the past into the hereafter. Look to return on invested capital for evidence of superior profitabiity relative to its peers. Explore the basis of this competitive advantage.

When credit is difficult to obtain, companies with free cash flow generation can obviously survive. Low capital expenditure needs, low working capital needs keep both commercial bankers and investment bankers from knocking at the door, or at least management need not answer their futile calls. The ability to self-fund is golden in these times. Great businesses have histories of free cash flow generation for some years, not merely flash in the pan occurrences.

The adage of investigating before you invest is more important than ever. pronouncements by strategists using selective data points may sound impressive but check the reliability of the data...it may not always be complete. Though the Buffetts of this world may find a price to swing the bat with fierce determination when that fat pitch arrives, most of us do not have the intelllectual capital or emotional wherewithall to do so with confidence. Nibble and graze...diversify rather than feast. You will be able to concnetrate your positions later as evidence mounts that you have chosen well. Cash may seem like the greatest refuge but when a market abounds with bargains, it represents the sirens' lure.

In an environment where daily returns resemble traditinal monthly or even annual returns, volatility creates tremendous fear. Show some greed when the world seems to be falling apart. If your portfolio contains questionable stocks, use this opportunity to buy high quality names that you can grow wealth with through time.

Ignore Cramer and other prophets of myopic fortune or doom. These are times to think big and have long horizons.

It is exceedingly tough out there and easy to be discouraged. Be careful but stay in the game!

The Success Effect

2008-11-30T18:54:00.001-05:00

Business and investing is all about people. Great ideas are not just about numbers, and are not just about metrics. Developing an insight into how a business is run is easily translated into what creates a business' competitive advantage. Those sorts of insights are best garnered by interviewing and observation of managements, their competitors, and their customers.

Prior to the onset of Sarbanes-Oxley and Regulation FD, most analysts spent considerable time in interviewing of CEOs and CFOs of companies under their coverage. Unfortunately, in today's world where selective disclosure fears abound, far less time is spent in training analysts how to interview, and what sort of questions can be asked.

The "Success Effect" is written by the business reporter for the Cincinnati Enquirer,John Eckberg. Eckberg kept his tapes from various interviews he has conducted as a reporter. These interviews offer unusual and unique insight into the minds of this collage of successful, entrepreneurial and motivated people.

The book is an easy read based on Eckberg's easy, conversational style. His interview candidates have ranged from true business scions such as Donald Trump, Larry Bossidy and Lou Gerstner to much lesser known business people such as Dennis Spiegel whose career evolved from the age of 13 when he began taking tickets at the gate of an amusement park to founding the largest amusement park design and operations firm.

The interviews never drag...I think the longest interview of the 47 presented spans ten pages. This staccato style makes this an ideal night table book, where each chapter represents a rapid observation of what that person holds true, what has influenced his/her life, as well as lessons in leading a successful life.

Eckberg also compiles some additional personal information for each interviewee... each chapter contains a little vignette of "Books on The Nightstand," and "CD's In The Changer."

One of the more interesting interviews is of Doug Newburg, the Director of Performance Education at the University of Virginia School of Medicine. He believes that top performers share a trait of "resonance"- a sustained energy flow, an ever-present buzz that is linked to performance and engagement. As he observes, "Real competition is the competition between your vision and your skills-not between you and other people." Essentially, the more engaged you are, the more you enjoy what you are doing, and the better you perform. People who make it, hate to lose. The people who don't make it are afraid of losing.

At the end of each interview, Eckberg summarizes the findings with a two or three line "carryout," a summary of lessons learned. Here is an example from the Oscar Robertson interview:

"For group success, help the worst guy on a team achieve. Talented staff take care of themselves. Let customers know you and your company. Familiarity brings revenues because business in a cyber-age is still about relationships. Opportunities are all around you all the time."

There are many role models here from all walks of life. There are valuable lessons in what it takes to lead, to prosper, to establish a brand or niche, and to succeed.

This is an enjoyable read, a great stocking stuffer for yourself, your partner, your friends. I highly recommend!

Ben Graham meets the Exchange Trade Note part II

2008-08-18T15:46:00.004-04:00

As discussed in the previous post, Nuveen has created an interesting Benjamin Graham based index. Here is a look at the Graham Small Cap Index constituents for the Benjamin Graham Small Cap Value ELEMENTS portfolio:

A O Smith Corp
Administaff Inc
Adtran Inc
Alon USA Energy Inc
American Eagle Outfitters Inc
American Financial Group Inc
Amkor Technology Inc
Applied Industrial Technologies Inc
Arkansas Best
Aspen Insurance Holdings
Axis Capital Holdings
bebe stores inc
Biovail Corp
Black & Decker Corp
Brinker International
Brown Shoe Co Inc
Carlisle Cos
Carpenter Technology Corp
Cash America International
CF Industries Holdings Inc
CSG Systems International
Darden Restaurants Inc
Endurance Specialty Holdings
Ethan Allen Interiors Inc
Flowers Foods
Frontier Oil Corp
GFI Group
Graco Inc
Granite Construction
Group 1 Automotive
Guess? Inc
Harte-Hanks
Hasbro Inc
HCC Insurance Holdings
Heartland Express Inc
Heartland Payment Systems Inc
Heidrick & Struggles International Inc
Helmerich & Payne
Herbalife Corp
HNI Corp
Holly Corp
Hubbell Inc
IPC Holdings
J B Hunt Transport Services
Jones Lang LaSalle Inc
Kaiser Aluminum Corp
Landstar System Inc
Lennox International Inc
Manitowoc Co
Manpower Inc
Max Capital Group
Men's Wearhouse
Meredith Corp
Methanex Corp
Micrel Inc
Montpelier Re Holdings
NutriSystem Inc
Odyssey Re Holdings
OfficeMax Inc
Oshkosh Corp
Packaging Corp of America
PartnerRe Ltd
Patterson-UTI Energy Inc
Perini Corp
PETsMart Inc
Phillips-Van Heusen Corp
Platinum Underwriters Holdings
Polaris Industries
Pool Corp
Precision Drilling Trust
RadioShack Corp
Reliance Steel & Aluminum
Renaissance Re
RLI Corp
Robert Half International Inc
Ross Stores Inc
Rowan Cos
Sanderson Farms Inc
SEI Investments Co
Sierra Pacific Resources
Skywest Inc
Sotheby's
St. Mary Land & Exploration
StanCorp Financial Group
Technitrol Inc
Temple-Inland Inc
Tempur-Pedic International Inc
Terra Industries Inc
Tidewater Inc
Titanium Metals Corp
Toro Co
Total System Services Inc
Trinity Industries Inc
Watsco Inc
Werner Enterprises
Williams-Sonoma Inc
Wolverine World Wide Inc
XL Capital Ltd
Zenith National Insurance Corp

Disclaimer:I, my family, or clients hold current positions in American Eagle Outfitters, Applied Industrial Technologies, Endurance Specialty Holdings, Graco, Harte-Hanks, HNI Corp., Hubbell, Manitowoc,Micrel,RLI, Ross Stores, and XL Capital.

Ben Graham meets the Exchange Traded Note

2008-08-18T14:58:00.005-04:00

Exchange traded notes (ETN) are a fairly new investment product that share some characteristics of exchange-traded funds, or ETFs. They are simply direct debt obligations issued by a bank or investment firm rather than an interest in a pool of securities that define an ETF.

A bank simply issues a note and promises to pay the holder whatever the total return of an index is over the maturity of the note, less a management fee. The bank may or may not use the cash to invest in the index...it matters not, what an investor should care about is the return on the note which is the return of the index less fees. So long as the bank is solvent, investors will get the returns that they are promised.

An ETF has essentially no credit risk from a fund collapsing...an ETF investor is entitled to his/her share of the collective unit assets. There is always some tracking error risk in that the return may differ slightly from the underlying index.

ETN holders have no tracking error risk but do need to concern themselves with the credit risk of the offeror.

With that intro, proviso, and warning, let's talk about the Ben Graham aspect of ETNs.

Deutsche Bank, a AA-/AA1 bank has issued as of early August, a new ETN whose return is linked to the performance of one of several Benjamin Graham Indices. These securities are senior unsecured obligations of Deutsche. To be clear, these securities are NOT principal protected. The sponsor of the ETN is Nuveen Investments. The indices have been constructed by a Nuveen subsidiary, Hyde Park as part of their ELEMENTs series of product.

"The Index tracks the value of a portfolio of 50 large-cap U.S. stocks that are selected according to the Benjamin Graham Methodology.The Methodology seeks to identify businesses with strong, liquid balance sheets that trade at a discount to their implied intrinsic value, implementing the investment principles of Benjamin Graham through a quantitative, objective process utilizing modern portfolio theory and statistical analysis. The Methodology consists of four steps: (i) Universe Screening, (ii) Stock Selection, (iii) Semi-Annual Re-allocation, and (iv) Annual Reconstitution."

Interesting to see the juxtaposition of modern portfolio theory with Graham Methodology!

Certainly, the essential elements of Graham's theories are in place: The seven major factors are:

1. Earnings Quality – a quantitative analysis that seeks to measure a company’s reported earnings as
compared to an assessment of its true economic earnings.

2. Valuation – an examination of the ratios of a company’s share price to certain financial metrics, including historical earnings and book value.

3. Forward P/E – a ratio of price to consensus estimates of future earnings. Such estimates will be based
on data obtained from one or more vendors who provide consensus earnings estimates.

4. Dividend Yield – the ratio of a stock’s dividend to its share price.

5. Profitability – an evaluation based on measurements of a company’s return on capital.

6. Debt and Liquidity – an analysis of a company’s current assets as well as its ability to service debt.

7. Measurements Relative to Industry Peers – key measurements of valuation and performance compared to average levels within a given stock’s industry.

The seven major factors and their related sub-factors are part of the objective, rules-based,proprietary Methodology. Each major factor has a specified weighting and the sum of all major factor weights is equal to 100%. Each sub-factor has a specified percentage weighting and each group of sub-factors under a single
major factor has a combined weight of 100%.

I think the initial list of large cap names should be of some interest to readers:

Abercrombie & Fitch
Alcoa Inc
Allstate Corp.
Altria Group
AmerisourceBergen Corp.
Analog Devices Inc.
Applied Materials
BJ Services
CBS Corp
Corning Inc
Eli Lilly
Exxon Mobil
Franklin Resources
Gap Inc
Garmin Ltd
Genuine Parts
Genworth Financial Cl A
Halliburton Co
Harley Davidson
Hartford International Group
Home Depot
Host Hotels & Resorts
Illinois Tool Works
International Paper
J C Penney
KLA Tencor
Legg Mason
Lowes
Magna International
Mattel
McGraw Hill
Merck
Murphy Oil
Noble Corp
Nordstrom
Nucor
Pfizer
Qualcomm
Seagate Technology
Sherwin-Williams
Southern Copper Corp
Staples Inc
Sysco Corp
Texas Instruments
TJX
United Parcel Service
Valero Energy
W W Grainger
Wyeth

There are three ETNs that have been created here with links to the respective prospectus:

* Benjamin Graham Large Cap Value ELEMENTS (NYSEArca: BVL)
* Benjamin Graham Small Cap Value ELEMENTS (NYSEArca: BSC)
* Benjamin Graham Total Market Value ELEMENTS (NYSEArca: BVT)

The management fees for all of these are 75 basis points annually. The notes mature August 14th, 2023.

Since ETNs do not pay any capital gains, dividends, or interest over their lifetime, they ought to be superbly tax efficient as what is termed a "prepaid contract," i.e. the difference between the sale and purchase will be classified as a capital gain, and no taxes are due until there is a sale. I do not believe that the IRS has made a definitive ruling into this assertion and a nasty surprise could await!

Finally, even though I have high regard for Deutsche Bank as a solid credit (I, my family, or clients do hold some Deutsche stock and preferred shares,) I cannot emphasize enough the importance of knowing that ETNs are an obligation of this issuer and there is no guarantee as to principal.

Disclaimer: I. my family, or clients have a current position in CBS, Corning, Exxon Mobil, Genuine Parts, Illinois Tool Works, Legg Mason, Pfizer, Sysco, and Wyeth.

Book Review-"Even Buffett Isn't Perfect"

2008-07-20T18:52:00.003-04:00

I am a complete sucker for investment books. My wife accuses me of owning several thousand books that have essentially the same title, usually some variant of Value Investing, valuation, or intrinsic value, or securities analysis. Of course, I have every Buffett or Munger book known to man as well as everything about or by Benjamin Graham. By the way, speaking of Graham, my good friend Geoff Gannon is putting together a series which will review Securities Analysis chapter by chapter. For those who are serious value investing students, I suspect that you will enjoy Geoff's always thorough and thoughtful posts.

Vahan Janjigian, a fellow CFA, is executive director of Forbes Investment Advisory Institute and publishes a number of newsletters with Forbes. He also has a blog and serves on the investment committee of a large RIA.

Dr. Janjigian's book gingerly attempts to criticize some of Buffett's mistaken investments and controversial points of view. I think the book is more successful with the latter than the former.

Janjigian admires Buffett's discipline and capital allocation methodologies. He admires Buffett's ability to manage executive talent. His last sentence in the book summarizes his viewpoint,"Based on the evidence, it is certainly fair to conclude that WB is one of the greatest investors-if not the greatest investor-of all time."

So where are Buffett's mistakes? Janjigian criticizes Buffett's views on taxation, especially those on estate taxes. I agree with Janjigian that there is an irony if not an artificiality or phoniness about urging the continuity of high estate taxes and concomitantly avoiding the situation through setting up trusts and foundations Evidence of avoiding income taxes is evident throughout Berkshire's life...the company and Buffett have always used the IRS Tax Code to their advantage. There is clearly nothing wrong with that but similarly. it is somewhat disingenuous to urge higher taxes after a career of avoiding them.

Like any investor, Buffett has made some mistakes. This is not a game of perfect, but rather one where investors should attempt to understand the downside risks in making an investment. The outcomes can be highly uncertain...the future always is hazy and usually, initial assumptions are plain wrong, either on the optimistic or the pessimistic side of expectations.

Janjigian addresses the Buffett diversification versus concentration question. "Buffett believes that if you can't invest enough money to have some say in how the company's capital is to be deployed, you are better off diversifying your portfolio." This is simply not true. Most Buffetteers and wannabes certainly attempt to focus their portfolios. WB does not say not to diversify...in fact, for the average investor who is not inclined to do sufficient due diligence, diversification is a salvation. For many professional portfolios, the great bulk of the portfolio is indexed. But in cases where one has specialized knowledge or skills, satellite investments outside the cord index are made and should add performance. Diversification is a protection against ignorance. If one is able to do due diligence, and select successful businesses at reasonable valuations, diversification will not serve you other than to reduce volatility and an unfortunate corollary, reduce returns.

VJ does a decent job in discussing attributes of diversification in a non-mathematical approach to statistical correlation. This is one of the strongest elements in this book.

Much of the rest of the book is in my view, completely obvious. "Buffett buys stocks cheap, not cheap stocks." "Successful investors must be able to distinguish between great companies and great stocks." VJ has an amazing grasp of the obvious and adds little insight into valuation of growth stocks. There are far better sources than this book for this element.

VJ addresses the fact that value works over the long run but growth or rather momentum can work over the short run. Buffett never trashes growth but views it as a partner in helping undervalued stocks recover when growth becomes temporarily disrupted. Other than Buffett's famous comments about lemmings, he has never discussed momentum investing per se, at least to my knowledge.

VJ makes some dangerous statements about PIPE stocks indicating that WB has been successful in buying special issue "Private Investment in Public Equity" holdings such as Salomon Brothers or US Air. True, these had special terms that a large buyer can extract but it is misleading to believe that what some brokers present as PIPEs will offer the average investor better returns. Most PIPE offerings are made in very small cap, highly risky businesses. VJ does suggest that the best access to such investments is through a hedge fund or through Berkie itself.

VJ makes the point that "Unless you have access to Buffett-like resources, it is better to think of yourself as a stock buyer than a business buyer." The argument that managements will rarely listen to outside advice is humbling for both institutional and retail investors. However, retail investors and small institutional investors can be very successful in motivating and organizing larger investors to add pressure to a board. The principle of thinking long term as an owner of a business rather than a punter of stocks is an important part of any real value investor's credo. I have known many managers who "played" stocks rather than owned businesses and who were looking for trends rather than valuation rationales for stocks. They are assuredly not value managers. I have had investee company managements who have indicated that I should just sell the stock if I didn't like what they are doing. Again, these are managements who just don't get "it." If the business has a strong moat that is not being defended, get rid of the management but hang onto the business. VJ's advice is ill-conceived at best in this topic.

Swinging for the fat pitch is WB's approach. WB does not suffer from analysis paralysis and VJ believes that some of WB's recent deals have had inadequate due diligence. Sometimes the obvious should not take very long!

WB readily admits to being "dead wrong." Salomon was a mistake that took an extraordinary amount of work to escape. Gen Re was much worse with poor judgment on WB's part re underwriting discipline and the derivatives book of GenRe securities. NetJets capital intensity does not seem to fit the usual Buffett textbook. Pier One had no moat. Mistkaes all. VJ actually misses the most egregious errors that I recall, namely Dexter Shoe which gave away 1.6% of BRK or about $3.5 Billion in value for what is now a tiny fragment of H.H. Brown Shoe Group, another BRK sub. Dexter, Buffett calls his worst mistake. VJ doesn't even address this. There have been others. WB was the largest investor in Handy and Harman, the silver processor and refiner. Unfortunately, it was also an auto parts supplier and metal bender. Buffett's endless fascination with silver attracted him to H&H. H&H ultimately merged into WHX, which went chapter 11 in 2003. Berky had escaped H&H many years before this ignominious end.

VJ dislikes WB's views about corporate governance. It is incorrect to say that Buffett opposes employee stock options. It was the accounting for them that he faulted as well as the low hurdles that most company's managements clear to get them. In many cases, the only requirement for managements to achieve is respiration, and there are even cases where compensation continues into the after-life! There is nothing misleading about WB issuing options in subsidiary companies with clear performance mandates versus his public statements about employee stock options issuance.

The composition of WB's board has been controversial in the past. No it certainly was not independent historically with Warren and Charlie, Susan and Howard Buffett; Malcolm Chace, Walter Scott were old business cronies; Ron Olson was a partner in Munger's old firm. But VJ missed the most obvious point, Buffett for most of the time that he was involved in BRK owned over half the stock. It was absolutely iron clad clear that management's interests were aligned with shareholders. Unlike most public corporations, management owned most of the stock. The role of the board is not to protect minority shareholder interests but rather to ensure that shareholders' interests are protected. This point is missed by VJ.

Bottom-line, if you are looking for advice to imitate WB's investment style, this is not the best source. If you are looking for a comprehensive list of WB's mistakes in judgment, this is incomplete. If you are looking for views on taxation contra to those of WB, read Steve Forbes rather than VJ's book.

The key takeaways after each chapter provide an excellent summary of each chapter. The final chapter, "Conclusion" successfully highlights the important points.

Dr. Janjigian has attempted to provide an antidote to the usual glorious heaping of praise that most Buffett books (and CNBC coverage) provide. The reality is that nobody walks on water (or parts the sea depending on your point of view.) Even great investors frankly screw up royally. But the incidence in the case of Buffett is remarkably low, the damage is a scratch or fender bender rather than a complete wreck. Should all of us be so fortunate, or disciplined!!

John Templeton- The Triumph of Optimism

2008-07-09T08:44:00.002-04:00

Sir John Templeton passed away yesterday. He died, much as he spent his life, peacefully.Geoff Gannon (and it is great to have him back in the blogosphere) has an extensive list of articles outlining Templeton's life as well as a list of his books. John Bethel of Controlled Greed also has a good post on Templeton, with reminiscences about Templeton's appearance on Wall Street Week immediately following the October 1987 crash.

Templeton's life was one of great inner reflection and his original sale of Templeton, Dobbrow and Vance was motivated partially by his resolve to never let himself get so busy in managing clients that he ran out of time to think, not only about investments, but also about the larger world, especially spiritual matters and religion. His investment career became focused on just one thing, a small Canadian domiciled mutual fund that Piedmont Management, the buyer of the rest of his firm had declined. So at age 56, Templeton started his career with a clean slate and a single client, the mutual fund.

I believe there is a valuable lesson in Templeton's life, the importance of keeping your perspective. The distance from his home at Lyford Cay to the floor of any global stock exchange was measured in psychological light years, not unlike the distance from Buffett's Kiewit Plaza office to those exchanges.John Train, in his book Money Masters describes this as "a silent reproach to excitement and hyperactivity."

One of the best books about Templeton's investment approach is,at least in my opinion, The Templeton Touch by William Proctor, published in 1983.In it, he highlights twenty-two maxims that Templeton said were his enabling principles. Let me highlight them:

For all long-term investors, there is only one objective-"maximum total real return after taxes."
Achieving a good record takes much study and work, and is a lot harder than most people think.
It is impossible to produce a superior performance unless you do something different from the majority.
The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
To put "Maxim 4" in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.
To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
Bear markets have always been temporary. Share prices turn upward from one to twelve months before the bottom of the business cycle.
If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and, when lost, won't return for many years.
In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.
In free-enter[rise nations, the earnings on stock market indexes fluctuate around the book value of the shares of the index.
If you buy the same securities as other people, you will have the same results as other people.
The time to buy a stock is when the short-term owners have finished their selling, and the time to sell a stock is often when the short-term owners have finished their buying.
Share prices fluctuate more widely than values. Therefore, index funds will never produce the best total return performance.
Too many investors focus on "outlook" and "trend." Therefore, more profit is made by focusing on value.
If you search worldwide,you will find more bargains and better bargains than by studying only one nation. Also, you gain the safety of diversification.
The fluctuation of share prices is roughly proportional to the square root of the price.
The time to sell an asset is when you have found a much better bargain to replace it.
When any method for selecting stocks becomes popular, then switch to unpopular methods. As has been suggested in "Maxim 3," too many investors can spoil any share-selection method or any market-timing formula.
Never adopt permanently any type of asset, or any selection method. Try to stay flexible, open-minded, and skeptical. Long-term top results are achieved only by changing from popular to unpopular the types of securities you favor and your methods of selection.
The skill factor in selection is largest for the common-stock part of your investments.
The best performance is produced by a person, not a committee.
If you begin with prayer, you can think more clearly and make fewer stupid mistakes.

Templeton was never afraid to maintain cash reserves when he got edgy about market opportunities, though he always said he had little ability to time markets. He was a pioneer in international investing, as much at home in Japanese and Canadian exchanges as he was in American exchanges. His funds frequently had positions in small, less familiar names.Basically, it came down to this:

"Search among many markets for the companies selling for the smallest fraction of their true worth."

He was always ware of socialism and regulation, which he viewed as disguised expropriation...entanglements that inhibit business and destroy the investor's incentive.

Like Buffett, he greatly feared the impact of inflation on his investments and sough beneficiaries of inflation, companies that possessed the ability to pass through cost increases.

A confident optimistic outlook and a willingness to not follow the crowd over the cliff with momentum stocks served his clientele very well.

And hopefully, following such discipline will continue to serve all of us well. I am grateful for the contribution he made to to world.

May he rest in peace.

An Interesting Screen-Deteriorating Operating Margins and Increasing Capital Intensity

2008-04-20T18:51:00.002-04:00

As one would expect, deterioration in operating margins will occur in economic slowdowns. Marginal competitors frequently will try to clear inventories at ever lower margins in order to generate cash flow. I am particularly interested concerned if a company exhibits not only operating profitability deterioration but also a build up in working capital intensity (i.e. accounts receivable and inventories may be building and cash is not coming in as quickly as one would like.) Finally, if at the same time, the company is building capital expenditures, free cash flow generation can be impeded.

In this screen, I am taking trailing four quarter observations and comparing these to trailing four quarter observations lagged back one year prior. I have confined my screen to non-financial stocks in the S&P 1500.

There is no attempt to scale the amount of deterioration. For example, in 3M, a company which I continue to like, the operating margin has decreased from 22.57% to 22.53%, hardly alarming. Operating working capital to revenue has increased to 14.1% from 10.35% which still represents significant improvement from working capital levels which hit 20%+ levels of two years ago. Similarly, capex at 3M as it undertakes its international expansion is at 7.52% of revenues versus 6.94% four quarters prior, again, not an alarming pace. Bottom-line, this is a screen which is designed to raise some questions and further analysis, not to prompt an instant sell or a short.

The data is from Cash Flow Analytics, a company founded by Professor Chuck Mulford of Georgia Tech.

Finally, the ultimate test of investment is a test of market price versus intrinsic value, clearly a judgment that each investor should make for him or herself.

You will find the screen in this link: http://tinyurl.com/3oayag

Disclaimer: I, my family, or clients have a current position in 3M

Recurring Revenues and Financial Services- The Competitive Moat of Fiserv

2008-04-08T14:00:00.003-04:00

In our last post, we discussed the notion of recurring revenues as it pertains to companies in the industrial sector. The genesis of this idea was a reaction to the prevailing wisdom of many investment strategists to find recurring revenue streams in consumer staple or health care stocks. It is my contention that there are recurring revenue themes across many sectors that remain unrecognized in the marketplace.

As a brief aside, I will mention that our posture on MSC Industrial Direct (MSM) has received some nice support from Mr. Market since our post. Today's earnings release and conference call continue to support our thesis.

Though financial services revenues from a 30,000 foot perspective seem to be one of the last sectors one would consider to have recurring revenues, particularly in light of recent experience, there are some companies whose competitive advantages provide some assurance that business remains relatively stable despite the vagaries of the economy. Switching costs are a major advantage for many companies in this sector. Even small community banks can have a reasonably sacrosanct deposit base and provided that their lending operations remain conservative and sound, they can fit a recurring revenue theme. We think some insurance companies also fit this theme especially when their business is specialized or niche in nature.

Today's post is written by my colleague and friend, John Moran. John joined us as a portfolio manager in January. As a fellow CFA, he brings considerable analytical skill to our firm. Previously with Cohen & Company, he was a portfolio manager and senior research analyst focused on financial services in an alternative asset platform. Between 2001 and 2006, he was employed by Ryan Beck and a predecessor firm (Gruntal & Co.) as an equity analyst in various sectors including financial institutions, consumer products, and healthcare.Before entering the investment industry, John worked for Lucent Technologies in real estate finance and at Chubb Corporation, a leading property and casualty insurance company, where he held various accounting and finance positions.

Here are John's thoughts regarding Fiserv (FISV), in our opinion, a strong moat company in financial services.

Intro.

Fiserv trades at 12.5x 2009 cash earnings and 8x EV/2009 EBITDA. This is a small price to pay for a business that should grow earnings in excess of 15% per year with several sustainable competitive advantages leading to a highly recurring revenue stream. Down nearly 15% since credit issues began to take a toll on its core customers in the financial industry, market price reflects a discount of 30% to the value of the business.

Business Description.

Fiserv Inc. (FISV) is a leading provider of IT services to U.S. banks, thrifts, and credit unions. The company also provides administrative support services and processing to the insurance industry. The business was repositioned late last year through the sale of selected nonbanking businesses and the $4.4 billion acquisition of CheckFree, the market leader in electronic billing and payment (EBP) market. Just over 80% of Fiserv’s 2008 sales will come from its main business of core processing and related products for financial institutions and CheckFree. The balance will be derived from the company’s insurance service segment, which provides policy, rating, and claims administration as well as billing and reinsurance services.

Core Processing.

Core processing is the nuts-and-bolts infrastructure that allows checks to be posted, payments to be tracked and processed, and accounts to be managed. The company’s products and services form the backbone of its client’s back-office systems and are critical to conducting business – they are not discretionary in nature. Moreover, changing core processing systems is costly and time consuming in implementation and employee training for customers. System changes also increase the risk of potential interruptions and service issues. Clients are therefore unlikely to leave due to a modestly cheaper or slightly superior product – once a contract has been added, the client relationship tends to be fairly sticky and pricing is reasonably inelastic. Longer-term contracts with early termination fees are the norm and renewal rates consistently run 90+%, leading to a revenue stream that is highly recurring and reasonably predictable.

The high switching costs for core processing, arguably the company’s best sustainable competitive advantage, is a double edged sword since the company’s competitors also benefit from installed bases. As such, Fiserv’s biggest challenge in this segment is generating organic sales growth. The company controls 34% of the core processing market, more than 2.5x its nearest competitor. Cost advantages from this scale position combined with a diverse and tightly integrated product set positions Fiserv better than many of its competitors to win new business. This is evidenced from the company’s 40% win rate on new core processing deals – exactly 2.5x greater than its nearest competitor according to the 2007 Automation in Banking report. Organic revenue growth has averaged just over 5% over the last five years and the business has generated operating margins near or above 20% on a consistent basis.

Consolidation among core processing companies has led to a concentration of larger players and several smaller competitors that are increasingly disadvantaged due to limited product sets and scale. The market is dominated by six major competitors with a combined 75% share down from 24 major companies in 1987 and 55% of the market is now controlled by the top three companies. While there are few compelling or willing acquisition candidates remaining, there are still some 15 independent processing companies with a little less than 25% market share – some are owned by their customers and some are small segments of larger companies. As industry dynamics continue to shift toward an oligopolistic structure, it seems highly likely that smaller competitors will either exit the business or lose clients to larger competitors due to service, product capabilities/breadth, pricing, or some combination thereof. Moreover, consolidating competition has intensified barriers to entry and should lead to higher marginal returns on incremental business for the companies that remain.

Electronic Billing and Payment (EBP)

Fiserv repositioned its business late last year and early this year by selling certain nonbanking businesses and acquiring CheckFree for $4.4 billion. The strategic rationale for moving away from businesses where the company lacks scale in nonbanking businesses (Fiserv Health, Investment Support, and two mortgage/lending services related businesses) and moving more aggressively into higher growth businesses where it does is compelling. The acquisition also reinforces Fiserv’s position as the leading provider of technology solutions for financial institutions and proceeds from the sales of other segments will be used to pay down debt.

CheckFree is the market leading electronic bill payment and Internet banking service provider and one of only three scale providers in a growing industry. The company was an early mover in the EBP market and has a 27% market share – more than 3.5x the share of its nearest competitor. Like the company’s competitive advantages in processing, CheckFree benefits from high switching costs and has a marked cost advantage due to scale economies of the EBP business. Also like FISV’s core processing business, more than 90% of revenues are recurring in nature.

Historically, Fiserv’s clients tended to be small and mid sized institutions that had limited internal technology groups and contracted for a fairly wide range of its services. While it maintained client relationships with larger institutions, the top 25 banks tended to buy only a handful of Fiserv’s services. With CheckFree, the company has increased exposure to larger bank clients and, as the CheckFree products are fully integrated with its existing offerings, FISV might have the opportunity to sell a broader range of existing services to larger institutions. These upstream sales opportunities are likely somewhat limited – besides which, incremental sales to top 25 banks would likely come with pricing concessions and increased customer concentration risk (pro forma for CheckFree, we estimate that Bank of America is the largest customer at somewhat under 5.5% of combined revenues). However, the company appears to have a tremendous opportunity to increase penetration of CheckFree’s bill payment and internet banking solutions within Fiserv’s core client base, where 52% of customers have yet to install an EBP solution and 25% use a competitive product.

Also, CheckFree has a reasonably long runway in the bill payment and internet banking space. Consider the following:

- Just over half of the 70 million U.S. households with access to internet banking are actually using it; customers appear to be fairly early in the adoption cycle.
- Of those 36 million households that use internet banking, only 13.4 million households (or just under 40%) currently pay bills online, suggesting that online bill payment is even earlier in the adoption cycle.
- The vast majority of those that have adopted online bill payment are served by the top 25 banks.
- CheckFree has historically grown revenue at 16% compound annual rate with high teen operating margins and 30% EBITDA margins.

Insurance.

The company’s insurance segment focuses on transaction processing and administrations services for the life, property and casualty, and workers’ compensation segments of the insurance industry. It is the largest third party administrator of flood insurance policies and claims in the U.S. and a leader in workers’ comp processing. Outside the flood insurance platform, the company’s competitive advantage in these businesses is somewhat limited as compared to the core processing and CheckFree businesses and competition is more intense. Organic revenue growth in the insurance segments had averaged well more than 5% with operating margins low teen operating margins until the last few years, when internal growth was 0% to slightly negative and operating margins for the business collapsed to a bit under 8%. The segment has faced headwinds as higher margin flood claims processing revenue decreased and lower margin workers’ compensation businesses increased. The 2007/2006 decline in flood claims processing revenues created comparability issues that should not be a factor this year.

Financials.

Full-year 2008 internal revenue growth is expected to be 5% to 7%, with the financial segment at the upper end of the range and the insurance segment at the lower end of the range. This is possibly conservative given that 25% of the financial segment will now be comprised of revenue from the faster growing CheckFree business. Moreover, downstream revenue synergies that could begin materializing in the back half of this year could increase the revenue growth rate.

Fiserv has completed nearly150 transactions since its inception in the mid 1980’s, with acquired companies historically operating their businesses more or less independently. CEO Jeff Yabuki, now entering his third year at the company, has focused more on centralization, cross selling, and operational efficiency. Last year that focus yielded $50 million in incremental operating income or about 130 bps of operating margin ($30 million from integrated sales and $20 million in operational efficiencies). The company has more opportunities in this area and potential cost saves from the CheckFree acquisition should accelerate operating margin improvement – management guides to savings of $100 million, about 24% of CheckFree’s existing cost structure, which strikes us as achievable by the middle of 2009. Moreover, the company will not be up against difficult comparisons in the insurance segment this year. All things considered, the 75 basis points in operating margin improvement that management is currently guiding to for this year appears reasonably easy to achieve and the company should be generating operating margins of about 20% by 2009.

Over the next two years, the company will generate in excess of $1.1b in free cash flow, with the majority being used to pay down debt. By the end of 2008, EBITDA should be at a run rate of $1.5+ billion and the earnings run rate should be in excess of $4/share. Returns on invested capital will be depressed for the next few years due to the increased debt taken on in conjunction with the CheckFree acquisition, but should ultimately revert back to historic low/mid teen levels, well in excess of the company’s cost of capital. Financial technology and outsourced processing businesses with sustainable competitive advantages have traded for between 9.5x-12x EBITDA (on an enterprise value basis) and between 15x-20x earnings – seemingly reasonable for FISV given the competitive landscape. On either basis, the current market price looks like it provides a comfortable discount to underlying value of a high quality business.

Disclaimer: I, my family, or clients have a current position in FISV and MSM.

Recurring Revenues and Industrials

2008-03-29T17:28:00.005-04:00

Economic uncertainty generally steers investors toward steady eddy businesses such as foods, consumer staples, healthcare and utilities. But what investors should be seeking is recurring revenues, predictable and stable revenues with a high degree of certainty.

Recurring revenues are highly desirable and frequently carry a higher level of margin than capital equipment businesses. Even industrial companies can demonstrate a high level of recurring revenue and a fairly low level of capital intensity, both very desirable qualities for these times.

Manufacturing in the States, largely as a function of the weak dollar continues to progress at a fairly decent pace, especially for export related manufacturing. But industrial distributors can benefit greatly from this strength as well. Uniquely, most distributors end up as significant beneficiaries of inflation on two fronts.

Unlike many manufacturers who largely pass on cost increases dollar for dollar, distributors typically have been able to pass on gross margins on top of cost increases, meaning that these companies don't lose their margin percentage. The second point related to inflation is that distributors can sometimes be fortunate enough to get ahead of the curve in dealing with higher costs. These companies can obtain a shorter-term benefit in terms of a one-quarter or longer pickup in their gross margins if lower cost inventory is sold at the higher price points.

I think one of the better opportunities in industrial distribution exists in MSC Industrial Direct, a company I recently reviewed in Marketthoughts.com

MSC Industrial (MSM) is one of the nation's leading industrial supply distributors. With a network of 4 regional Customer Fulfillment Centers and over 90 branches nationwide, the company assures its customers same day shipping, at no extra cost, with over 99.99% availability. The company truly recognizes the importance of satisfying its customers' needs. If they fail to meet the service deadline standard, they send their customer $100.

The company's history dates back to 1941 but became a more significant factor as a direct sales organization with the publication of its first catalog in 1964. In 1994, the company began to expand into maintenance, repair and operations (MRO) products, which provide a more stable demand stream of sales and cash flow for the business. In addition to its master catalogs, the company also publishes 123 specialty catalogs tailored to specific industries or products.

The vp-finance of MSM described in the Wall Street Transcript (TWST.com-subscription required) a couple of years ago the steady demand for this business:

"...we have the ability to reduce the total procurement cost of MRO (maintenance, repair and operating) supplies for our customers. Every business uses MRO. It encompasses everything from abrasives and cutting tools and measuring instruments to lubricants, sanitary supplies, cleaning supplies, chemicals, solvents, hand tools, power tools, hardware, electrical supplies, plumbing supplies, HVAC and more; essentially, if you can think of an MRO item, it's likely that we have it in our catalog."

This is a highly fragmented industry. Again from the interview:

"Why do we grow and why have we grown so fast? Well, the industry that we compete in, the one for industrial supplies, is very, very fragmented. The total MRO marketplace in the United States alone is approximately $300 billion. If you exclude the demand from original equipment manufacturing, you probably have a $150 billion marketplace. that $150 billion represents what we call semi-planned and unplanned needs. Unplanned needs are pretty much self- explanatory ' something breaks and you need to replace it. So you call a distributor and they have the part and you get it. Semi-planned are those things you know you are going to use up over time; you just don't know when you are going to need it and how much you are going to need. Generally, these are things that people stock in tool cribs or in supply
rooms and historically they keep large inventories of these items just in case they need them. They are not things you want to be out of, because you can shut down a machine or a line or an entire factory. I mentioned the industry is very fragmented. There are approximately 150,000 distributors that share the $150 billion marketplace and they employ a sales force somewhere in the neighborhood of half a million sales people. Most of those distributors are very small and have very few SKUs (stock keeping units) on hand. And they generally are niche players. So they may be a safety distributor or an electrical distributor. These people play in a very small marketplace and historically, since MRO in any one particular business has not been paid a lot of attention, people are doing a lot of manual sourcing of MRO
supplies and dealing with a lot of different distributors. MSC is a superior business model because we have 590,000 SKUs in stock compared to the 15,000 or so a small distributor stocks. this allows an individual or a business or an educational institution or a government agency to consolidate their buying to one very reliable vendor that has it in stock and can get it to them quickly. "

The company has a particular competitive advantage in its extensive e-commerce abilities that enable customers to lower their procurement costs. This includes many features such as swift search and transaction abilities, access to real-time inventory, customer specific pricing, workflow management tools, customized reporting and other features. The systems can also interface directly with many purchasing portals such as ARIBA and Perfect Commerce, in addition to Enterprise Resource Planning (ERP) Procurement Solutions such as Oracle, SAP and Infor. Consequently, the firm offers its customers inventory management solutions that reduce sourcing costs, out of stock situations, and inventory investment, all of which become even more important when business slows.

MSM's valuation has contracted significantly of late; likely discounting further manufacturing and economic weakness, yet investors may be ignoring the potential benefits from share gain trends. On a trailing P/E basis, the company is as cheap as it has been in the last decade:

1998....32.8 X
1999....18.4
2000....23.2
2001....34.0
2002....34.8
2003....35.7
2004....30.8
2005....25.0
2006....18.4
2007....15.6
TTM.....15.4

The company is currently trading at an EV/EBITDA of about 8 times despite earning 20% return on invested capital last year. In the last five years, ROIC has averaged better than 15%. Here's a look at the ratio analysis courtesy of tenkwizard.com

Google Docs - msm ratios-marketthoughts

Check out the relatively low level of capital intensity that this company has demonstrated over time. The company has generated over $700 million in cash flow from operations since 2000 and has spent only $128 million in capex over that period. As well, the company has treated shareholders as partners. Share buybacks have returned over $280 million to shareholders. Here is a look at the deployment of cash flow and returns to shareholders since 2000 courtesy of Reuters Knowledge:

http://tinyurl.com/yvfvv2

Dividends, which were instituted in 2004, have grown steadily from an initial rate of $0.32 per share annually to a current annual pace of $0.72 and have returned $231 million to shareholders. The current yield is about 1.9%.

In January, the company announced that it has authorized an increase in its stock repurchase plan to 7.0 million shares, which includes the approximately 1.9 million shares remaining under the previous authorization.

The company has shown steady improvement in working capital utilization and currently operates on a cash cycle of 98 days versus 113 days three years ago.

Effective voting control of the firm is held by the founder and his sister who cumulatively hold 63% of the vote. Lone Pine Capital, run by Steve Mandel, a well-known hedge fund manager holds about 7.9% of the company.

Overall, this is a high ROIC business with a reasonably steady growth in recurring revenues. It is a business that seems to becoming more important to its customers and is grabbing market share in a very fragmented industry of mom and pop shops. Its competitive advantages come from scale and technological prowess as well as logistics. Some slowdown will occur in economic times such as we have but the valuation appears to compensate adequately.

Disclaimer: I, my family, or fclients have a current position in MSC.

A Lemons Market- Information Asymmetry and Bear Stearns

2008-03-14T15:42:00.002-04:00

Asymmetric information gets to the root of today's market problem in Bear Stearns. George Akerlof, Michael Spence, and Joseph Stiglitz won the 2001 Nobel Prize in Economics for their work in this area.

Akerlof, who wrote the earliest paper in this area, "The Market for Lemons: Quality Uncertainty and the Market Mechanism" describes the market for used cars as a market that is distorted by quality uncertainty. Owners of decent used cars are unable to get a "decent" price to make selling these cars worthwhile, therefore they don't place these cars in the market. Because "quality" is not readily ascertainable, the quality of traded automobiles should be sub-average.

A lemon market will be produced by the following:

1. Asymmetry of information
- no buyers can accurately assess the value of a product through examination before sale is made
- all sellers can more accurately assess the value of a product prior to sale
2. An incentive exists for the seller to pass off a low quality product as a higher quality one
3. Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)
4. Deficiency of effective public quality assurances (by reputation or regulation)
5. Deficiency of effective guarantees / warranties

The market in financial services stocks has become a lemons market. Questions about asset value prevail, liquidity concerns arise, and the true condition of the assets is enigmatic. Despite 225 basis points of Fed Funds rates and co-ordinated central bank liquidity, and a broad Term Security Lending Facility, the impact on market sentiment and credit spreads has been negligible.

There is but one solution to the problem... transparency and disclosure, being more open in what is going on and why. The mystery that surrounds the arrangement between JP Morgan and Bear Stearns contaminates the rumor mill and raises investors' concerns.

Bear Stearns may have $84 in book value which certainly gets the Ben Graham instincts going, but the reality is much more uncertain. Valuation in a financial services stock is wholly dependent on future cash flow streams. There is precious little in tangible assets. There is huge uncertainty about valuation of assets comprised of pyramids of paper assets. Given the uncertainty, Bear Stearns' counterparty ratings are clipped and may be viewed by some as almost toxic.

I cannot imagine how difficult it is for BSC employees as they watch their franchise quake in the crisis. We have friends and associates who either work there or have spent part of their careers there. My thoughts are with you.

But in the grand scheme of things, the market will survive this much as it has prior brokerage and banking crises. Great names like Drexel, LF Rothschild, Robertson Stephens, Gruntal, Hutton, and Continental Illinois are no longer part of today's world, having blown up.

Great investors understand the businesses in which they invest and ignore the noise. Focus, do your own work, and understand what it is you own. Emphasize the underlying economics of what you own and avoid the expensive distractions of today's tape.

Disclaimer: I. my family, or clients do not have a position in any of the securities mentioned in this post.

Beliefs, Perceptions and Reality-Semiconductor Capital Equipment

2008-03-12T14:20:00.003-04:00

Growth has a seductive charm. There is a widespread belief that momentum drives growth and that a succession of knocking down challenges and consequent victories is what characterizes a successful business. But sustained growth is seldom straightforward. Sustained growth frequently occurs as a result of changing course, breaking rules, and changing the rules of the game. I think some of the rules have changed for the semiconductor capital equipment companies.

Years ago, within the semiconductor industry, there was a strategy that merging companies would result in a reduction in the historic overcapacity issue. This trend certainly developed as Texas Instruments sold its DRAM capability to Micron and Hyundai and LG merged their operations. Small players would be wiped out or have to find niches to survive.

Last month, the Semiconductor Industry Association (SIA) reported that global sales of semiconductors grew last year by 3.2%. It really is an amazing figure given the fact that cell phone unit shipments grew 20%, that laptops grew 32.2%, that LCD TVs grew 50%, and consumer appetite for electronics seems unabated globally.

Total bit shipments for DRAMs nearly doubled in 2007, but total revenues declined by 7.4 percent due to a decline of more than 39 percent in ASPs. NAND flash revenues were up 26 percent but unit shipments grew even faster at nearly 46 percent, while ASPs declined by 13.7 percent.

Increased concentration in the industry simply has fanned the flames of competition and price cutting rather than quell them. To quote Steve Pelayo of HSBC who recently was interviewed in The Wall Street Transcript (subscription required):

"DRAM manufacturing has been in a state of oversupply, which resulted in greater than 75% average selling price (ASP) declines last year. As a result of the significant ASP pressure, many DRAM players today are now reporting operating margins that are significantly in the red, as much as negative 50% operating margins. So clearly too much excess supply in DRAMs and a lack of profitability is causing a massive contraction in their capital spending plans this year."

Post tech bubble, semiconductor capital spending did a face plant, down 40% in 2001 and another 30% in 2002. The equipment companies responded by diversifying their revenue sources into other segments such as solar equipment and flat panel displays. In past cycles, whenever semiconductor demand slowed or caught a sniffle, pneumonia ensued for their capital equipment suppliers. This time may be different!

Growth has slowed but in fact these businesses have improved. Let's look at the capital intensity of some of the semiconductor companies versus that of their equipment suppliers:

Capital spending as a percentage of revenues (TTM)

Micron (MU) 59.3 %
Intel (INTC) 11.25 %
Advanced Micro (AMD) 24.75 %

Applied Materials(AMAT) 5.08 %
ASML Holding (ASML) 7.46 %
KLA-Tencor (KLAC) 5.09 %
Novellus (NVLS) 2.12 %

With this lower fixed cost intensity, equipment companies should not see their margins crater and improved what Pelayo calls their "cyclical resiliency."

All of the semiconductor capital equipment companies I have cited above generated free cash flow in the last twelve months. Pelayo adds:

"The cash flow generation capabilities have proven much more improved too, with some consistently generating 20% plus returns on operating cash flow, and in some cases similar returns even on a free cash flow basis (including cash outlays for capital spending). All of this positive cash flow just continues to add to the companies' treasure chests of cash, which has resulted in many of the larger players starting to pay dividends and buy back stock. The dividend yields are still less than 2% or so, but I think they have the opportunity to increase over time. So far, equipment suppliers have been really focused on buying back their stocks. Companies like Applied Materials have bought back a tremendous amount and decreased their shares outstanding by as much as 15% or so."

The solar opportunity for these suppliers seems to receive very little attention by investors. Solar manufacturing has many similarities to semiconductor production and presumably, can provide significant fewer growth for these companies. As I suggest earlier, getting knocked down, getting beaten up by too high a reliance on traditional customers helped the semiconductor capital equipment companies approach other niches. Changing course and changing the rules of the game has made them better businesses.

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

Renaissance and Revival

2008-03-08T21:19:00.002-05:00

It has been an extraordinarily long time since I last published thoughts here for which I truly apologize. Needless to say, capital markets have been challenging and clients prefer a higher level of care and attention when markets are rocky. Businesses evolve through these challenges and create opportunities to add skillsets and analytics and establish an even firmer foundation and discipline. Renaissance and revival are frequently the result of such times.

I particularly want to thank a fellow Canadian, Jay Walker, the Confused Capitalist for his gentle cajoling me back into the blogosphere. Jay has just celebrated the second anniversary of the start of his excellent blog and I congratulate him for his terrific work. His understanding of real estate appraisal and investments make his blog a valuable resource in these times.

One especially interesting e-mail from an anonymous reader suggested that I am Geoff Gannon of Gannon on Investing whose publishing frequency has also been impacted by other projects. I am not, nor is he. Geoff, your insightful commentary and wisdom are missed.

A few other friends that I wish to thank for their help and indulgence in this period of absence. Henry To at Marketthoughts.com continues to provide investors valuable reflections on the stock market and the global economy as well as an outstanding forum. I am pleased to be a monthly contributor to his service. David Korn, who with Henry and Kirk Lindstrom publish the Retirement Advisor, a timely resource for people who are either approaching or in retirement has also been kind enough to publish some of my thoughts in his website, BeginInvesting.com.

To my loyal readers, I appreciate your patience, your readership, and in particular the continued interest in past topics and posts. I endeavor to improve the frequency in sharing our thoughts.

Back to stocks. Many years ago, I was introduced to Alleghany Corp (Y) by a lucky accident. I had previously worked for the Canadian subsidiary of Lincoln National (LNC) which had just sold off its title insurance subsidiary, Chicago Title to Alleghany at what appeared, at least to me, to be a bargain price. Housing back in the early to mid- 80's was reviled as much as it is currently, in fact, in our mortgage department, we were recipients of people's keys that were being mailed in as people were giving up their homes. Title insurance was considered a terrible red-haired step child at the parent company with little chance of earning a return. John Burns, then the CEO of Alleghany saw opportunity in this distress sale. The payback on this investment was 18 months, absolutely remarkable for what was viewed as a no-growth business. Needless to say, I became a big fan of Burns and of Alleghany. Chicago Title was ultimately spun-off to shareholders and later became part of Fidelity National (FNF).

Visiting Burns at Alleghany over the years reinforced the value discipline that this remarkable gentleman has. He is an avid student of value investing and of course Buffett. His attention to detail, his keen awareness of valuation,and his knowledge of the insurance industry were always very impressive.

Many of us value hounds collect stories of Berkshire, White Mountains (WTM), Leucadia (LUK), and Markel (MKL), yet too infrequently is Alleghany mentioned. The objective of the firm sounds very Buffett-like:

"Alleghany's objective is to create stockholder value through the ownership and management of a small group of operating businesses and investments, anchored by a core position in property and casualty insurance. Alleghany is managed by a select company staff which seeks out attractive investment opportunities, delegates responsibilities to competent and motivated managers, defines risk parameters, sets management goals for its operating businesses, ensures that managers are provided with incentives to meet these goals, and monitors their progress.The operating businesses function in an entrepreneurial climate as quasi-autonomous enterprises.Conservatism dominates Alleghany's management philosophy. Alleghany's philosophy shuns investment fads and fashions in favor of acquiring relatively few interests in basic financial and industrial enterprises that offer the potential to deliver long-term value to the investor."

Alleghany has brought some very unique insurance businesses into the fold. Capital Transamerica of Madison, WI was an insurance company with a magnificent underwriting record in specialty lines and a history of shareholders equity growth that George Fait, its founder and president would remind me at insurance conferences actually outgrew Berkshire's record. It was true!

Another successful specialty insurance franchise was acquired with RSUI, Royal Specialty Underwriting, Inc. , the Atlanta, Georgia-based excess and surplus underwriting subsidiary of Royal & Sun Alliance Insurance Group plc.

Alleghany holds a majority ownership in Darwin Professional Underwriters (DR) a company tightly focused on Directors and Officers, and Errors and Omissions insurance. Stephen Sills, the founder and CEO of DR, was the chief underwriter and founder and ultimately the CEO of Executive Risk, a very highly regarded company in this field. Executive Risk eventually went public. Chubb (CB) acquired this business in 1999 at a very full price. Alleghany, on the other hand, established Darwin with Sills in 2003 as an 80/20 venture as an underwriting manager under Capital Transamerica, as usual, avoiding paying a huge acquisition premium.

Years before Berkshire bought its position in Burlington Northern Santa Fe (BNI), John Burns had accumulated a large position in the 1990's. The cost basis, about $12.07 versus today's $88.00.

Strong executive leadership continues to impress since Burns' retirement (he remains Chairman.) Wes Hicks has extensive experience as a senior executive, capital manager and research analyst in the insurance and investment industries. He joined Alleghany from Chubb Corporation, where he was CFO. Prior to Chubb, he was a senior research analyst covering the property-casualty and multiline insurance industries at J.P. Morgan Securities (where he was also a managing director) for two years and Sanford C. Bernstein & Co., Inc for eight years.

Going through the recent 10-K, results remain quite strong. Ex cats and cap gains they earned $30.29 in 2007 vs. $28.20 in 2006. Cash and invested assets are $4.9b and the company's book value grew by almost 16% yoy. All the insurance subs wrote at an underwriting profit for the Q except CATA, which was due to higher loss and loss adjustments (but was offset somewhat by higher net premium). Overall they did a very respectable 77% combined ratio.

Trading at about 1.1x book value, the company appears very well capitalized if not over-capitalized. RSUI’s (66% of underwriting profit) most admired peers (MKL, RLI, and CGI) command multiples of book value between 1.5x and 1.8x – CGI is the object of $2.3b takeout at 1.6x – and a well run, growing, profitable insurance company should go for more than 1.1x. In addition, the firm carries the Darwin (DR) stake and real estate owned in the Sacramento, CA area at below-market historic price, providing hidden asset value and additional upside to book value. This hidden asset value may in fact equate to the stock trading at book.

In my estimation, the fair value for this business is $425-$475. The potent combination of multiple expansion and book value growth as well as outstanding investment ability could prove very profitable over the coming years. The company also recognizes its value and has recently announced a $300 million share buyback.

One negative aside. Standard & Poor's downgraded slightly Alleghany's credit rating to BBB from BBB+, in my view casting more doubt on S&P's credit ranking abilities than on Alleghany's credit. The slight downgrade was done without any discussion with Alleghany executives perhaps leading some of us to question the degree of due diligence that may have been demonstrated here. Wes Hicks also expressed some surprise and disappointment in this.

In my view, among the financial services stocks, the company stands out for its conservatism, its strong underwriting discipline, and its great executive team which has masterfully allocated capital over the years.

Disclaimer: I, my family, or clients hold a position in Alleghany, Berkshire, and Markel.

Happy Thanksgiving!!

2007-11-22T10:00:00.001-05:00

Happy Thanksgiving wishes to our American readers! Certainly, no matter what the circumstances that life may bring you, there is always much for which to be thankful.

It has been said that the hardest arithmetic to master is that which enables us to count our blessings. Albert Schweitzer described the importance of gratitude,

" To educate yourself for the feeling of gratitude means to take nothing for granted, but to always seek out and value the kind that will stand behind the action. Nothing that is done for you is a matter of course. Everything originates in a will for the good, which is directed at you. Train yourself never to put off the word or action for the expression of gratitude."

America's National Day of Thanksgiving actually was proclaimed by President Lincoln in October of 1863 which set apart the last Thursday of November "as a day of Thanksgiving and Praise." The nation was still in the midst of civil war and the battle of Gettysburg had occurred just several months prior. Lincoln had not yet delivered his Gettysburg address.

Despite the horrible anguish of war, Lincoln delivered the following proclamation:

"The year that is drawing towards its close, has been filled with the blessings of fruitful fields and healthful skies. To these bounties, which are so constantly enjoyed that we are prone to forget the source from which they come, others have been added, which are of so extraordinary a nature, that they cannot fail to penetrate and soften even the heart which is habitually insensible to the ever watchful providence of Almighty God"...

"It has seemed to me fit and proper that they should be solemnly, reverently and gratefully acknowledged as with one heart and one voice by the whole American People. I do therefore invite my fellow citizens in every part of the United States, and also those who are at sea and those who are sojourning in foreign lands, to set apart and observe the last Thursday of November next, as a day of Thanksgiving and Praise to our beneficent Father who dwelleth in the Heavens. And I recommend to them that while offering up the ascriptions justly due to Him for such singular deliverances and blessings, they do also, with humble penitence for our national perverseness and disobedience, commend to His tender care all those who have become widows, orphans, mourners or sufferers in the lamentable civil strife in which we are unavoidably engaged, and fervently implore the interposition of the Almighty Hand to heal the wounds of the nation and to restore it as soon as may be consistent with the Divine purposes to the full enjoyment of peace, harmony, tranquility and Union."

Though war rages in many parts of the world, though terrorism remains an ever-present concern to all of us, though there remains "lamentable civil strife" in many nations, the magnificent words of Lincoln ring true today.

My Thanksgiving wishes for all of us include for you and yours the full enjoyment of peace, harmony and tranquility.We have much for which to be grateful and thankful. I count your loyal readership among my blessings! Have a good one!

Fear Brings Opportunity and Digging for Value

2007-11-14T09:01:00.001-05:00

Whitney Tilson is the founder and Managing Partner of T2 Partners, a hedge fund, as well as a mutual fund operation. He has co-founded a terrific newletter and established a semi-annual investment conference, Value Investing Congress, where he features a number of legendary investors. As an extension of the conference, he has introduced a new blog to highlight value investment thinking. One of the recent posts is, in my opinion, quite demonstrative of the "inverse emotionalism" that is required to be a successful value investor.

Zeke Ashton of Centaur Capital describes the fear that has infected financial services stocks very aptly:

"Clearly, we’ve got fear now, and at the epicenter of that fear is the U.S. real estate market. This fear is reflected in extraordinary volatility and stock price declines for those companies seen most vulnerable to the real estate bust – most notably homebuilders, mortgage lenders, and mortgage guarantors – coupled with all-time high prices for disaster protection on these names."

If there is a single mantra for value investors, Ashton nails it here:

"But as all value investors know, fear brings opportunity. One of the axioms of fear-based selling is that everything viewed as being in proximity to the danger gets sold."

Indeed, fear brings opportunity, and panic is never discriminating. Damage occurs at the periphery of the disaster and securities are unjustly marked down. True value investors sift through the rubble to unearth the bargains that were caught in the cross-fire. Timing is impossible, but strict adherence to a discipline and patience will provide great long-term returns. In a behavioral sense, it is always difficult to overcome the social pressure to conform. Being ostracized by others (especially clients who don't yet "get it") is a difficult position to maintain. No wonder closet-indexing is so prevalent; closet indexers turn out to be momentum players, just like the indices they hug! But, doing your own thing, ignoring the noise, celebrating the fear of others is a good high probability bet if your decisions are disciplined.

Here is the direct link.

Where Have All the Deals Gone? and Star Wars Thinking

2007-11-09T16:46:00.001-05:00

There is an interesting dichotomy that exists in capital markets. Not so many months ago, pre-August, there was a widespread perception that we were running out of stocks. Private equity interests were gobbling up anything that had a reasonably steady cash flow. Such companies were easily leveraged by the accommodating banks and investment bankers. Needless to say, the music stopped in the takeover waltz (as all of us can see, Chuck Prince has stopped dancing) In one of the more memorable and now infamous quotes that have come out of this capital market era, Chuck told the FT:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Despite the fact that liquidity had a major hiccup, and deal cancellations have been fairly rampant, U.S. private equity firms are still dancing. They have bested last year's record of $258 billion and have passed the $263 billion mark with a month and a half to spare, according to Dow Jones' Private Equity Analyst.The majority of the capital, just over $200 billion has gone to leveraged buyout shops.

I think this is an important factor to bear in mind. Certainly, every time markets go sour, similar behavior occurs. Fear leads us to truncate our investment horizons, long-term growth is set aside, growth forecasts are reduced, earnings multiples are brought down, required rates of return are brought up. Prices collapse.

But what is different this time is that there is more private equity firepower than ever that is ostensibly on the sidelines for now. Buyouts will continue to occur but will require greater equity funding and less leverage. Returns on equity driven by leverage may well be less than historical returns but perhaps prices to effect a takeover may well be less demanding.

The world has changed as financial institutions are taking hits from CDOs. But it ain't entirely over. At The Deal's M&A conference this week, Leon Black observed, "there's no question that this summer the world changed for private equity" as the credit markets that allowed "private equity to go from being 3% of the M&A market to 35% in 2007 shut down for doing highly leveraged deals." "The ability of private equity and acquisitive strategic buyers to innovate in terms of financing is almost unlimited."

One other observation re innovation in capital markets. Equity capital markets issuance globally totaled $445 billion over the first six months of 2007 on 3,000 deals, the highest dollar volume since the record set in 2000. As some of you may recall, this wasn't exactly a precursor for positive markets for the next two years. Much of the capital raise has occurred in Asia and emerging markets. In the third quarter, a total of 248 IPOs raised $46.8 billion world-wide in the quarter, up from 179 that raised $40.71 billion in the same period last year.

But outside of public equity lives the PIPE market, private investment in public equity, a market that has historically been viewed as a last-ditch source of financing. Historically, small cash-starved tech or healthcare companies that couldn't secure more conventional debt financing utilized this market. According to financial research company Sagient Research Systems, the PIPE market hit historic highs in the third quarter of 2007, with $38.8 billion, or 996 transactions, 33% greater than the volume of PIPE transactions through the same period in 2006.

Private placements such as PIPEs can be done at lower cost than traditional equity deals. Because such deals are sold to accredited or institutional investors, the securities do not require registration with the SEC. Consequently, a great deal of time and expense can be saved. As banks try to value their existing loan and structured portfolios, PIPEs are finding a way to infuse capital into deals.

Credit problems remain a thorny issue for capital markets. But market innovations are more available than ever. Nasty markets will put prices into the gun sights of some of these participants. Prices can be silly and exaggerated at either end of the spectrum, both way too expensive and way too cheap. Technicians may worry about falling knives but decent businesses that have been hacked by fearful sellers may create great buying opportunities.

Consider yesterday's Restoration Hardware news. A private equity company is doing a buyout at 2.5 times Wednesday's price! Though this business has struggled in the retailing slump, obviously there still appears to be some franchise value that many investors missed.

As an investor, don't rely on the short-term trends in a stock to tell you what it is worth. Earnings surprises, earnings revisions represent noise. We cannot guess the unknowable future. We are far better equipped to understand the present and what it means for the future. Use market weakness to rethink your analysis. But analyze rather than rationalize...hang onto your companies that have enduring competitive advantage and great returns on invested capital. Stick with ROIC and dismiss growth for now. A high return on invested capital is the signpost of a great franchise. Ensure that cash flow generation is there, don't rely on earnings and especially earnings forecasts.

Remember that an equity represents a long-term claim on assets. Yet most analysts base their opinion on next year's or maybe two years of forecasts.
That's not how anyone should value a stock.

There is a great line from Obi Kenobi in Star Wars that comes to mind, "Who is more foolish? The fool or the fool who follows him?"

Stay calm, relaxed and aware. There's lots of fat pitches coming our way.

Disclaimer: I, my family, and friends do not have a current position in any securities mentioned in this post.

IT Services and Technology

2007-11-08T16:58:00.001-05:00

Cisco Systems (CSCO)'s results of last night have cratered a lot of tech stocks today, particularly hardware. IBM. EMC, Network Appliance (NTAP) have all had a good drubbing in today's marketplace.

Though the sector has exhibited standout performance relative to most other sectors, notably the ailing banks, there are concerns that the impact of credit markets may lead to a decrease in orders for both tech goods and services.

One of the tech sectors that makes the most sense to me under most economic scenarios is IT Services. The notion of consultative help rather than having permanent staff is attractive in any slowdown scenario.

Cognizant (CTSH) was clipped today on mixed fourth quarter guidance. Cognizant, as well as other Indian IT services providers enjoy an attractive cost advantage that could benefit from additional demand from an economic slowdown. Cognizant is known for its high quality consultative approach. What seems to concern investors about the outlook is commentary from CTSH that it was not seeing a fourth quarter "budget flush." As most of us have experienced, managers have a tendency to spend out whatever remains in their current year budget to ensure that this becomes the base for next year's budget. The flushing through of budgets does not appear to be occurring for CTSH. I believe that one area of particular concern for IT providers is the spending plans of financial services companies.

Concerns about financial services reducing demand for IT may be somewhat misguided in my opinion. Cognizant cited a survey to assess clients' budget plans for 2008 involving about 150 decision makers representing a broad cross section of clients. According to management, 92% of clients do not expect overall IT budgets to decline for 2008. . Clients were also asked what would occur to offshoring budgets in the event of a decline in overall IT budgets. Only 19% felt that an overall budget reduction would meaningfully impact offshore spending plans. Among financial services customers, about 90% do NOT expect outsourcing budgets to decline.

Valuations in the sector are all over the map. CTSH has TTM EPS of $1.13 , equal to its operating cash flow per share. Free cash flow is $0.56 per share.At a 1.8% FCF yield currently, it does not represent a bargain.

On the other hand, Accenture (ACN) has trailing EPS of $2.06, operating cash flow of $2.67, and free cash flow of $2.58. Based on today's close, that's a free cash flow yield of 7.3%! I like the high conversion of operating cash flow into free cash flow. Just over 10% of each dollar of revenue for ACN is free cash flow, slightly higher than CTSH's 8.6%.

Both companies have active buyback programs with CTSH just announcing a $100 million buyback. Last fiscal year, ACN bought back a total of $2.3 billion in stock. There remains an authorization for $1.65 billion.

About 22% of ACN revenues came from financial services in the most recent fiscal year. About 57% of ACN's revenues come from outside the Americas. On the other hand CTSH, unique among Indian IT outsourcers generates some 80% of its revenues from the States. Its reliance on the financial services sector is also somewhat heavier at about 47% for FY 2006 and the most recent quarter.

In my view, Accenture with a market cap of $27 billion, only about $760 million in debt, and cash of $3.5 billion represents excellent value. Its enterprise value to TTM EBITDA is only 8.4 times.

Disclaimer: I, my family, or clients own a current position in ACN. None have a current position in CTSH.

Some Thoughts on Formulaic Investing

2007-11-05T13:49:00.001-05:00

As some of you know, I am an occasional contributor to Shai Dardashti's "Reflections on Value Investing." I think you will be impressed with the quality of serious contributors to the investment thinking that characterizes this blog. I commend it to your attention.

In today's edition, I discuss formulaic investing based on an article written some time ago by my friend Geoff Gannon.

Formulaic investing provides an important discipline to the investing process. It attempts to disengage us from the emotions that are so frequently associated with future poor results. Though not a substitute for thinking about other parts of the mosaic that comprise every investment, formulaic approaches form a very important backdrop to valuing a business. Necessarily, they are backward looking...valuations that depend entirely on formulaic approaches are extrapolating the past into the hereafter, not a sensible approach to looking at a business. After all, a stock's value consists of some sort of discounted value of all future cash flows. The past is, well it's passed. In immutable businesses, of which there are none, the thinking could end there. Remember the Buffett aphorism "The investor of today does not profit from yesterday's growth." Another one comes to mind, " If past history was all there was to the game, the richest people would be librarians." But as a starting point to the question, "What is this business worth?" formulas represent a useful benchmark for the economic reality of a business. Where it goes from here, what competitive influences will do, how it finances itself, how long the competitive advantage period will last are all unaddressed questions that are the add-ons that are needed to fully understand a business.

I apologize for my long absence from the blogosphere. Work expands, time contracts. Market opportunities are expanding with the crescendo of fear. Within portfolios, I continue to uphold the cornerstone of a value investment style, lethargy bordering on sloth.I appreciate your patience!

Don't Blame the Cow- Blame the Cowboy

2007-10-01T23:24:00.001-04:00

Interesting goings on in the financials. UBS got the ball rolling (and a few heads) with the announcement of a write down of SFr 4 billion resulting in a forthcoming loss for the third quarter. Credit Suisse (CS) also taking its truth serum, announced up to SFr 800 million in write-downs but its third quarter will still be showing black ink.

Getting rid of the uncertainty by taking the "big bath" write-off is a cleansing experience, an expurgation of evil, and as market reaction demonstrated, investors welcomed the action.

Citigroup (C) also assesses its credit woes, subprime writeoffs, and consumer linked weakness and announces its $5.9 billion loss but a return to normalcy for the fourth quarter.

Is business truly back to normal or do investors sense the demise of Charles Prince? Has the bleeding actually stopped or is there anticipation of a typical Citi night of the long knives being heralded?

The restructuring announced at the beginning of the year needs to take hold for Mr. Prince to survive. Since the first quarter of 2006, operating results have been frustrating to investors as operating leverage has been negative for every quarter with the exception of the second quarter of this year. Clearly, there is no positive news forthcoming re operating leverage in the third quarter. The "dislocations in the mortgage-backed-securities and credit markets, and deterioration in the consumer-credit environment" are ubiquitous to a degree. With a bank like Citi that covers the "field" as broadly as anyone, it is difficult not to step in a "cowpie." But investors are growing tired of management's inability to navigate the field. Rather than blame the cow, it's getting to be time to blame the cowboy.

It should not go unnoticed, but on Friday, the US suffered its biggest bank failure since 1993. NetBank, a $2.5 billion in assets bank went down the pipe and into the hands of the Office of Thrift Supervision (OTS) who immediately named the FDIC as receiver. NetBank's insured deposits ($100,000 limit, $250,000 for IRAs) were snapped up by another Internet based bank, ING. A reminder that uninsured deposits were not acquired. Customers with uninsured deposits will get 50 cents on the dollar now for uninsured balances. They get to stand in line with other creditors for the other half.

The news release from the OTS spelled out the reasons for failure. "NetBank sustained significant losses in 2006 primarily due to early payment defaults on loans sold, weak underwriting, poor documentation, a lack of proper controls, and failed business strategies." The OTS failed to mention a series of ill-conceived acquisitions and diversification efforts. Trying to manage too many businesses while failing to manage the balance sheet was a prescription for disaster.

Bank investment at times seems carefree and simple. Bank consolidations occur with some regularity and banking essentially is a hedge fund business, controlling a large amount of assets with a sliver of equity, all under the imprimatur of FDIC guarantees. Equity investors generally understand the repercussions of leverage, but depositors sometimes forget.

There is no reason for anyone to have greater than $100,000 exposed in a single bank. Be aware of your bank's balance sheet, its ratings, and its earnings.

Disclaimer: I, my family, or clients have a current position in Citigroup and Credit Suisse. None have a position in any of the other securities mentioned in this post.

The Sub-Prime Crisis and the Hedge Fund Collapse

2007-09-29T20:40:00.001-04:00

Here as we approach the 20th anniversary of the crash of October 19th, 1987, the academic world is starting to read the entrails of the hedge fund crash of 2007 as it relates to the sub-prime crisis.

In August, the financial world trembled as hedge funds involved in CDO's, most notably two funds of Bear Stearns, collapsed. Even this week, news of potential equity investments by Buffett or perhaps others have led to speculation in Bear Stearns stock (BSC).

What is sometimes missed is how verklempt the financial world got in August. A wave of deleveraging of hedge funds ensued which resulted in some very strange occurrences, namely cheap stocks, or value stocks, got pummeled, and expensive stocks, or popularly shorted stocks, rose. This caused a lot of pain on the street, especially among quantitative hedge funds, or quants.

In an academic article "What Happened to the Quants in August 2007?" by Andrew Lo, an MIT prof and a quant hedge fund manager, as well as a letter to clients by Cliff Asness, another well-respected hedgie, the conclusions are pretty much the same:

Here is a quote from Lo in an article in the International Herald Tribune: "Now that we have so many boats in the harbor, you can't whiz by at 50 knots without rocking a few boats." He is referring to the proliferation of hedge funds in equity neutral or long/short equity which ten years ago totaled about $10 billion. Today, that's a $160 billion figure. "In the middle of the ocean, your wake has no impact, but in a crowded harbor, a fast exit can cause quite a disruption."

Asness describes a similar viewpoint, "I have said before that 'there is a new risk factor in our world,' but it would have been more accurate if I had said 'there is a new risk factor in our world and it is us.' In his view, the gulf between cheap versus expensive got way too narrow in August, but has now become wide again. The problem was that too many boats were heading for the same exit.

The most highly shorted stocks showed a big uptick in trading volume. Worse yet, they beat the least shorted stocks by about twelve percentage points through the middle of August.

In Lo's paper he suggests that:

"The losses to quant funds during the second week of August 2007 were initiated by the temporary price impact resulting from a large and rapid unwinding" of one or more quantitative equity market-neutral portfolios. The speed and magnitude of the price impact suggests that the unwind was likely the result of a sudden liquidation of a multi-strategy fund or proprietary-trading desk, perhaps in response to margin calls from a deteriorating credit portfolio, a decision to cut risk in light of current market conditions, or a discrete change in business lines."

Forced mysterious liquidation is very reminiscent of those days in October of 1987, a reminder that an outbreak of fear and panic can occur at any time. Heightened risk sensitivity can often mask opportunity.

Is Government Involvement in Energy Worth the Investment Risk?

2007-09-29T17:15:00.001-04:00

Interesting how badly politicians can screw up supply-demand imbalances. As a Canadian who endured Canada's National Energy Policy of the early 1980's, it worries me to see the proposed royalty changes that the Alberta government panel has recommended. Our American friends who endured last year's Hallowe'en surprise are swearing to me (both in an affirmation sense as well as a profane sense) that they have had it with Canadian energy policy. Its not just individual investors who are incensed.

EnCana Corporation,(ECA) the Calgary based natural gas and oil sands producer was quoted yesterday as saying that if the panel's recommendations for draconian increases in royalties are implemented:

"EnCana plans to cut its 2008 capital investment in Alberta by about C$1 billion, or 30% to 40% of the C$2.5 billion to C$3 billion the company has planned for Alberta-based activity."

Furthermore, it would reallocate capital to investments outside Alberta.

Investors should remind themselves that the proposed royalty changes at this stage are recommendations with no certitude that they will be implemented.

Strange indeed to see a province that has enjoyed such wealth creation in this energy cycle and attracted capital largely because of a political culture that has favored capitalism finds itself seemingly breaking from that tradition.

My libertarian leanings are not directed just at my fellow Canadians. Witness the political interference that has created the mess in the ethanol markets in the U.S.

The long anticipated ethanol oversupply has arrived and will continue to put downward pressure on ethanol margins and crush spreads. The politics of bio-fuel triggered very strong emotions last year, for example,

" Perfect cannot be the enemy of the good. Corn ethanol is not perfect, but it is the best alternative. Our realistic options in the next decade are limited to oil or ethanol. Do we want to feed our farmers or Middle East terrorists?"

The New York Times (09/30 edition) features an article on the sudden surplus of ethanol. As the article highlights:

"But companies and farm cooperatives have built so many distilleries so quickly that the ethanol market is suddenly plagued by a glut, in part because the means to distribute it has not kept pace. The average national ethanol price on the spot market has plunged 30 percent since May, with the decline escalating sharply in the last few weeks."

Commodity based industries have no moat...you are as good as your worst competitor and price becomes the only differentiator. At the 2006 Berkshire Hathaway annual meeting, Charlie Munger made some negative comments about the economics of ethanol, in his imitable fashion right in front of Bill Gates, his fellow Berkshire director who had just announced some months earlier an $84 million investment in Pacific Ethanol (PEIX). Charlie also made the following statement:

"Running cars on corn is about the stupidest thing I ever heard of. Our government is under tremendous political pressure [to keep pushing and supporting corn ethanol] even though it makes no sense." He added, "More energy is used producing ethanol than it creates and that's without considering the damage to the topsoil producing fuel when we could be producing food." Munger further stated, "It's silly to drive up the price of food in order to provide an uneconomic fuel, as well as a dumb government policy. "

Believe me, I am a great supporter of going green, and I believe the long term returns may well be substantial. But getting there through ethanol is going to be a little ugly over the near term.

In a Goldman Sachs report earlier this week by their biofuel research team,estimates were reduced to reflect the new realities of ethanol. Aventine's (AVR) target price was cut to $11 from $17. There are $24 target estimates out there. Pacific Ethanol (PEIX) was trimmed to $9 from $11...the high target here is $17.60. Finally, VeraSun (VSE)was trimmed to $10 from $11 by Goldman...there is a $24 estimate out there.

I am an investor, not a "player" of commodities. I'm not being arrogant, I am merely avoiding an area where I have zero competency. The scatter in target prices and estimates and growth rates suggests that there will be an opportunity here, I can't decide whether its on the long or short side.

Goldman suggests that margins need to fall to incentivize a slowdown in future capacity growth and that utilization levels of 80% versus the current full utilization are need to bring ethanol into balance. Of course, 80% utilization spells weak margins in ethanol economics.

Here is a look at the GS charts on supply/demand as well as crush spreads for ethanol:
Ethanol Supply and Demand

It appears that according to GS, there is a 200 million gallon per month surplus of supply, roughly 40% of current capacity.

Ethanol prices are now trading at over a $0.40 per gallon discount to gasoline, the other side of the $0.50 premium that it traded for most of this decade. Based on a little bit of rusty physical chemistry, it should trade at a discount...there is less BTU value. As the GS report points out, and Charlie reasoned two years ago, there is no reason that the markets should not be rational about BTU content in the pricing of ethanol.

Here is a GS chart on the Ethanol spread:
Ethanol Spread to Gasoline has weakened considerably

The report argues that the new target prices suggested are based on replacement costs, what it costs to build a plant. Reasonable enough, but ultimately the value of any plant depends on the economics of the plant, not what it may cost to build it. If cash flows are poor, there is a high likelihood that the value is impaired, at least the sunk cost.

The National Energy Policy of Canada was introduced in 1980 to increase both Canadian control and Canadian ownership of the energy industry. It also sought to protect all Canadians from surging oil prices. The federal government would accomplish their goals through measures such as price controls and federal taxes on oil and gas production. These measures would increase federal government control in the oil and gas industry.

Similarly, since 1978, the United States government has granted a multitude of tax incentives and subsidies to promote the growth of a domestic ethanol industry. Taxpayers' repeated payments in the form of subsidies to corn growers, ethanol producers, and opportunity cost serve no other purpose than to artificially prop up the corn and ethanol industry.

Allowing government to choose winners and losers instead of the market has impeded investment in other alternative fuels which may make much more economic and even environmental sense. Equally stupid in my view, is the large handouts that go to conventional energy companies, another seemingly endless cycle.

From an investment standpoint, it still leaves me wondering about energy investments in North America, is government involvement here worth the investment risk?

Disclaimer: I, my family, or clients have a current position in Berkshire Hathaway. I, my family, and clients do not have a current position in any of the other securities mentioned.

Nordson and High Quality Capital Goods Companies

2007-09-29T15:04:00.001-04:00

Today's Barrons highlights Nordson Corporation (NDSN) as an attractive capital goods company. I agree that this is a wonderful business at a fairly attractive price.

The article describes the company's global positioning with some 70% of its sales from overseas, yet the gloom that many investors feel about a slowing in the U.S. economy is yet to be evident in Nordson's results. Here is a quote from their third quarter 10-Q:

"On a geographic basis, third quarter sales volume was up in all regions, influenced by acquisitions and higher Industrial Coating and Automotive Systems segment sales. Volume was up 32.1% in the Americas, 15.2% in Japan, 10.8% in the U.S., 9.9% in Asia Pacific and 8.6% in Europe."

In a recent Wall Street Transcript interview of June 11th (subscription required,) Charles Brady of BMO Capital is quite positive on the capital goods space:

"We are still fairly bullish for the industrial space for the remainder of 2007, as well as going into 2008, particularly for some of the smaller mid-cap companies. That is really our area of focus, as these companies often have a much nichier, growthier focus in some of their product lines and geographic areas. In addition, the acquisition pipeline for some of the small and mid-tier companies still remains robust, and there are a number of deals out there that are going to add to the organic growth rates."

Let's have a closer look at this business.

As per the 10-K, NDSN produces precision dispensing equipment that applies adhesives, sealants and coatings to a range of consumer and industrial products during manufacturing operations. The Company also produces technology-based systems for curing and surface treatment processes, as well as life sciences applications. Its products are used around the world in the appliance, automotive, bookbinding, container, converting, electronics, food and beverage, furniture, life sciences, medical, metal finishing, non-wovens, packaging, semiconductor and other industries. Nordson markets its products in the United States and 57 other countries. It operates in three business segments: adhesive dispensing systems, advanced technology systems, and finishing and coating systems.

Here is a spreadsheet the last decade of cash flows for Nordson.

As the Barrons article indicates, the operating cash flow has exceeded net income throughout the decade. From my analysis, about $880 million in CFFO was used to add only about $167 million in capex and about $350 million in acquisitions over this period. Shareholders also shared in the wealth with $172 million in dividends and buybacks (net of share issuance) of $73 million.The five year dividend growth rate is fairly low at 3.65%.

Looking at the financial ratios, NDSN has also demonstrated considerable improvement over the years. Here is some ratio analysis of NDSN per www.tenkwizard.com

As one can see, normalized ROIC has steadily improved to 20.8% from low to mid single digit levels. In fact, the last time ROIC peaked at 20%+ was in 2000. The business back in 2000 was still quite global with over 50% of revenues generated outside of the U.S. versus today's 70%. But productivity enhancements have also been established, the business has about 10% fewer employees with revenues up about 20% over that period. Clearly, growth has shifted to Asia-Pacific opportunities as well. And that dollar weakness! The euro has appreciated some 63% since the year 2000.

There are some competitors to Nordson that I believe should be considered as well. Actuant (ATU), Graco (GGG), and Donaldson (DCI) are all interesting niche businesses in miscellaneous capital goods.

Here is a spreadsheet comparison of these companies which looks at the operating profitability, and the cash flow characteristics of these businesses. It is based on their trailing twelve month statistics as provided by www.cashflowanalytics.com. As you can see, the companies vary widely.

The real standout in terms of its profitability is Graco (GGG). Its operating margin of 27.24% compares exceeds those of NDSN at 15.38% and the others.Pre tax ROA of almost 44% dwarfs that of NDSN, at 13.35%.

Graco's core competency is manufacturing. Some 30% of its sales come from Europe and the Far East. As per the 10-K, the development of technologically superior, multiple-featured, reliable products is a key strategy of Graco with a particular emphasis on a goal of generating 30% of annual sales from products introduced in the prior three years.

Here are some of Charles Brady's thoughts on Graco per TWST:

"Last year, they (GGG) acquired a company called Lubriquip from IDEX Corporation (IEX) that they are in the process of integrating, and we believe the integration is ahead of schedule. It is a company that has margins well below the Graco average of the mid- to high 20s, so the overall corporate margins for Graco have been dragged down by this acquisition. As is typical for Graco, they will take costs out, make some manufacturing changes and get the margins back up to a much higher level. So we've probably got at least two quarters of continued negative impact from the acquisition, but once we get through that, we expect to see a fairly strong pickup in the overall margin, just from the improvement from that acquisition of Lubriquip."

I will be reviewing a number of these companies in the next several posts.

As always, I appreciate your readership.

Disclaimer: I, my family, and clients do not have a current position in any of the securities mentioned in this post.

Alan Greenspan's View of Housing

2007-09-16T20:44:00.001-04:00

Alan Greenspan was interviewed by the Financial Times in today's paper.

Not surprisingly, he indicated that the decline in house prices is "going to be larger than most people realize." However, he also warned that the Fed should be careful not to ease rates too aggressively because the risk of "inflationary resurgence" was greater now than when he headed the Fed.

The former Fed chairman said the current turmoil in financial markets was “an accident waiting to happen”.

He also noted that the off-balance sheet investment vehicles that issued much of the asset-backed commercial paper represented a “savings and loans disaster waiting to happen” because of the mismatch between their assets and liabilities. Mr Greenspan thought the issuance of asset-backed commercial paper ”is probably not going to get back to where it was.”

He also observed that collateralised debt obligations – securities that slice up and repackage loans to meet the risk-appetite of different investors – “will never get back to the levels and structures that they were, because now everybody knows you cannot price them”.

Mr. Greenspan, always enigmatic as chairman of the Federal Reserve has watched the economic world flow past him and remains aloof. He has shown long-held caution that investors are too complacent and too confident that steady economic growth will somehow be managed. Yet, it seems somewhat disingenuous to be as oblivious to today's credit market disasters that were sown by the reckless interest rate reductions that he himself orchestrated.

Let me take you back to testimony he delivered to the House Banking Committee Hearing on the Financial Services Modernization Act back in 1999:

"Technologically driven proliferation of new financial products that enable risk unbundling have been increasingly combining the characteristics of banking, insurance, and securities products into single financial instruments. These changes, which are occurring all over the world, have also dramatically altered the way financial services -- financial services providers operate in the way they deliver their products."

"In the United States, our financial institutions have been required to take elaborate steps to develop and deliver new financial products and services in a manner that is consistent with our outdated laws. Costs of these efforts are becoming increasingly burdensome and serve no useful public purpose. Unless soon repealed, the archaic statutory barriers to efficiency could undermine the global dominance of American finance, as well as the continued competitiveness of our financial institutions and their ability to innovate and to provide the best and broadest possible services to U.S. consumers."

"Ad hoc administrative responses to these market forces lead to inefficiencies and inconsistencies, expansion of the federal safety net, potentially increased risk exposure to the Federal Deposit Insurance Funds and a system that will undermine the competitiveness and innovative edge of major segments of our financial services industry."

"Moreover, affiliation with banks need not, indeed should not, create bank-like regulation and affiliates of banks. This shift in supervisory mode, which is already underway, is market driven."

Here is another interesting Greenspan quote before a Senate Committee on Banking, Housing, and Urban Affairs in 2004:

"The key to developing secondary markets was securitization, and Fannie and Freddie played a critical role in developing and promoting mortgage securitization, the process whereby mortgages are bundled together into pools and then turned into securities that can be bought and sold alongside other debt securities. Securitization by Fannie and Freddie allows mortgage originators to separate themselves from almost all aspects of risk associated with mortgage lending."

"Asset-backed securities and the secondary markets in which they trade generally provide both households and businesses with excellent access to credit at an appropriate risk-adjusted interest rate. Moreover, credit supply is far more stable today than it was because it is now founded on a much broader base of potential sources of funds. The aspiring homeowner no longer depends on the willingness of the local commercial bank or savings and loan association to hold his or her mortgage."

As the newspaper, The Australian observed: Alan Greenspan's new book is called The Age of Turbulence but the former Federal Reserve chairman has so many critics these days it might appropriately be subtitled, The One That I Caused.

Warren Buffett Speaks

2007-09-13T15:10:00.001-04:00

Janet Lowe has authored a completely revised version of her "Warren Buffett Speaks: Wit and Wisdom from the World's Greatest Investor." In order to provide complete disclosure, let me advise that John Wiley & Sons, the publisher, sent me a complimentary copy for which I am quite grateful.

There are many adoring fans of Buffett, myself included. I own and peruse regularly almost all of the writings about WEB as well as his own well-crafted annual reports. Of course, most of us who have been involved in value investing can recite almost verbatim, some of the quotations that are here. But many less familiar ones are here as well.

Ms. Lowe has completed a beautifully written and well organized book that provides a concise guide to investing as well as about life in general.There is no preaching or proselytizing here. The message is relaxed and provides excellent "thinking" in an easy read.

Some of the less familiar quotes provide great insight into how one should lead one's life. For some of my younger readers who aspire to being investment analysts or portfolio managers, there is valuable advice. Indeed, to those among us who are crotchety and old ( like yours truly and a few of my former co-workers) it provides a valuable reminder of certain principles.

Let me highlight a few:

The importance of cultivating good character: "Always hang around people better than you and you'll float up a little bit. Hang around with the other kind and you start sliding down the pole."

The importance of a mentor: "You're lucky in life if you have the right heroes. I advise all of you, to the extent that you can, pick out a few heroes. There's nothing like the right ones."

Understanding your place in the world (and this is a Munger quote): "If you're a duck on a pond, and it's rising due to a downpour, you start going up in the world. But you think it's you, not the pond."

Working with Good People: "I choose to work with every single person that I work with. That ends up being the most important factor. I don't interact with people I don't like or admire. That's the key. It's like marrying."

In addition on that same theme:

"Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if they don't have the first, the other two will kill you."

Having a Philosophy: "When proper temperament joins with proper intellectual framework, then you get rational behavior."

in addition, consider:

"If principles can become dated, they're not principles."

On investing: "The market is there only as a reference point to see if anybody is offering to do anything foolish. When we invest in stocks, we invest in businesses."

and an important one to consider in these volatile times:

"You can't get rich with a weather vane."

Buffett's philosophy and techniques have been a touchstone for me and many value investors for many years. The investment principles hewed by Benjamin Graham have stood the test of time, and hence truly are principles:

Look at stocks as small pieces of the business.
Look at market fluctuations as your friend rather than your enemy-profit from folly rather than participate in it.
Margin of Safety

These truly are the cornerstones for successful investing.

Finally, one poignant quotation that I found truly touching about the definition of friendship:

"I remember asking that question of a woman who had survived Auschwitz. She said her test was, 'Would they hide me?'"

There have been some great, and some not so great books about WEB. There are some great ones on the way. This much revised and updated compact edition deserves a place on your bookshelf, if not your desk. Buy it, read it, live it!

Fear, Corrections, and Regret- Crisis of Confidence

2007-08-12T18:46:00.001-04:00

Corrections happen. They are painful, come up spontaneously and unexpectedly, frequently take your breath away and replace your confidence with fear. It is important , at least in my view, to remember at times like these, all of those factors that brought you into capital markets or your specific investment holdings in the first place. Don't let yourself be spellbound with fear.

The flurry of liquidation will subside as redemptions end, as valuations come to irresistible levels, and as anxiety diminishes. Though bargains, in my view do not yet abound, considerable valuation opportunity has opened in the last week. One day leaps of faith represent little indication of anything beyond traders' bravado. Risk adjustments are taking place fairly quickly in the corporate bond realm, and it is important to recognize that you as the owner of the equity have the bottom rung or the residual position.

The malaise of the junk bond market spills over into equity markets fairly easily. Spreads which had narrowed to silly levels of 60-70 basis points over Treasuries now find themselves in a more reasonable, but hardly generous 250-280 basis points over. Think of equities as being the lowest form of junk debt to put the proper perspective in place. Hence, risk premia in Discounted Cash Flow models must open up to reflect the fact that the bond guys are getting their pound of flesh, at long last.

Though the housing market has gone to hell in a handbasket, this is hardly news. There is no entitlement to home ownership for someone with bad credit or no dough...if you think otherwise, get real. If you are worried about your CDO holdings, despite having an "investment grade" tranche of BBB, get real. There is a reason that those who were yield hogs, got slaughtered and chances are, your going-in yield on the BBB tranche was some 200 basis points over where more "normal" credits traded. It ain't going to be pretty if you find yourself stuck in one of these situations. Liquidity dries up and the only enticement is offering your tainted merchandise with a lower price. The old investment adage "the first loss is the best loss" often applies. Being mesmerized by fear of taking a loss is a horrible trait that most of us (and especially men!) have.

Make an honest assessment of the quality of your investments. If it smells (i.e. cash flow from operations is negative, increased working capital is needed as a percentage of revenues as revenues grow, increased capital intensity, diminishing interest coverage, falling profitability) just sell it. If retained earnings is a negative number on the balance sheet, your company may be selling on hope rather than fundamentals. You probably shouldn't have been there in the first place. Take time to learn what the credit rating of the underlying bonds and debenture of your equity investments might be. Despite their poor timeliness and recently tainted reputation, the bond rating agencies can generally distinguish good interest coverage from bad. If your company is below investment grade in its debt ratings, you may be in for a rocky ride as the equity valuation adjusts to the increased yield on the debt.

There is little solace in this great Buffett quote, "You can't tell who is swimming naked until the tide goes out." Central banks around the world injected almost $300 billion in liquidity on Thursday and Friday of last week to try to fill in for where the tide had gone out. Fear is rampant out there, apparently even among central bankers. Don't let it mesmerize you!

Personally, this feels more like a panic than a crisis...more of a rough patch that may last weeks rather than a "drag your guts in the gravel" crisis. I have heard or read three warnings of the present market resembling a pre-crash 1987 scenario...I doubt it. Unless bond and money markets becomes so disabled that we need 150-200 basis points to clear merchandise, I don't sense more than another 5% of downside in aggregate averages. Who knows? Mr. Market seems quite despondent and may overshoot my objective.

Though many investors seem to want to see a Fed rate cut, its negative impact on the dollar could reverse the flow of foreign capital...I am not counting on such Fed action.

What to do? In my view, it is late to try to raise cash. In my view, you may regret not having taken sufficient risk in buying some equities in this weakness. What's on my shopping list?

Though it flies in the face of most strategists' advice, I like a number of financial services stocks. US Bancorp (USB) and Citi (C) are two of my choices among large domestic banks. I like Allied Irish (AIB) and Credit Suisse (CS) as well for international exposure. Even some community banks, which I have avoided for some time are starting to look more reasonable to me.

Some of the business services companies such as payment processors and tax preparation companies look interesting. Kartik Mehta of FTN Midwest Securities is interviewed in this week's Wall Street Transcript (subscription required.) These companies generate a significant amount of cash flow and a significant amount of recurring revenue and have low capex needs. Frequently, they tie into small business but also have some bank exposure. Companies like First Data (FDC) and Alliance Data (ADS) have already been chased down by private equity. By the way, I continue to believe that private equity deals will continue to be part of our investment scenario for at least the next year. In the business services I like Global Payments (GPN) and Total System Services (TSS)

Here is an interesting screen of companies that have bought back stock, every year for the last five years, in excess of stock issuance as well as pay better than a 2% yield, and that are down more than 10% in the last month. This is not a buy list, but an explore list. There are some companies hear that I would not touch!

Stick to your discipline and show some patience. Buy stocks that you feel comfortable with over a longer period of time. Buy into businesses that if Mr. Market continues in his anger, you will feel comfortable to step up to the plate again and adding to your positions at even better prices!

Ignore the histrionics and the hysteria. Like your batting coach told you in Little League, "You've got to keep swing ing the bat." There should be a fair number of fat pitches coming our way!

Disclaimer: I, my family, or clients have current positions in USB, C, AIB, CS, GPN, AZN, CMA, FII, and TOT.

Ecolab Followup-Transforming from Soap to Services

2007-07-14T15:14:00.000-04:00

About a month ago, I wrote a post on Ecolab (ECL) describing it as a model of consistency. As I quoted Dmitry Siulverstein who covers specialty chemical research at Longbow Research:

I think the biggest appeal of Ecolab is predictability. The company gives you a very narrow guidance for earnings for the year, and a $0.02 range for earnings in the quarter. Quarter-in and quarter-out, they deliver results at the top end of their guidance. This predictability and sustainability of results, combined with the company's excellent position in its market where they are continuing to gain market share and growing significantly above the growth rate of their industry, makes this somewhat of a growth name.

Last week’s edition of The Wall Street Transcript (TWST subscription required) had an interview with Doug Baker, the Chairman, President and CEO of Ecolab. I frequently use TWST interviews to get a deeper picture of the corporate strategy of the business.

Here are some excerpts from that interview that I think help to position the corporate strategy:

“We are the food safety and infection prevention experts. Our promise to our customers is that we will help them create cleaner, safer, healthier products and environments…Our primary drivers are a continued focus on innovative new products and programs backed by unbeatable service support. Today, 40% of our sales are products and programs introduced in the last five years, and those products are backed by more than 13,500 sales and service experts worldwide. We excel at sales and service execution because it's core to satisfying our customers and delivering on our promise to them.”

“We're expanding our pest elimination business, which has the leadership position in the US, and driving it globally…Health care, particularly acute care, is also an area of interest for us and is a place that we've been investing, both through acquisitions and through organic growth of our existing business. Kitchen equipment repair is another target area in the US. It is just as it sounds - fixing cooking and cooling equipment in restaurants. Interestingly, restaurants (our largest market segment) spend as much on kitchen equipment repair as they spend on everything else we sell them, so it's a "double-the-market" idea for us. It's also a fragmented industry that gives us a lot of opportunity to build on our leadership position. We're also helping our customers reduce the amount of water and energy it takes for them to get a clean, safe and healthy environment.”

Mr. Baker describes the primary drivers that have provided Ecolab its dominant position in the marketplace:

"It is a fragmented business. We are the leader in this industry. We have a 12% share of the $40 billion market opportunity. There were several key actions in the past that enabled us to attain this:"

"Development of solid product technology. This is where we took what have historically been liquid products and offered them in a much more convenient and easier to use solid (waterless) form. We can offer a solid product in place of a five-gallon pail of cleaning product, cutting the weight by seven-eighths, from 45 pounds to eight pounds and achieve superior cleaning results. It gave us huge advantages in terms of greater ease of product use, safety, storage, product usage control, lower transportation cost, and reduced customer disposal volume, all of which reduced overall customer costs and developed greater customer satisfaction."

"Development of our chain accounts business…Foreseeing the rapid growth in restaurant and lodging chains, particularly in the US foodservice market."

"The third would be our advanced sales and service concept. We don't just sell products - we couple them with high levels of individualized customer service…Our service capabilities in assisting our customers with solving critical cleaning and sanitizing problems - and protecting their brand names in a world increasingly concerned about food-borne illness."

Food contamination is a serious issue. An estimated 76 million cases of food-borne disease occur each year in the United States. The majority of these cases are mild and cause symptoms for only a day or two. Some cases are more serious, and CDC estimates that there are 325,000 hospitalizations and 5,000 deaths related to food-borne diseases each year.

A new report published in April of this year by the US Centers for Disease Control and Prevention reveals a 50 percent increase in E coli infections since 2004, and a huge 78 percent increase in Vibrio infections - caused by eating raw shellfish - over the past decade.

Food safety is becoming a much more serious issue. Here is a link which highlights the confusion that exists that relates to food safety monitoring and regulation. As the article describes:

“Under current law, food safety monitoring, inspection and labeling functions are spread across 15 agencies in the federal government, including the US Department of Agriculture (USDA) which oversees meat, poultry and egg products; the Food and Drug Administration (FDA) which oversees most other food products; and the US Commerce Department's National Marine Fisheries Service which inspects fish. The agencies collectively administer at least 30 laws."

The General Accounting Office (GAO) has called for legislators to radically amend the system, which the federal auditor said leaves the US food chain open to attack by terrorists.

It seems to me that strengthening of regulatory oversight as well as its unification will force many producers to enhance their food safety procedures, which should only mean continuing demand for Ecolab services.

Large opportunities exist in the healthcare markets as well. Here are some stats from a presentation made to a Credit Suisse conference earlier this year:

“What's interesting about the healthcare industry as shown here is that hospital-acquired infections are the Number 4 killer in the US. And that's more than auto accidents and murders combined. It's something that we think we can make a lot of headway in, improving in the US -- particularly when it involves something as basic as basic sanitation. So we're developing products for the healthcare area, to help them address that. It's a $3 billion market. We just entered it a couple years ago.”

With EBITDA/ interest paid of almost 17 times, this steady demand company is under-levered.

In my original post, I had neglected to mention the 29% ownership of Henkel, the massive German detergents, cosmetics, and adhesives company.

Ecolab's agreement with Henkel limits the German company to owning no more than 35 percent of Ecolab's stock between now and the end of 2010.

Per the most recent proxy statement:

“Henkel’s equity ownership in the Company is subject to an agreement (“Stockholder’s Agreement”) containing certain restrictions pertaining to, among other things, Henkel’s acquisition, transfer and voting rights of our Common Stock. Generally, the Stockholder’s Agreement terminates when Henkel owns less than 2% of our voting shares. Pursuant to the Stockholder’s Agreement, Henkel is precluded from acquiring more than 35% of our outstanding Common Stock or from acting, alone or in concert with others, to control or influence the Company. Henkel may sell its shares of our Common Stock under certain conditions specified in the Stockholder’s Agreement, subject to our right of first refusal. Any disposition by Henkel of any shares of our Common Stock would be effected in an orderly manner....including our right of first refusal."

Henkel could make a takeover bid after that point. Alternatively, Ecolab could purchase Henkel’s stake (at current prices, worth around $3.2 billion) Added to current long term debt of about $550 million, even at a 7.5% interest rate would result in EBITDA interest coverage of 2.8 times.

There is precedent. In October of 2004, Clorox Co. and Henkel KGaA agreed to a $2.8 billion stock swap and cash deal, in which Henkel sold back its 29 percent ownership stake in Clorox in return for $2.1 billion in cash, as well as a handful of Clorox businesses and a position in a Spanish joint venture valued at $745 million.

The company remains on my watch list but I am increasingly intrigued by this company that is transforming itself from soap to services.

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

The Quarterly Earnings Ogre-Creating Mouse Olympics

2007-07-10T16:48:00.001-04:00

Here we are again in earnings season. Eddy Elfenbein at Crossing Wall Street took Moodys to task yesterday for its recent report that suggested an advantage of a company going private was that it was freed from quarterly earnings reports and hence, liberating to management. Eddy is so right...private equity investors frequently receive monthly operating and financial data.

But with all due respect (and I greatly respect Eddy's commentary) the real problem is not the frequency of the reporting, it is the guidance and the reliance on guidance by management, by analysts, and yes, by us, the investing public. All paranoia aside, earnings season is a setup for mouse olympics....keeping the hurdles low!! Find an expectation that you can beat, and that's where you set the bar. But like Pavlov's dog, if we keep reacting to quarterlies and quarterly guidance, the feedback mechanism only encourages managements to maintain this charade.

Most earnings guidance is complete and utter B.S. in my view. Get your mind out of the short-term earnings surprise clutter and noise and focus on long-term value creation.

Don't get me wrong....North American disclosures of quarterly earnings are far superior to many European jurisdictions that provide semi-annual reporting. But what should we be looking for from management?

It ain't earnings guidance. What I want to know is how is management managing the business. What is the impact of competition and how do we stand in the marketplace? What are we doing about it? Justify the capital expenditures and tell me about the rate of return hurdles that justified them.

Although the creation of long-term company value is widely accepted as management’s primary responsibility, much research suggests that managing predominantly for short-term earnings expectations often impairs a manager’s ability to deliver such value to shareholders.

According to a survey (conducted on behalf of the CFA Institute) of more than 400 financial executives, 80 percent of the respondents indicated that they would decrease discretionary spending on such areas as research and development, advertising, maintenance, and hiring in order to meet short-term earnings targets and more than 50 percent said they would delay new projects, even if it meant sacrifices in value creation.In other words, satisfy the analysts and make sure that the accounting number is hit to meet the quarterly expectation. In other words, forget about long term value and working for the owners of the business.

Hitting the "number" by forgoing some value creating opportunities impairs long term value creation. The obsession with the short term number becomes destructive to the ultimate goal most of us should have, a stronger, more viable company that is value creating. An excessive short-term focus creates a disregard for long-term strategy and discourages investment.

Most of us are aware of Buffett's feeling about quarterly guidance...he doesn't, and a number of his portfolio companies have stopped as well. John Bogle ex-CEO of Vanguard expressed his views as well: “the role of management should not be beating abstract numeric estimates but improving the operations and long-term prospects of organizations.”

I believe that much of the effort expended by corporations in providing guidance is misleading and unproductive and creates an unhealthy short-term culture. To quote the CFA Institute study:

"Although there may be certain benefits to providing earnings guidance, the costs and negative consequences of the current focused, quarterly earnings guidance practices are significant, including (1) unproductive and wasted efforts by corporations in preparing such guidance, (2) neglect of long-term business growth in order to meet short-term expectations, (3) a “quarterly results” financial culture characterized by disproportionate reactions among internal and external groups to the downside and upside of earnings surprises, and (4) macro-incentives for companies to avoid earnings guidance pressure altogether by moving to the private markets. Corroborating research identifies the most significant costs of issuing guidance to be management time (which 53 percent of respondents identified as very costly), a focus on short-term earnings (42 percent), and employee time (35 percent). Additionally, earnings guidance contributes to an illusion of complete business predictability, a faulty premise for both companies and their investors. Recent evidence suggests that companies are indeed addressing the shortcomings of the current earnings guidance landscape. The trend is to shift from quarterly to annual guidance and, in some instances, to withholding guidance entirely. According to research conducted by the National Investor Relations Institute (NIRI), the number of companies providing quarterly guidance decreased from 75 percent in 2003 to 52 percent in 2006. The number of companies providing annual guidance has increased to 82 percent from 38 percent over the same period, and the percentage of companies that now provide only annual guidance is 43 percent."

What I think Moody's is saying is that going private gets a company out of producing quarterly guidance which is then subjected to the Wall Street process-distilling the complexities and nuances of a value creation strategy into a single number. That number, for the most part, is still enumerated by management as guidance and is shaded by Wall Street analysts. Performance is scrutinized very carefully by private equity investors, but it does not come down to a single sacred number.

The long term goal of value creation is what is sought, not an accounting number that Joe Kernen or Maria Bartiromo can rebuke or praise based on its fidelity to consensus. Information that provides insight into long term value creation is what private equity investors want and get and what all of us deserve.

I believe that better decision-making will come by having managements' quarterly discussions focus on strategic discussions, cash flow drivers, and more insightful disclosure. Operating data rather than financial data can provide higher quality information that is less subject to accounting manipulation. A lot of production data or sales data can be produced on a monthly basis.

It's tough to get over the sturm and drang of earnings surprise. It's tough to reject what analysts will spend hours composing as a quick and dirty first response to an earnings release. Private investors are getting the numbers that they deserve. The rest of us should too! And all of us should be insisting on getting answers to the right questions about value creation.

Disclaimer: I, my family, or clients have a current position in Berkshire Hathaway.

Angelica and Pirate Capital

2007-07-10T13:52:00.001-04:00

In a recent post about Value Creation or Destruction, we had highlighted Angelica (AGL) as a company that in my opinion, was failing to create shareholder value and was consequently, subject to shareholder activism. We had cited Pirate Capital's involvement in the stock.

As we had pointed out, free cash flow had been negative for three of the last five years as a result of increasing capex intensity. The resultant returns on invested capital have not been encouraging with the last two years just between 1% and 1.6%.

Yesterday, Pirate filed another 13-D with an interesting letter to the board of AGL. They highlight their greater alignment with AGL shareholders versus management:

"Contextually, we want to impress upon the Board that Pirate remains a beneficial owner of Angelica stock, with approximately 935,000 shares, or almost 10% of Angelica's outstanding shares. On the other hand, executive officers and directors beneficially own just over 260,000 shares (including restricted stock units), in the aggregate, and have been granted, without purchase, options on just over 440,000 shares, based on the Company's latest proxy statement. Clearly, based on our ownership, we believe that we are more closely aligned with shareholder interests than Angelica's management."

The letter also questions the valuations that management has been willing to pay for its acquisitions vis-a-vis the valuation accorded the stock itself:

"The greatest area of consternation to us, as the second largest shareholder in Angelica, is the disconnect, or the meaningful valuation gap, between the aggregate price that Angelica paid for the 11 bolt−on acquisitions made between 2003 and 2006, which we understand to be in excess of $125 million, or approximately 1x sales, and the current market valuation for Angelica, which closed last night at $22.36 per share, or just over 0.5x fiscal 2006 total gross sales for Angelica."

I can understand their concern. Since the beginning of 2003. AGL has generated a cumulative $124 million in operating cash flow. of which $105 million was sustainable operating cash flow (after debt service and non-recurrings.) About $130 million was expended to support operations through capex and operating related intangibles. Some $76 million in long-term debt has been added. As is clear, free cash flow over the period was negative at -$26 million . Contrast this with the period since the beginning of 1999 through 2002 where $150 million in free cash flow was generated cumulatively and $77 million in long term debt was paid down. Operating cash flow over this previous period was $231 million of which about $186 million was sustainable.

By their nature, capital expenditures can be lumpy and may cause temporary setbacks to free cash flow over time. But over longer term periods, these expenditures tend to smooth out. The trends here are not very encouraging.

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

How Much in Value versus Growth Stocks- Good Beta versus Bad Beta?

2007-07-08T15:52:00.001-04:00

In today's New York Times, there is an article by Mark Hulbert (in the business section p28) that addresses the issue of equity allocation between value stocks and growth stocks. How many times do financial planners get asked about the allocation of a 401 (k) or an RRSP as to what portion should be invested in growth versus value? How many times do individual investors wonder about which box to tick?

Last week, I warned about the homogeneity of thinking that many value investors harbor. Hulbert, of Hulbert Financial Digest fame, points out the Ibbotson research that since 1969, value stocks have outperformed growth by an average of 2.5% a year. Typically, value stocks were about 15% less volatile than growth stocks as well. Sounds like value stocks win under most circumstances, right?

Not exactly. So why even think about a growth stock? First of all, Buffett insists that growth and value are joined at the hip...i.e. it is feasible to buy a growth stock that is undervalued. A value buyer does not disdain owning a stock that exhibits success and is highly profitable...all that matters is that it comes at an appropriately cheap price.

More subtly however, is a different proportion of a flavor of risk that growth stocks contain as compared to value stocks. Hulbert refers to an article by John Campbell of Harvard and Tuomo Vuolteenaho, now of Arrowstreet Capital. Here is a link to that article, published in 2003 but still certainly worthwhile reading for avid students of markets and CFA's.

They argue that returns on the market portfolio have two components, and that recognizing the difference between these two components can eliminate the incentive to overweight value, small, and low-beta stocks. The value of the market portfolio may fall because investors receive bad news about future cash flows; but it may also fall because investors increase the discount rate or cost of capital that they apply to these cash flows. In the first case, wealth decreases and investment opportunities are unchanged, while in the second case, wealth decreases but future investment opportunities improve. These two components should have different significance for a risk-averse, long term investor who holds the market portfolio. Such an investor may demand a higher premium to hold assets that covary with the market’s cash-flow news than to hold assets that covary with news about the market’s discount rates, for poor returns driven by increases in discount rates are partially compensated by improved prospects for future returns.

The "discount rate" risk is essentially the risk that interest rates will rise. Growth stocks, since much of their value occurs from future earnings, are very vulnerable to changes in interest rates. Far off future earnings which are discounted to a present value are worth less when that discount rate increases.

The "cash flow" risk is essentially the risk that a company will not sustain its ability to continue to grow its cash flow, perhaps because of competitive forces, perhaps because of business risk, perhaps because of its own financial leverage and capital structure.

For a long term investment horizon, say ten years or more, discount rate risks are less threatening. Interest rates rise and fall, ebb and flow with business conditions. Hence, growth stocks which fall off because of their greater sensitivity to interest rate hikes should come back over time since these risks are self-correcting. However, for cash flow risks, the comeback trail is very difficult when the competitive advantage period has run out.

Hence, the need to blend both value and growth stocks into a portfolio. Much like a high cholesterol level that consists mostly of "good" cholesterol, portfolios that contain a skew toward the "good" discount rate risk serve long term investors well.

Building on this paper is some research by Luis Viceira and Jakub Jurek of Harvard entitled Optimal Value and Growth Tilts in Long-Horizon Portfolios. Here is a link for that paper.

Here is one of their summations:

"We find that the mean-allocation of equity-only investors is heavily tilted towards value stocks at short-horizons, but the magnitude of this tilt declines dramatically with the investment horizon, implying that growth is less risky than value at long horizons."

If your time horizon is short-and I am not talking about before today's close or settlement date- but say a couple of years. You should place almost your entire equity allocation ( stress-not all your capital but just your equity allocation) into value stocks. An investor with a long-term horizon, say ten years, should be willing to allocate up to half of the equity portion of his/her portfolio to growth stocks.

As the authors describe it:

"We find that on average equity-only investors with short horizons optimally choose portfolios heavily tilted toward value and away from growth, regardless of their risk aversion. Aggressive short-term investors find it optimal to hold long large positions in value stocks offset by large short positions in growth stocks, because the mean return spread between value and growth is positive, and their returns are highly positively correlated. Highly risk averse short-term investors hold large positions in value stocks because of their smaller return volatility and high correlation with growth. However, the optimal allocation to value decreases dramatically and correspondingly the optimal allocation to growth increases for investors with longer horizons. This effect is strongest for long-horizon, highly risk averse investors, who hold large long positions in growth stocks. The increasing portfolio demand for growth stocks across investment horizons is driven by inter- temporal hedging motives. Growth stocks are better suited than value stocks to hedge against adverse changes in investment opportunities in the equity market, because they are more highly negatively correlated with changes in aggregate stock discount rates than value stocks are. Thus long- horizon representative investors find value stocks riskier than growth stocks, and see the unconditional value spread as a risk premium for bearing this risk."

The importance of understanding the optimal value and growth tilts in the portfolios of long-horizon investors is underscored by the composition of the retail mutual fund universe. Morningstar and Lipper want to put funds into their "appropriate" boxes, a characterization that I have always found quite artificial and misleading. Nevertheless, value and growth tilts are the norm, rather than the exception, in the mutual fund industry that serves the investment needs of most retail investors.Funds with a dedicated value or growth tilt accounted for 78% of total assets under management (36% growth and 42% value).

What I suggest here is not to go blindly into every growth story with audacity and newfound certitude based on these findings. Seek great businesses with earnings power. Look for quality when it is there, not when it may have a chance to develop!

Don't accept high risks with low probabilities with nonchalance. Many "story" stocks are best kept fictional rather than finding the reality of your hard-earned savings in your portfolio.

Don't shun growth ideas if you describe yourself as a value investor. Don't shun value stocks, even if you have a long time horizon. There are great opportunities in both, especially if you have time to allow the magic of compounding to build your wealth.

Who Knew?

2007-07-05T00:01:00.001-04:00

Some interesting action in Hilton Hotels calls pre the announcement.

July 35's traded 3,660 contracts with open interest of 14,038
Link

and July 40's traded 3,312 with open interest of 16,509
Link

Are SEC regulators watching? The whole notion of the SEC was to restore investor confidence post 1929 stock market crash. Keeping a watchful eye over potentially unscrupulous insider trading is part of what SEC enforcement is all about. Have markets become lax in their surveillance and discipline of their members?

Disclaimer: I, my family, and clients do not have a position in any securities mentioned in this post.

Value Creation or Destruction-As Simple as (1), (2), (3)- Finding the Value Direction!

2007-07-03T15:43:00.001-04:00

As some of you know, I write a monthly post for Marketthoughts.com, an excellent service that is published by Henry To, a fellow CFA. I recommend Henry’s service very highly. I should mention Bill and his many contributions to Henry's service and forum. I play a rather minor, very modest role with a once a month post...a sideshow to the real thing.

Here is an excerpt from my piece published on June 21. I think it may help some of my readers understand what goes into value creation as well as what prompts some corporate activists to rattle their swords.

As a timely example of the value creation / destruction debate, I have selected Angelica, a NYSE listed company as an example that is currently undergoing pressure from an institutional holder, Pirate Capital .

In it, I review some basic tenets of creating a discounted cash flow model by using free cash flow. It strikes me that so often, terms like DCF and FCF just get tossed out to blog audiences without going through an explanation of just what they mean. These are not high fallutin terms. Understanding the creation of value can really be just as simple as (1), (2), (3)

A little review of finance to begin. From first principles we recognize that the value of any company is a function of the Present Value of future cash flows, a Buffett principle if ever there was one, and certainly the basis of most EVA® (Economic Value Added) Theory and corporate finance.

Consequently:

Operating Income (1)

Less: Taxes

= EBIT after Taxes

Plus: Depreciation and Amortization

Less: Capital Expenditures (2)

Less: Changes in Working Capital (3)

= Unlevered Free Cash Flow

The main drivers of free cash flow are as simple as (1), (2), (3), essentially operating margins, the intensity of capital expenditures, and the investment in working capital. These factors work together to provide the valuation of the entire firm. The valuation of the equity of the firm is simply the value of the firm less the value of the debt. Much like a house may be valued for a certain price, the equity is simply the value of the house less the value of the mortgage.

Discounting these future free cash flows back to the present depends on the cost of capital, a cost which moves directly with the cost of borrowed money. Needless to say, the sell-off in government bonds over the last few weeks suggests that a higher discount rate is needed to reflect the cost of money. That in itself is disturbing, but there is more.

As you can see from my calculation of unlevered free cash flow, the combination of downward pressure on operating margins, increased capital expenditure needs, and increased working capital needs put downward pressure on valuation.

A recent Wall Street Journal article of June 19, 2007 (subscription needed) highlights “Companies Fall Behind in Cash Management.” The article suggests that large US companies are stalling in their working capital management and becoming inefficient. As the article indicates:

“Reducing working-capital needs can lead to significant improvements in a company's overall cash flow. And strong cash flow can boost a company's return on assets -- a measure of a company's ability to generate profit and earnings growth through the use of its assets and investment. Reductions in working capital over the past several years have helped buoy stock-market valuations.”

The survey of working capital utilization trends is compiled by a consulting firm, Hackett Group- REL and is published in CFO magazine. Their most recent published survey was last year, compiling year-end 2005 results and showing that for the fourth year in a row, working capital management had improved. Not so this year. Though the results have yet to be published, the WSJ article suggests that inefficiencies are creeping into the system.

I thought it would be useful to pinpoint all three elements of free cash flow generation in order to screen some companies where all three factors were deteriorating i.e. operating margins were falling, working capital intensity was increasing, and capex was increasing. I applied my screening to S&P 1500, the composite of the S&P 500, the S&P mid-cap 400, and the S&P Small cap 600. Only non-financial companies were considered.

S&P 1500 Screen

This is not a list of short candidates necessarily. Many of these companies, despite the one year deterioration in operating margins or the increasing investment, the market may be mis-pricing some of these names, in either direction. In fact, check the disclaimer…I, my family, or clients may own some of these stocks because in my opinion, they represent value. But in aggregate, there’s a lot here that could go wrong here. The aggregate price to free cash flow based on trailing twelve months numbers is 69.2 times representing a free cash flow yield of only 1.45%. At an average 48.51 times operating cash flow (NOT earnings but operating cash flow), there is a lot to be consider.

Exercises like this represent only an opening salvo in your analysis. A more complete understanding of the working capital dynamics and competitive industry dynamics will tell you a lot more about the reasons that valuation should be under pressure. The deterioration could represent a short term phenomenon reflecting a recent acquisition, or it could suggest something more difficult and deep-rooted.

Finally, the appropriate discount rate used to discount these cash flows must be chosen carefully. I am modeling companies based on a base case of 6% government bond yields plus a risk premium that is determined by the volatility of the cash flow stream and the quality of the balance sheet. Is 6% too high a base case? Better safe than sorry.

And that is my bottom-line here. I am still finding companies that are worth buying (at least I hope so!) But the “wall of worry” that many people are willing to clamber has a lot of chasms in it. The “animal spirits” certainly seem to be there in spades when we look at the Blackstone IPO which reportedly was six to ten times over-subscribed despite the great uncertainty about the firm’s taxation and pro-forma compensation assumptions. As one observer cites, “If you have enough orders there's no point in waiting.” Since that time, another alternative asset manager has filed to go public. Och-Ziff Capital Management Group filed its proposed IPO yesterday hoping to raise $2 billion. The decision to pursue an IPO infers that the proposed tax changes Congress suggested last month for hedge and private equity funds may not deter more of them from going public.

Bill Gross at Pimco may well be onto something as far as seeing a 25 year bull market in bonds drawing to an end. The effect on the cost of capital is obvious.

The (1), (2), (3) of corporate finance is incredibly important in deciphering the “value direction” of a business. When those three factors turn south, you should recognize that management is destroying value rather than creating it.

Great investors develop a sense of the value building or value destroying behaviors of businesses or as I call it, the value direction. The work of corporate activists often relates to changing the capital intensity (both working capital and fixed capital) of a business. As well, corporate activists will work to change the cost of capital usually by increasing the amount of debt on a balance sheet. The cost of debt is reduced by the tax deductibility of interest payments. Consequently, lowering the cost of capital by increasing debt will increase the value of the firm (so long as the debt is manageable.)

Angelica Corp (AGL) is a case in point.

An activist investor, Pirate Capital LLC sent a letter to Angelica Corp.'s board Monday, July 1st encouraging it to explore all strategic alternatives, including the sale of Angelica, according to a regulatory filing Monday.

In its letter, signed by Manager Thomas Hudson Jr., Pirate Capital wrote: "For the past several years, Angelica's management has failed to improve its operating results, and in fact its net income has declined precipitously... We believe this failure has significantly hampered value generation for shareholders. ...

"Specifically, we, as a substantial holder of Angelica stock, demand that the company engage a nationally recognized investment banking firm to explore all strategic alternatives to increase shareholder value, including, but not limited to, the sale of the company, sales of assets, or another extraordinary transaction, and that the board of directors publicly identify the investment banking firm and its mandate."

Let’s have a look at Angelica’s cash flow drivers:

Angelica Cash Flow Drivers Spreadsheet

Sustainable free cash flow has been negative in 3 of the last five years, and down substantially from levels attained in 2002. (row 23 of the spreadsheet) The compound annual growth rate of revenues over the ten year period has been -1.34%. The compound annual growth rate of operating profit has been -12.7%. (rows 7 and 8 of the spreadsheet)

Gross margins in 2007 were up slightly from 2006 levels but are about half of what they were just five years ago. Fortunately, SG&A expenses have also dropped off significantly. The operating cushion (essentially operating margins without depreciation and amortization expense) is at the worst level in ten years. (rows 28, 29, and 31)

Moving onto working capital intensity, there has in fact been considerable improvement in working capital management. Working capital to revenues has trended down from levels of low to mid 30% ten years ago to current levels of 12% of revenues…an all time low. (row 40) Most of this benefit has occurred through better inventory management (row 35)

However, fixed capital investment tells a different story. Capex to revenues is at an all time high of 9.2%. The last few years have been fairly intensive capex years especially when compared to the years prior to 2003 when capex was generally about 2% of revenues. (row 55)

Capex does not appear to have been especially productive with returns on invested capital for the last few years looking like this:

Jan 2007 1.60 %

2006 1.00

2005 4.70

2004 5.30

2003 6.70

2002 3.20

2001 2.90

2000 2.10

A company only creates value when its return on invested capital exceeds its cost of capital. Clearly, the company does not appear to have earned any reasonable return over its cost of capital for some years.

What is the remedy here? It appears that interest coverage is okay at 2.88 times EBITDA to interest. However, there are also rent payments and cash taxes. Taking these into account provides coverage of about 1.9 times (cash taxes + interest + rents) I am not sure that one could safely add much incremental leverage to reduce costs of capital.

There is an old adage in the business…the best way to get yourself out of a hole is to stop digging. I have no idea where the capex is going but at least the numbers tell me it isn’t demonstrating any profitability as of yet. It appears at least from an initial examination to be a program that is not working. Beyond that, perhaps some additional cost efficiencies can be garnered to improve operating profitability. Who knows? Maybe there are some additional efficiencies that can be garnered from working capital management beyond what has already been achieved.

In my opinion, the three most important steps an investor can take in understanding what it is he or she owns is incorporated in the technique I have shown. The old basic (1), (2), (3) will provide a lot of information about what direction value is heading and whether management is adding or subtracting.

Disclaimer: I, my family, and clients do not have a current position in Angelica Corporation. There are numerous securities mentioned in the screen that is part of this post. Relating to that, I, my family, or clients have a current long or short position in Amgen, Becton Dickinson, Bed Bath and Beyond, Chattem, Compuware, Fiserv, Foot Locker, Furniture Brands, Global Payments, Jones Apparel, Lexmark, Mentor, Merck, Pharmaceutical Product Development, Southwest Airlines, TTM Technologies, and Yahoo.

The Dangers of Homogeneous Thinking

2007-07-01T17:25:00.000-04:00

One of my favorite aphorisms is, “When everybody is thinking the same, nobody is really thinking!”

Sometimes I think value investors fall into this kind of a thinking trap, universally accepting a single-minded approach to a stock, an industry, or a market without fully thinking it through. For example, in the early 1980’s, I fully embraced a low P/E approach to investing after becoming a disciple of David Dreman’s approach described in his original book on Contrarian Investing. I regard low P/E approaches as being generally sound in helping to keep you out of trouble. Unfortunately, when used too rigorously, such approaches also keep you out of a lot of higher growth, high ROIC kinds of businesses as well. I can recall at the time of Buffett’s initial investments in Coca Cola (KO) that many low P/E “value” investors thought that Buffett was losing his discipline in paying what seemed like a riotously expensive 13 times for this at the time considered relatively dull business, especially when so many companies at the time were selling at 8 or 9 times earnings.

Most of us as value investors tend to look down at most other methods of investing, in fact ridiculing most others as lacking rationality or being too emotion centered. Lockstep adherence to a single dogma or doctrine can lead to peculiar self-justified beliefs that get reinforced by restricted focus on the behaviors or portfolios of others “drinking the same Kool-aid.” In short, many value investors simply become too imitative rather than exercise their own judgment.

James Surowiecki, author of The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations spends a lot of time discussing this phenomenon. There can be wise crowds as opposed to the “mob” that characterized the Internet or real estate bubbles. What characterizes the wise crowd? According to Surowiecki:

I) Diversity of opinion

Each person should have private information even if it's just an eccentric interpretation of the known facts.

II) Independence

People's opinions aren't determined by the opinions of those around them.

III) Decentralization

People are able to specialize and draw on local knowledge.

IV) Aggregation

Some mechanism exists for turning private judgments into a collective decision.

Note that a wise crowd consists of decentralized specialists drawn from differing diverse backgrounds that apply their independent thinking and localized knowledge to address the problem. Information drawn is not centralized; rather each person gleans his own private information.

Michael Shermer of Scientific American refers to the intellectual attribution bias, where we consider our own actions as being rationally motivated, whereas we see those of others as more emotionally driven. Our commitment to a belief is attributed to a rational decision and intellectual choice ("I'm for value investing because the long run statistics demonstrate that growing cash flow streams are ultimately recognized by the market."); whereas the other person's is attributed to need and emotion ("he's for technical analysis because he's a always followed the crowd and doesn’t want to do the fundamental spadework."). Be very wary of this thinking, there are many rational choices available which may or may not agree with yours!

Surowiecki stresses the need for diversity within a crowd to ensure enough variance in approach, thought process, and private information. He warns of the dangers of the information cascade…a situation in which every subsequent actor, based on the observations of others, makes the same choice independent of his/her private signal. In an informational cascade, everyone is individually acting rationally. Still, even if all participants as a collective have overwhelming information in favor of the correct action, each and every participant may take the wrong action. The tendency to rely on others to assess the information and merely copy is very strong in my view among many investors. It is more efficient for everyone else to simply copy those around them.

The great investors have applied a mosaic of thinking processes to come up with their conclusions. Charlie Munger is an intellectual jewel who relies on a vast and diverse knowledge base to support his investment thinking. Mohnish Pabrai incorporates such thinking in his portfolios and has written extensively about this in Mosaic: Perspectives on Investing and in Dhando Investor. Bill Miller of the renowned Legg Mason Value Trust has also described the importance of a diverse thinking process in his investment approach and exhibited it in spades with very non-traditional equity choices that are investments in his mutual fund. Much of this thinking is outlined in the Legg Mason Value Trust 25^th anniversary review which is here. I highly recommend reading this very useful but lengthy essay.

The unique approach that Miller utilized in embracing technology stocks at a time that most of us failed to consider them is outlined:

“In late 1999, Bill spent a fair amount of time discussing the fundamentals of technology stocks and how we valued them. Many traditional value investors had chosen to ignore technology companies or to maintain minimal exposure to them despite long data trails and compelling evidence that the sector had the ability to create substantial, long-lasting shareholder wealth. Our research was based on the belief that although technology changes reasonably rapidly, it didn’t follow that such changes were random or unpredictable. And we believed, based on our analysis of financial services companies and health care companies, that technology companies often created change and instability in other unrelated businesses. Focusing our research in the area of technology and trying to understand the valuation of companies in that space led to considerably better performance for the Fund than if we had simply employed simplistic backward looking valuation methods.”

“In another 1999 letter to shareholders, Bill incorporated the work of William James from his essay “The Will to Believe.” Bill discussed James’s argument that in many cases one was justified in believing something well in advance of what others may consider sufficient evidence. The argument as it relates to owning a stock, in Bill’s view, is that the level of evidence one needs to believe something is a function of how important it is not to be wrong. The evidence bar will be set higher the more important it is not to make a mistake. If being right has a high value and being wrong a low value, then the evidence needed for belief can be a lot lower since being wrong is not very costly, and being right has a high payoff.”

This parallels the probability weighted theory that Pabrai describes in Dhando Investors well as the “decision-tree” description that Munger has used in marveling about Buffett’s thinking patterns.

We learned today of the Buffett lunch auction being “won” (if $650 grand for a lunch is a win) by Pabrai and another money manager, Guy Spier of Aquamarine Capital Management. Spier has the following link on his website, The Ignorance of Crowds. I think that those of us who try to develop investment talent at investment management firms can gain some valuable insights from this article.

It describes the Linux phenomenon of an open source development model. This level of collaboration works because “it dramatically increases the speed with which problems, or bugs, is uncovered and fixed. When only a relatively small number of programmers work on a complex program, debugging consumes huge amounts of time and causes lots of delays — and many bugs still manage to sneak through. When you mobilize hundreds or thousands of people, however, they find and fix bugs much more quickly and thoroughly.”

“The power that a crowd of contributors has to solve problems derives not just from its sheer size, although that is important, but from its diversity. It’s only because the members of the crowd have, as the author put it, “differing agendas and approaches” that they’re so effective at finding so many bugs so quickly. If the participants shared similar outlooks, they’d all end up looking for the same things in the same places. What an unorganized, fairly random group of people provides is not just a lot of eyeballs but a lot of different ways of seeing. As University of Michigan professor Scott Page writes in his new book, The Difference: How the Power of Diversity Creates Better Groups, Firms, Schools, and Society (Princeton University Press, 2007), ‘When solving problems, diversity may matter as much as, or even more than, individual ability.’”

But diversity does not imply egalitarianism. “The open source model — when it works effectively — is not as egalitarian or democratic as it is often made out to be. Linux has been successful not just because so many people have been involved, but because the crowd’s work has been filtered through a central authority who holds supreme power as a synthesizer and decision maker. As the Linux project has grown, Torvalds has gathered a hierarchy of talented software programmers around him to help manage the crowd and its contributions. It’s not a stretch to say that the Linux bureaucracy forms a cathedral that coordinates the work of the bazaar and molds it into a unified product.”

Ideas can be drawn from a wise crowd where they can be openly debated and uncovered. Drawing such ideas from the masses will work provided you have independent inputs and avoid the problem of information cascades where “nobody is really thinking.” The greatest breakthroughs will always begin with “one good idea in one person’s head,” and the greatest products will always reach perfection through the concerted efforts of a highly skilled team, a meritocracy that chooses the best contributions, synthesizes the best ideas and melds them together for a final investment decision.

Individual value investors should celebrate the diversity of the marketplace, there are, as Buffett describes, many ways to get to heaven. Don’t merely be imitative of some guru, or some approach. Find yourself; find your own independent thinking pattern. Think in terms of payoffs…what is the risk if I am completely and totally wrong? And conversely, what is the gain if I am correct. Don’t get too stewed by your own juices, by the intellectual pew in which most value investors seek comfort. Look for flaws, look for opinions contrary to your own and try to understand them, not merely dismiss them. Yours may not be the only rationally motivated opinion! In this way, your thinking will be shaped from a quilt of numerous thought patterns, a mosaic that is finally unified into an investment idea.

I describe what some may think is a very arduous process. Yet, it truly is not. It is a wondrous intellectual challenge, a puzzle that requires you to draw a piece from every philosophical exposure you have thought about in life. Avoid homogeneous thinking and lockstep imitation. Celebrate diversity!