GSV Capital (GSVC) is a stock that made headlines this past June when it bought a stake in Facebook that valued all of Facebook at $70 billion. For reference, Microsoft bought a stake back in October 2007 at a price that valued Facebook at $15 billion and Goldman Sachs invested (with clients) in January or so of this year at a valuation of $50 billion. GSV stock spiked up on the news up to over $19/share which was over 1.4x net asset value (NAV) per share.
The total portfolio value of GSVC was around $45 million and the Facebook investment (225,000 shares at $29.28 in the private market) was $6.6 million, so Facebook accounted for 14.7% of the GSVC's portfolio. At $19.50, the market cap of GSVC was $64 million, $19 million more than NAV. The market was essentially discounting an immediate quadrupling of the Facebook position; that would value all of Facebook at $280 billion!
The stock has come down now to $13.92/share versus a net asset value per share of $13.47, a very slight premium.
Is GSVC a good way to play Facebook?
First of all is the question whether you would want to 'play' Facebook. Even at GSVC's entry price, Facebook is valued at $70 billion. Even if it does as well as Google going forward, that would be a market cap of $200 billion, a triple.
Holding all else in the portfolio equal, a tripling of GSVC's stake in Facebook would lead to a net asset value of $58.2 million, or a 30% gain in the NAV of GSVC. This is certainly not bad, but again, we are talking about Facebook doing just as well as Google and that's not a sure thing.
Also, venture funds tend to hit some homeruns, but many investments go to zero. We really have no idea how the other 85% of the portfolio will perform.
In any case, let's take a quick look at this thing:
GSV Capital is a new BDC (business development company) that was IPO'ed early this year at $15/share. It was set up by Micheal T. Moe, founder of ThinkEquity Partners. He used to work at Montgomery Securities and Merrill Lynch (head of Growth Equity Research or something like that), and he is the author of the book, "Finding the Next Starbucks" (I have not read this book). As far as credentials goes, he looks fine.
But I have never really been a growth stock investor so I really have no idea about his reputation or past performance in other situations where he may have managed money directly.
GSVC intends to focus on private secondary markets like SecondMarket, SharesPost to buy their investments.
On September 27, they priced a follow on offering of 1.9 million shares at $14.15. Adjusted net asset value after the offering is $70.5 million and net asset value per share is $13.47/share. So this offering does somewhat dilute the Facebook exposure unless they buy more Facebook shares in the private secondary market.
Other than Facebook, they do have a $2 million stake in Groupon and a $6.9 million stake in Twitter, both of which are seen to be potentially 'hot' IPOs.
GSVC is managed by a separate investment company, GSV Asset Management that does charge the standard 2% management fee and 20% incentive fee. Total expenses so far as percentage of net assets is around 5%, which is very high. I don't know how much the secondary offering will reduce that (as some are fixed costs specific to GSVC).
Officers and Directors own a 3.3% stake, but that is not surprising as Moe expects to earn money from the management and incentive fees that will be paid to his GSV Asset Management.
So what to think of this thing? I am not a big fan of venture capital and high priced technology stocks/investments. But for people who really want to be exposed to that sort of thing, this may not be a bad vehicle to keep an eye on.
One other thing to keep in mind is that the existence of this private secondary market will certainly dampen any impact a future IPO may have as prices are ratchetted up in a quasi-public market; this didn't used to happen. Therefore, prices paid by GSVC will most likely be much, much higher than what typical venture capital investors pay when they get in on the ground floor. This will certainly dampen potential returns for GSVC.
The other thing is that although GSVC can make tons of money if we get a nice bubble going and a strong IPO and post-IPO market, that sort of seems almost like a necessity for GSVC to make any money. That is not the sort of situation that I would want to be in myself.
Also, I would be careful not to put too much emphasis on Facebook, Twitter and Groupon as bad investments in other areas can easily offset any big gains achieved in the above three 'hot' companies (assuming they have successful IPOs and the stocks fly).
Pages
▼
Friday, September 30, 2011
Thursday, September 29, 2011
HRG: Harbinger Group Inc.
Recently, a money manager wrote a four page memo wondering if the Harbinger Group (HRG) is the next Berkshire Hathaway. It's a nicely written letter.
Of course, as he says, every time someone says "the next Warren Buffett...", you should put your hand on your wallet and make sure it stays in your pocket.
Having said that, any time there is an opportunity to invest with a successful investor at an attractive price or a discount, I am interested.
HRG is basically an investment vehicle with around $927 million in equity capital and a total market value of around $724 million. This 22% discount to book value is enough to get value investors interested. HRG was founded by George H.W. Bush in 1954 as the Zapata Corp, an oil company. Then it became Malcom Glazer's investment vehicle in 1994 and in June 2009 was sold to Harbinger Capital at $7.50/share. At that point, HRG only held cash previously having sold whatever business they owned.
HRG is currently 93.3% owned by the Harbinger Capital and related parties. Harbinger Capital is the main hedge fund management entity run by Philip Falcone, a successful billionaire hedge fund manager (although he has had some performance problems in the last couple of years).
So the general idea is that you get to invest in a vehical run by the hedge fund superstar Philip Falcone at less than book value.
First, just a couple of comments about Mittleman's letter. He talks about some of the great successes where an investor or investors took over a company and used it as a vehicle to grow over time. Of course, exhibit one in any such list is Berkshire Hathaway. Some others are Cumming/Steinberg and Leucadia National, the Rales brothers and Danaher Corp and Carl Icahn and Icahn Enterprises.
I may be wrong, but one point is that in most of the above cases, the investment vehicles were the primary investment vehicle of the investors. Berkshire Hathaway was just an investee of Buffett's hedge fund and turned into his primary investment vehicle only after the hedge fund closed, and Icahn Enterprises (intially American Real Estate Partners) eventually became Icahn's primary vehicle.
However, with HRG, it is a $770 million market capital company owned by Harbinger, but Harbinger Capital still runs a hedge fund with $7 billion or so in assets under management. Therefore, the primary focus of Philip Falcone is going to be his hedge fund. That is where he will focus on creating value.
I suppose one can argue that this will shift over time as the hedge fund now seems to be a single bet on Lightsquare, a wifi project of Falcone's that has upset hedge fund investors. So maybe Lightsquare will be one business and the investment business will be run in HRG. I don't know.
So we don't really know if this HRG is going to be a primary focus of Falcone's or not over time. If the hedge fund doesn't work out, it may become it, but that would mean going from managing $7 billion to what is now less than $1 billion in equity of HRG.
The second point is that in the letter, Mittleman says that Spectrum Brands in which HRG holds a large stake is grossly undervalued. He used Clorox as one comparable which I think is a bit of a stretch. Clorox has a brand value that is very valuable, I think. Spectrum Brands brands are not nearly as valuable, I don't think. For example, Spectrum Brands owns Rayovac batteries. I don't think Rayovac is really as competitive and valuable as Duracell, for example. Clorox is dominant, Spectrum doesn't really seem to be to me. Having said that, I have to admit that I haven't really dug into Spectrum Brands. A casual look a while ago made me feel their brands are OK, but not dominant or special.
Anyway, Mittleman feels that HRG is worth around $7.19/share now, or if Spectrum Brands is valued higher in the market, HRG can be worth up to $12.82/share or $10.95 on a fully diluted basis versus a current stock price of $5.20.
To keep this post simple, I won't look at all the separate businesses that HRG owns. Most of the value in HRG is in Spectrum Brands (SPB), a listed stock they own 54.5% in.
SPB is a fully consolidated holding of HRG, so to do a sum-of-the-parts (value the listed SPB separately), we have to separate out the SPB portion from the balance sheet and see what is left over. I will assume that the new businesses HRG has acquired is worth book value (Fidelity & Guaranty Life and North American Energy Partners).
So here are some figures:
stock price shares outstanding market cap
HRG $5.20 139.3 million $724 million
SPB $24.27 52.3 million $1.27 billion
So HRG owns 54.5% of SPB, so their ownership stake is worth: $692 million. $724 million market capitalization minus their stake in SPB is $31.9 million. So basically, the 'stub' is trading at $31.9 million.
What is the stub actually worth? As I said, since they do have cash on their balance sheet and whatever they purchased this year is probably worth close to book value, looking at shareholders' equity of HRG excluding the consolidated shareholders' equity of SPB would give a reasonable value for the stub. What is HRG's shareholders' equity excluding SPB?
HRG's shareholders' equity at the end of the second quarter was $926.6 million (this excludes the minority interest portion of SPB). SPB's shareholders' equity at the end of the same period was $1.05 billion. Therefore, HRG's portion of SPB's equity on it's balance sheet would have been $572 mllion.
HRG's equity excluding it's share of SPB equity is $354 million. This is what, at book value, HRG is worth excluding it's holdings in SPB.
So the market is valuing HRG's equity excluding SPB at 8.9% of book, or a whopping 90% discount to book value! That is mighty cheap.
But wait. It's not like we can buy HRG and then make 10x our money if this corrects (unless you do a stub trade where you buy HRG and short SPB stock; this has other issues to that need to be addressed but we'll skip that here).
It just means that HRG now is undervalued by $319 million. The total value of HRG's non-SPB position at book value is $354 million, and adding back the current value of the SPB holding of $692 million is $1.05 billion. Divide that by 139.3 million shares and you get $7.53/share as the fair value of all of HRG versus the current stock price of $5.20.
HRG is therefore trading at 69% of fair value, or a 31% discount.
That is not bad at all.
However, we have to keep in mind that almost 70% of the value of HRG as it stands now is dependent on SPB. You have to like SPB to like HRG as the SPB performance will have a big impact on the value of HRG.
I don't own HRG currently, but it is certainly an interesting thing to watch.
Again, the risks are basically the future of SPB, future deals, and how much time Falcone actually spends on this vehicle. It is not an insignicant position for Harbinger Capital, but his priority must still be with his $7 billion hedge fund.
Of course, as he says, every time someone says "the next Warren Buffett...", you should put your hand on your wallet and make sure it stays in your pocket.
Having said that, any time there is an opportunity to invest with a successful investor at an attractive price or a discount, I am interested.
HRG is basically an investment vehicle with around $927 million in equity capital and a total market value of around $724 million. This 22% discount to book value is enough to get value investors interested. HRG was founded by George H.W. Bush in 1954 as the Zapata Corp, an oil company. Then it became Malcom Glazer's investment vehicle in 1994 and in June 2009 was sold to Harbinger Capital at $7.50/share. At that point, HRG only held cash previously having sold whatever business they owned.
HRG is currently 93.3% owned by the Harbinger Capital and related parties. Harbinger Capital is the main hedge fund management entity run by Philip Falcone, a successful billionaire hedge fund manager (although he has had some performance problems in the last couple of years).
So the general idea is that you get to invest in a vehical run by the hedge fund superstar Philip Falcone at less than book value.
First, just a couple of comments about Mittleman's letter. He talks about some of the great successes where an investor or investors took over a company and used it as a vehicle to grow over time. Of course, exhibit one in any such list is Berkshire Hathaway. Some others are Cumming/Steinberg and Leucadia National, the Rales brothers and Danaher Corp and Carl Icahn and Icahn Enterprises.
I may be wrong, but one point is that in most of the above cases, the investment vehicles were the primary investment vehicle of the investors. Berkshire Hathaway was just an investee of Buffett's hedge fund and turned into his primary investment vehicle only after the hedge fund closed, and Icahn Enterprises (intially American Real Estate Partners) eventually became Icahn's primary vehicle.
However, with HRG, it is a $770 million market capital company owned by Harbinger, but Harbinger Capital still runs a hedge fund with $7 billion or so in assets under management. Therefore, the primary focus of Philip Falcone is going to be his hedge fund. That is where he will focus on creating value.
I suppose one can argue that this will shift over time as the hedge fund now seems to be a single bet on Lightsquare, a wifi project of Falcone's that has upset hedge fund investors. So maybe Lightsquare will be one business and the investment business will be run in HRG. I don't know.
So we don't really know if this HRG is going to be a primary focus of Falcone's or not over time. If the hedge fund doesn't work out, it may become it, but that would mean going from managing $7 billion to what is now less than $1 billion in equity of HRG.
The second point is that in the letter, Mittleman says that Spectrum Brands in which HRG holds a large stake is grossly undervalued. He used Clorox as one comparable which I think is a bit of a stretch. Clorox has a brand value that is very valuable, I think. Spectrum Brands brands are not nearly as valuable, I don't think. For example, Spectrum Brands owns Rayovac batteries. I don't think Rayovac is really as competitive and valuable as Duracell, for example. Clorox is dominant, Spectrum doesn't really seem to be to me. Having said that, I have to admit that I haven't really dug into Spectrum Brands. A casual look a while ago made me feel their brands are OK, but not dominant or special.
Anyway, Mittleman feels that HRG is worth around $7.19/share now, or if Spectrum Brands is valued higher in the market, HRG can be worth up to $12.82/share or $10.95 on a fully diluted basis versus a current stock price of $5.20.
To keep this post simple, I won't look at all the separate businesses that HRG owns. Most of the value in HRG is in Spectrum Brands (SPB), a listed stock they own 54.5% in.
SPB is a fully consolidated holding of HRG, so to do a sum-of-the-parts (value the listed SPB separately), we have to separate out the SPB portion from the balance sheet and see what is left over. I will assume that the new businesses HRG has acquired is worth book value (Fidelity & Guaranty Life and North American Energy Partners).
So here are some figures:
stock price shares outstanding market cap
HRG $5.20 139.3 million $724 million
SPB $24.27 52.3 million $1.27 billion
So HRG owns 54.5% of SPB, so their ownership stake is worth: $692 million. $724 million market capitalization minus their stake in SPB is $31.9 million. So basically, the 'stub' is trading at $31.9 million.
What is the stub actually worth? As I said, since they do have cash on their balance sheet and whatever they purchased this year is probably worth close to book value, looking at shareholders' equity of HRG excluding the consolidated shareholders' equity of SPB would give a reasonable value for the stub. What is HRG's shareholders' equity excluding SPB?
HRG's shareholders' equity at the end of the second quarter was $926.6 million (this excludes the minority interest portion of SPB). SPB's shareholders' equity at the end of the same period was $1.05 billion. Therefore, HRG's portion of SPB's equity on it's balance sheet would have been $572 mllion.
HRG's equity excluding it's share of SPB equity is $354 million. This is what, at book value, HRG is worth excluding it's holdings in SPB.
So the market is valuing HRG's equity excluding SPB at 8.9% of book, or a whopping 90% discount to book value! That is mighty cheap.
But wait. It's not like we can buy HRG and then make 10x our money if this corrects (unless you do a stub trade where you buy HRG and short SPB stock; this has other issues to that need to be addressed but we'll skip that here).
It just means that HRG now is undervalued by $319 million. The total value of HRG's non-SPB position at book value is $354 million, and adding back the current value of the SPB holding of $692 million is $1.05 billion. Divide that by 139.3 million shares and you get $7.53/share as the fair value of all of HRG versus the current stock price of $5.20.
HRG is therefore trading at 69% of fair value, or a 31% discount.
That is not bad at all.
However, we have to keep in mind that almost 70% of the value of HRG as it stands now is dependent on SPB. You have to like SPB to like HRG as the SPB performance will have a big impact on the value of HRG.
I don't own HRG currently, but it is certainly an interesting thing to watch.
Again, the risks are basically the future of SPB, future deals, and how much time Falcone actually spends on this vehicle. It is not an insignicant position for Harbinger Capital, but his priority must still be with his $7 billion hedge fund.
Joel Greenblatt on CNBC
Joel Greenblatt was on CNBC yesterday and said that the stock market is now, as measured by a ratio to free cash flow, in the 95th percentile of cheapness in the past twenty years. The market is typically up 15-20% a year after this kind of cheapness, and a value portfolio can be up mid-30s percent.
Check out the video here.
Some stocks mentioned are GME, AEO, BBY, MSFT, WFC and HPQ. He does mention specifically HPQ and WFC.
Joel Greenblatt is a real deal hedge fund manager and not one of those guys that have a lot to say with no track record to speak of.
At the beginning of the video, it is mentioned that Greenblatt has earned 50%/year returns between 1985 through 1994. The reason they use that time period is that 1985 is when the hedge fund started, and Greenblatt returned all outside investor capital in January 1995 (and it was not due to poor returns like Steinhardt or Robertson).
Many will say that 1985-1994 was a bull market so it was easy to make money. Well, I don't know too many people who did that well during that time period so it can't be easy.
Here are the actual return figures, year-by-year. The figures are net of expenses, but before incentive fees (hedge funds typically take a 1% or 2% management fee and 20% incentive fee).
Return
1985 (9 months) +70.4%
1986 +53.6%
1987 +29.4%
1988 +64.4%
1989 +31.9%
1990 +31.6%
1991 +28.5%
1992 +30.6%
1993 +115.2%
1994 +48.9%
Notice that 1987 was the year of black monday and it was a flat year but Greenblatt made +29.4%. The years 1988-1991 were flattish, with a recession, Iraq war, banking crisis etc... And yet the performance never slows down.
In any case, I keep saying that this blog isn't going to be an information aggregation site or fan site of investing superstars, but I will post things when I think it is especially interesting and important.
It is important to listen really hard to what Greenblatt has to say. He says that the market is now attractively priced because the news is pretty bad. This is the same with individual stocks. When you listen to his picks, people will always say but this, but that, but what about xxx etc... Actually, those known problems are the reason why stocks trade cheap. If there aren't any problems, they wouldn't be cheap!
Anyway, when Greenblatt speaks, it's always a good idea to listen!
Check out the video here.
Some stocks mentioned are GME, AEO, BBY, MSFT, WFC and HPQ. He does mention specifically HPQ and WFC.
Joel Greenblatt is a real deal hedge fund manager and not one of those guys that have a lot to say with no track record to speak of.
At the beginning of the video, it is mentioned that Greenblatt has earned 50%/year returns between 1985 through 1994. The reason they use that time period is that 1985 is when the hedge fund started, and Greenblatt returned all outside investor capital in January 1995 (and it was not due to poor returns like Steinhardt or Robertson).
Many will say that 1985-1994 was a bull market so it was easy to make money. Well, I don't know too many people who did that well during that time period so it can't be easy.
Here are the actual return figures, year-by-year. The figures are net of expenses, but before incentive fees (hedge funds typically take a 1% or 2% management fee and 20% incentive fee).
Return
1985 (9 months) +70.4%
1986 +53.6%
1987 +29.4%
1988 +64.4%
1989 +31.9%
1990 +31.6%
1991 +28.5%
1992 +30.6%
1993 +115.2%
1994 +48.9%
Notice that 1987 was the year of black monday and it was a flat year but Greenblatt made +29.4%. The years 1988-1991 were flattish, with a recession, Iraq war, banking crisis etc... And yet the performance never slows down.
In any case, I keep saying that this blog isn't going to be an information aggregation site or fan site of investing superstars, but I will post things when I think it is especially interesting and important.
It is important to listen really hard to what Greenblatt has to say. He says that the market is now attractively priced because the news is pretty bad. This is the same with individual stocks. When you listen to his picks, people will always say but this, but that, but what about xxx etc... Actually, those known problems are the reason why stocks trade cheap. If there aren't any problems, they wouldn't be cheap!
Anyway, when Greenblatt speaks, it's always a good idea to listen!
Wednesday, September 28, 2011
GLRE: Hedge Fund Exposure at Book
Greenlight Capital Re is a reinsurance company that was started up by David Einhorn of Greenlight Capital. Einhorn is one of the new generation hedge fund managers putting up impressive figures (along with Bill Ackman of Pershing Square) as a deep research, focused (concentrated) equity hedge fund. Einhorn does short stocks too so it is basically an equity long/short fund. The level of research they do is very deep, and this can be seen in his book "Fooling Some of the People All of the Time".
Hedge funds have always had trouble with capital; in good times they receive a lot of money to invest, and when things turn bad people want to redeem and get out all at once (most recent run-for-the-exits being in 2008). This is problematic for hedge fund managers because investors tend to want to leave when the news is bad so the markets tend to be falling. The managers are forced to sell into the weak market which hurts performance. Sometimes this feeds on itself; weak markets provoke redemptions which leads to worse performance (from selling their large holdings into a weak market) and even more redemptions.
By creating an insurance company, Einhorn hopes to raise some 'sticky' capital; capital that can't be redeemed when the headlines get scary. Since insurance companies receive 'float' to invest, the capital won't be subject to the whims of investors. The capital raised for the insurance company will also be permanent capital (equity capital). If all goes well, this capital raised for the insurance company and the float it receieves on insurance policies written will become nice, long term, sticky capital for Greenlight Capital to invest.
This is basically the model of Berkshire Hathaway. I think Henry Kravis has mentioned enviously that Berkshire Hathaway has a great business model (private equity firms like KKR raise investment funds that have a fixed term, like five or seven years after which they have to return the capital to investors. For KKR to stay alive, they have to keep raising new funds from investors to replace funds that are returned upon maturity).
The use of an insurance company to raise sticky capital has been tried before. Moore Capital Management, a hedge fund, started Max Re (former ticker symbol, I think, was MXRE) with the same strategy. They wanted to use a fund of funds model to invest the float. In this case, the insurance business did relatively well and the fund of funds performance turned out to be very subpar. The last I heard, the plan was to put the insurance company investments into traditional fixed income like other insurance companies rather than have Moore Capital continue to manage it. Oddly, when I did a quick google on this subject, I couldn't find any mention anywhere of MXRE. I couldn't find any old SEC filings either.
Anyway, back to the topic of Greenlight Capital Re.
Is Einhorn Any Good?
The first and most important question in this idea, of course, is how good is Greenlight Capital, the hedge fund? The hedge fund was founded in 1996 and I do remember he returned +29%/year in the first ten years of it's existence through 2006.
Through the end of 2010, Greenlight Capital has gained +21.5%/year net of fees. That is a pretty good return no matter how you slice it. That's more than +20%/year over 14 years. What's even more amazing is that this happened in not such a wonderful market environment. Remember, the stock market peaked back in 2000 and excluding a brief new high in 2007, the market has gone nowhere since then. In fact we had two horrible bear markets. And yet, Greenlight had what would be a pretty good return even in a bull market.
OK, since we know that the first ten years was really good at +29%/year (which is also astounding as the period 1996-2006 included the internet bubble and collapse/bear market), the more recent returns were obviously not as good.
Greenlight started managing the investments of Greenlight Capital Re in 2004 so the returns are available in the company's SEC filings. Let's look at Greenlight's returns from 2004:
Investment Returns
2004 +5.2% (inlcudes only two quarters, not full year)
2005 +14.2%
2006 +24.4%
2007 +5.9%
2008 -17.6%
2009 +32.1%
2010 +11.0%
That's an average of 10.5%/year. (The insurance company's investments are managed by an Einhorn entity called DME Advisors which is separate from the hedge fund, but it is assumed that the portfolios have similar characteristics).
What About the Insurance Company?
Here is a table summarizing some figures from Greenlight Capital Re.
net
premiums combined Total Loss and Total
earned ratio inv LAE sheq BPS
2006 26.6 109.60% 244 5 312 14.27
2007 98.0 92.20% 591 42 606 16.57
2008 114.9 96.50% 494 81 491 13.39
2009 214.7 96.50% 831 137 729 18.95
2010 287.7 102.80% 1,052 186 839 21.39
All figures in $millions except combined ratio and BPS.
Total inv: Total investments
Total sheq: Total shareholders equity
BPS: Fully diluted adjusted book value per share
The combined ratio is the number that shows if an insurance company is making or losing money on it's insurance business, excluding investment gains/losses. A combined ratio of over 100% means it lost money and under 100% means the business made money.
The average combined ratio for GLRE for the past five years is around 100%, which means it is breaking even on the insurance business. I don't know how good this number is as the insurance business is really just starting up. You will notice that net premiums written has grown from $27 million to $288 million in the last five years. That's because they started with zero in 2004.
The insurance business is hard to predict, but I think we can be pretty sure that Einhorn has directed his insurance executives to act Berkshire-like in their policy writing; in other words, write business for profit, not for volume.
Much of the insurance business is driven by volume. Agents are paid commissions so they are motivated to sell policies at whatever the price. But some insurance companies, notably Berkshire Hathaway, focus on only writing business that is priced decently.
I think Einhorn is really focused on that for the insurance business (even though he doesn't run it. As a 17% owner, founder and chairman, I think he will pick people who have the right approach to insurance).
Of course there is still a risk. However, the risk at this point at GLRE is pretty limited. For example, as of June 2011, the loss and loss adjustment expense reserves at GLRE were about $219 million versus total shareholders' equity of $770 million. It is more typical that this loss and loss adjustment expense to be much larger versus shareholders equity. The larger the loss and LAE is versus shareholders equity, the larger the impact of underwriting errors.
For reference, here are comparisons of loss and loss adjustment expense reservevs (loss and LAE) and total shareholders' equity of GLRE compared to Ace (ACE), White Mountain (WTM) and Transatlantic Holdings (TRH):
Loss and LAE reserves Total Shareholders Equity
GLRE $219 million $770 million
ACE $39 billion $24 billion
TRH $ 9 billion $4.3 billion
WTM $5.6 billion $4.2 billion
So loss and LAE reserves at GLRE is only 28% of total shareholders' equity while other reinsurers seem to have the loss and LAE reserves above shareholders' equity; sometimes far above.
It's important to point out that GLRE's insurance business is still in the upstart stage, so this figure will probably go up over time, as long as pricing allows (I don't think Einhorn will encourage writing underpriced policies).
So at this point, underwriting errors will not have that much of an impact on GLRE.
The biggest driver of GLRE's performance will be the returns on their investments.
GLRE had an IPO in May 2007. Shares were offered to the public at $19.00/share, and the fully diluted adjusted book value per share at as of the end of March 2007 was $13.67 (the offering was at 1.4x BPS).
Investments
As of June 2011, GLRE had total investments of $1.04 billion versus total shareholders' equity of $770 million. This is a long/short portfolio of equities, primarily, and I think he still owns a bit of gold (this is one thing I don't like too much about Einhorn; it bugs me when an equity specialists starts dabbling in commodities).
Since the portfolio is long/short, this $1.04 billion is not competely exposed to the equity market. In the 10Q for the second quarter of 2011, it says that the portfolio has a net long position of around 23%. This means that out of the $1.04 billion portfolio, the net exposure (long positions minus short positions) is around $230 million.
Over time, if the insurance business can at least break even, then the growth in book value of GLRE will reflect the investment performance of Einhorn. If the insurance business continues to grow and the insurance float grows, then total investments will grow versus shareholders' equity and that will provide some leverage on the returns Einhorn can achieve.
For now, total investments is around 1.35x shareholders' equity, so if Einhorn can deliver a 10% return on total investments and the insurance business breaks even, GLRE's book value should grow around 13.5%. (The fully diluted adjusted book value per share of GLRE has grown at around 13%/year over the past five years versus an average of around 10%/year return on their investments)
As of the end of June, the fully diluted adjusted book value per share of GLRE was $19.82, down 7.3% for the year (which makes sense as the performance on the investment portfolio was -5.3% year-to-date, a ratio of 1.38). Since the equity portfolio is a long/short, we really have no idea how GLRE has done since June.
If we assume the portfolio has been relatively flat, then GLRE at $20.50 is trading at a 3% premium to book value per share. That's quite a bargain if you think Einhorn can still continue to be a successful investor.
There is no reason to believe that Einhorn can't continue to do well. He also owns 17% of GLRE so he is really incented to make this work; if this works and the company can grow, I'm sure he would love to have GLRE become a Berkshire-like vehicle for him. The risks are obvious; that Einhorn had a lucky streak in his early years and he is done, or the insurance business will not do well and eventually blow up, or a combination of both.
Hedge funds have always had trouble with capital; in good times they receive a lot of money to invest, and when things turn bad people want to redeem and get out all at once (most recent run-for-the-exits being in 2008). This is problematic for hedge fund managers because investors tend to want to leave when the news is bad so the markets tend to be falling. The managers are forced to sell into the weak market which hurts performance. Sometimes this feeds on itself; weak markets provoke redemptions which leads to worse performance (from selling their large holdings into a weak market) and even more redemptions.
By creating an insurance company, Einhorn hopes to raise some 'sticky' capital; capital that can't be redeemed when the headlines get scary. Since insurance companies receive 'float' to invest, the capital won't be subject to the whims of investors. The capital raised for the insurance company will also be permanent capital (equity capital). If all goes well, this capital raised for the insurance company and the float it receieves on insurance policies written will become nice, long term, sticky capital for Greenlight Capital to invest.
This is basically the model of Berkshire Hathaway. I think Henry Kravis has mentioned enviously that Berkshire Hathaway has a great business model (private equity firms like KKR raise investment funds that have a fixed term, like five or seven years after which they have to return the capital to investors. For KKR to stay alive, they have to keep raising new funds from investors to replace funds that are returned upon maturity).
The use of an insurance company to raise sticky capital has been tried before. Moore Capital Management, a hedge fund, started Max Re (former ticker symbol, I think, was MXRE) with the same strategy. They wanted to use a fund of funds model to invest the float. In this case, the insurance business did relatively well and the fund of funds performance turned out to be very subpar. The last I heard, the plan was to put the insurance company investments into traditional fixed income like other insurance companies rather than have Moore Capital continue to manage it. Oddly, when I did a quick google on this subject, I couldn't find any mention anywhere of MXRE. I couldn't find any old SEC filings either.
Anyway, back to the topic of Greenlight Capital Re.
Is Einhorn Any Good?
The first and most important question in this idea, of course, is how good is Greenlight Capital, the hedge fund? The hedge fund was founded in 1996 and I do remember he returned +29%/year in the first ten years of it's existence through 2006.
Through the end of 2010, Greenlight Capital has gained +21.5%/year net of fees. That is a pretty good return no matter how you slice it. That's more than +20%/year over 14 years. What's even more amazing is that this happened in not such a wonderful market environment. Remember, the stock market peaked back in 2000 and excluding a brief new high in 2007, the market has gone nowhere since then. In fact we had two horrible bear markets. And yet, Greenlight had what would be a pretty good return even in a bull market.
OK, since we know that the first ten years was really good at +29%/year (which is also astounding as the period 1996-2006 included the internet bubble and collapse/bear market), the more recent returns were obviously not as good.
Greenlight started managing the investments of Greenlight Capital Re in 2004 so the returns are available in the company's SEC filings. Let's look at Greenlight's returns from 2004:
Investment Returns
2004 +5.2% (inlcudes only two quarters, not full year)
2005 +14.2%
2006 +24.4%
2007 +5.9%
2008 -17.6%
2009 +32.1%
2010 +11.0%
That's an average of 10.5%/year. (The insurance company's investments are managed by an Einhorn entity called DME Advisors which is separate from the hedge fund, but it is assumed that the portfolios have similar characteristics).
What About the Insurance Company?
Here is a table summarizing some figures from Greenlight Capital Re.
net
premiums combined Total Loss and Total
earned ratio inv LAE sheq BPS
2006 26.6 109.60% 244 5 312 14.27
2007 98.0 92.20% 591 42 606 16.57
2008 114.9 96.50% 494 81 491 13.39
2009 214.7 96.50% 831 137 729 18.95
2010 287.7 102.80% 1,052 186 839 21.39
All figures in $millions except combined ratio and BPS.
Total inv: Total investments
Total sheq: Total shareholders equity
BPS: Fully diluted adjusted book value per share
The combined ratio is the number that shows if an insurance company is making or losing money on it's insurance business, excluding investment gains/losses. A combined ratio of over 100% means it lost money and under 100% means the business made money.
The average combined ratio for GLRE for the past five years is around 100%, which means it is breaking even on the insurance business. I don't know how good this number is as the insurance business is really just starting up. You will notice that net premiums written has grown from $27 million to $288 million in the last five years. That's because they started with zero in 2004.
The insurance business is hard to predict, but I think we can be pretty sure that Einhorn has directed his insurance executives to act Berkshire-like in their policy writing; in other words, write business for profit, not for volume.
Much of the insurance business is driven by volume. Agents are paid commissions so they are motivated to sell policies at whatever the price. But some insurance companies, notably Berkshire Hathaway, focus on only writing business that is priced decently.
I think Einhorn is really focused on that for the insurance business (even though he doesn't run it. As a 17% owner, founder and chairman, I think he will pick people who have the right approach to insurance).
Of course there is still a risk. However, the risk at this point at GLRE is pretty limited. For example, as of June 2011, the loss and loss adjustment expense reserves at GLRE were about $219 million versus total shareholders' equity of $770 million. It is more typical that this loss and loss adjustment expense to be much larger versus shareholders equity. The larger the loss and LAE is versus shareholders equity, the larger the impact of underwriting errors.
For reference, here are comparisons of loss and loss adjustment expense reservevs (loss and LAE) and total shareholders' equity of GLRE compared to Ace (ACE), White Mountain (WTM) and Transatlantic Holdings (TRH):
Loss and LAE reserves Total Shareholders Equity
GLRE $219 million $770 million
ACE $39 billion $24 billion
TRH $ 9 billion $4.3 billion
WTM $5.6 billion $4.2 billion
So loss and LAE reserves at GLRE is only 28% of total shareholders' equity while other reinsurers seem to have the loss and LAE reserves above shareholders' equity; sometimes far above.
It's important to point out that GLRE's insurance business is still in the upstart stage, so this figure will probably go up over time, as long as pricing allows (I don't think Einhorn will encourage writing underpriced policies).
So at this point, underwriting errors will not have that much of an impact on GLRE.
The biggest driver of GLRE's performance will be the returns on their investments.
GLRE had an IPO in May 2007. Shares were offered to the public at $19.00/share, and the fully diluted adjusted book value per share at as of the end of March 2007 was $13.67 (the offering was at 1.4x BPS).
Investments
As of June 2011, GLRE had total investments of $1.04 billion versus total shareholders' equity of $770 million. This is a long/short portfolio of equities, primarily, and I think he still owns a bit of gold (this is one thing I don't like too much about Einhorn; it bugs me when an equity specialists starts dabbling in commodities).
Since the portfolio is long/short, this $1.04 billion is not competely exposed to the equity market. In the 10Q for the second quarter of 2011, it says that the portfolio has a net long position of around 23%. This means that out of the $1.04 billion portfolio, the net exposure (long positions minus short positions) is around $230 million.
Over time, if the insurance business can at least break even, then the growth in book value of GLRE will reflect the investment performance of Einhorn. If the insurance business continues to grow and the insurance float grows, then total investments will grow versus shareholders' equity and that will provide some leverage on the returns Einhorn can achieve.
For now, total investments is around 1.35x shareholders' equity, so if Einhorn can deliver a 10% return on total investments and the insurance business breaks even, GLRE's book value should grow around 13.5%. (The fully diluted adjusted book value per share of GLRE has grown at around 13%/year over the past five years versus an average of around 10%/year return on their investments)
As of the end of June, the fully diluted adjusted book value per share of GLRE was $19.82, down 7.3% for the year (which makes sense as the performance on the investment portfolio was -5.3% year-to-date, a ratio of 1.38). Since the equity portfolio is a long/short, we really have no idea how GLRE has done since June.
If we assume the portfolio has been relatively flat, then GLRE at $20.50 is trading at a 3% premium to book value per share. That's quite a bargain if you think Einhorn can still continue to be a successful investor.
There is no reason to believe that Einhorn can't continue to do well. He also owns 17% of GLRE so he is really incented to make this work; if this works and the company can grow, I'm sure he would love to have GLRE become a Berkshire-like vehicle for him. The risks are obvious; that Einhorn had a lucky streak in his early years and he is done, or the insurance business will not do well and eventually blow up, or a combination of both.
Tuesday, September 27, 2011
Sony
I recently read a comment that Japanese investors typically like to buy Sony stock at 0.7x or so book value per share (BPS). That does sound a little cheap, so I took a quick look again, only to remind myself why I don't own too many Japanese stocks!
Sony really is a company that I would love to love. I've known it as a kid and I have very positive memories associated with the Sony brand. I am a big fan of Akio Morita and I grew up with the Sony walkman.
So this is a company whose stock I would love to own in a core portfolio for the long haul. It's a solid, Japanese blue chip.
But of course, you have to look at the business and not invest emotionally like that (that would be Howard Marks' first-level thinking!). I decided to type this up because the same thing happens over and over in Japan as I still occasionally keep looking for interesting investment opportunities there.
Anyway, let's take a quick look at Sony. The idea is that it is cheap on a P/B ratio basis.
The March 2011 annual report shows book value per share of 2,539 yen per share, and the closing price of the stock last night was 1,475 yen per share. So Sony is not trading at 0.70x BPS, but a whoppingly cheap 0.58x BPS!
But wait a minute. What difference does it make what the P/B ratio is if they don't make good money on that equity? The standard measure for the attractiveness of a business is return on equity (ROE).
If a business can earn a nice ROE and you can buy that business at under BPS, that's a great combination: Good business at an attractive price.
So let's take a look at the ROE of Sony. For reference, I also put the operating margin in the table.
Sony ROE and Operating Margin
ROE Operating margin
2001 13.60% 1.80%
2002 5.00% 2.90%
2003 3.80% 1.80%
2004 6.20% 2.00%
2005 4.10% 3.00%
2006 3.80% 0.90%
2007 10.80% 5.40%
2008 -3.10% -2.90%
2009 -1.40% 0.40%
2010 -9.40% 2.80%
Five year average: 0.14% 1.32%
Ten year average: 3.34% 1.81%
This looks horrible. The average ROE over the past ten years has been 3.34%, and over the last five was 0.14%. Operating margins aren't much better.
Is a business that generates 3.34% return on equity attractive? I think not at all. Would I pay book value for such a business? Of course not. Would you pay a discount to it?
Well, if you asssume they can do just as well as the last ten years and generate 3% ROE and you pay 0.6x book for it, that's an implied rate of return of 5%. Not very exciting. I would pass on this.
More worrisome is that in the last ten years, Sony was only able to achieve a double digit ROE in two years: 2001 and 2007. I suppose 2001 was at the tail end of the internet stock bubble and boom times, and 2007 was also a boom time peak right before the housing collapse.
Now, if it takes the peak of a boom for SNE to make reasonable returns, that's not very encouraging. I do remember 2007 being a flukishly good year for Sony. I think they did well with the Playstation, large TVs, cameras etc... U.S. and global consumers were spending like crazy.
And yet operating margin in that environment was only 5.4%. Not so exciting.
If those boom years didn't happen, then Sony's historical ROE would be even worse.
Every time I look at Sony, I wonder about the U.S. manufacturers of televisions, radios, stereo equipment etc... Where did they all go? The Japanese basically took that market.
Is the same happening now in Japan? Is Korea and China taking over those industries? I think so. Many Japanese used to tell me that there is no way that the Koreans and Chinese will catch up; that they don't have the technology to compete with the Japanese. Ain't gonna happen.
But every single day, that becomes less and less true.
At first, Sony lost a large block of business not just because of the Asians, but because the world went digital. Their 'moat' or technological edge for a long time was in microelectronics etc... They were able to make things smaller; smaller motors etc...
When the world went digital, all of that became useless. This literally happened almost overnight. And then Sony was late to enter the digital game (even though they do seem to have a large market share domestically in portable music players etc...). But what is their 'edge' in the digital world? All of that expertise they gained from manufacturing lost most of it's value. Now you only need to wrap a chip with some plastic; no gears, tiny motors etc...
What about the Playstation? It's also frightening to think that Sony's return on capital over the past decade includes some big business successes.
The video game business is highly fluid. Dominant players seem to change quite often, and the Apple iPod/iPhone and online PC gaming seems to be sort of a game changer.
In any case, I don't really have a deep understanding of each of Sony's business lines and I do acknowledge that this nominal, superficial cheapness will attract domestic and global investors to Sony and the stock price will probably go up when the global market stabilizes.
But from the simple above analysis, Sony really doens't look all that attractive. I admit that I haven't picked apart Sony's balance sheet for mitigating factors to the above (for example, valuable holdings not earning returns on it's balance sheet, or hidden assets and other things), so there may be something else that makes Sony interesting.
For a long time, the Japanese stock market has seemed to be the most hated stock market in the world. Of course, contrarians/value investors are always interested in looking where others don't. I too have been interested in Japanese stocks for a long time for the same reason.
But time and again, every time you take a look at something, I realize why Japanese stocks haven't gone anywhere in decades. Of course, the fact that it started at a ridiculous valuation in December 1989 accounts for much of the reason. But the quality of the businesses from an equity shareholder point of view is just not attractive at all.
No matter how cheap stocks look on a book value basis, it doesn't mean much unless the businesses can earn some decent ROE.
Sony really is a company that I would love to love. I've known it as a kid and I have very positive memories associated with the Sony brand. I am a big fan of Akio Morita and I grew up with the Sony walkman.
So this is a company whose stock I would love to own in a core portfolio for the long haul. It's a solid, Japanese blue chip.
But of course, you have to look at the business and not invest emotionally like that (that would be Howard Marks' first-level thinking!). I decided to type this up because the same thing happens over and over in Japan as I still occasionally keep looking for interesting investment opportunities there.
Anyway, let's take a quick look at Sony. The idea is that it is cheap on a P/B ratio basis.
The March 2011 annual report shows book value per share of 2,539 yen per share, and the closing price of the stock last night was 1,475 yen per share. So Sony is not trading at 0.70x BPS, but a whoppingly cheap 0.58x BPS!
But wait a minute. What difference does it make what the P/B ratio is if they don't make good money on that equity? The standard measure for the attractiveness of a business is return on equity (ROE).
If a business can earn a nice ROE and you can buy that business at under BPS, that's a great combination: Good business at an attractive price.
So let's take a look at the ROE of Sony. For reference, I also put the operating margin in the table.
Sony ROE and Operating Margin
ROE Operating margin
2001 13.60% 1.80%
2002 5.00% 2.90%
2003 3.80% 1.80%
2004 6.20% 2.00%
2005 4.10% 3.00%
2006 3.80% 0.90%
2007 10.80% 5.40%
2008 -3.10% -2.90%
2009 -1.40% 0.40%
2010 -9.40% 2.80%
Five year average: 0.14% 1.32%
Ten year average: 3.34% 1.81%
This looks horrible. The average ROE over the past ten years has been 3.34%, and over the last five was 0.14%. Operating margins aren't much better.
Is a business that generates 3.34% return on equity attractive? I think not at all. Would I pay book value for such a business? Of course not. Would you pay a discount to it?
Well, if you asssume they can do just as well as the last ten years and generate 3% ROE and you pay 0.6x book for it, that's an implied rate of return of 5%. Not very exciting. I would pass on this.
More worrisome is that in the last ten years, Sony was only able to achieve a double digit ROE in two years: 2001 and 2007. I suppose 2001 was at the tail end of the internet stock bubble and boom times, and 2007 was also a boom time peak right before the housing collapse.
Now, if it takes the peak of a boom for SNE to make reasonable returns, that's not very encouraging. I do remember 2007 being a flukishly good year for Sony. I think they did well with the Playstation, large TVs, cameras etc... U.S. and global consumers were spending like crazy.
And yet operating margin in that environment was only 5.4%. Not so exciting.
If those boom years didn't happen, then Sony's historical ROE would be even worse.
Every time I look at Sony, I wonder about the U.S. manufacturers of televisions, radios, stereo equipment etc... Where did they all go? The Japanese basically took that market.
Is the same happening now in Japan? Is Korea and China taking over those industries? I think so. Many Japanese used to tell me that there is no way that the Koreans and Chinese will catch up; that they don't have the technology to compete with the Japanese. Ain't gonna happen.
But every single day, that becomes less and less true.
At first, Sony lost a large block of business not just because of the Asians, but because the world went digital. Their 'moat' or technological edge for a long time was in microelectronics etc... They were able to make things smaller; smaller motors etc...
When the world went digital, all of that became useless. This literally happened almost overnight. And then Sony was late to enter the digital game (even though they do seem to have a large market share domestically in portable music players etc...). But what is their 'edge' in the digital world? All of that expertise they gained from manufacturing lost most of it's value. Now you only need to wrap a chip with some plastic; no gears, tiny motors etc...
What about the Playstation? It's also frightening to think that Sony's return on capital over the past decade includes some big business successes.
The video game business is highly fluid. Dominant players seem to change quite often, and the Apple iPod/iPhone and online PC gaming seems to be sort of a game changer.
In any case, I don't really have a deep understanding of each of Sony's business lines and I do acknowledge that this nominal, superficial cheapness will attract domestic and global investors to Sony and the stock price will probably go up when the global market stabilizes.
But from the simple above analysis, Sony really doens't look all that attractive. I admit that I haven't picked apart Sony's balance sheet for mitigating factors to the above (for example, valuable holdings not earning returns on it's balance sheet, or hidden assets and other things), so there may be something else that makes Sony interesting.
For a long time, the Japanese stock market has seemed to be the most hated stock market in the world. Of course, contrarians/value investors are always interested in looking where others don't. I too have been interested in Japanese stocks for a long time for the same reason.
But time and again, every time you take a look at something, I realize why Japanese stocks haven't gone anywhere in decades. Of course, the fact that it started at a ridiculous valuation in December 1989 accounts for much of the reason. But the quality of the businesses from an equity shareholder point of view is just not attractive at all.
No matter how cheap stocks look on a book value basis, it doesn't mean much unless the businesses can earn some decent ROE.
Berkshire Hathaway Price-to-Book
There has been a lot of talk after Berkshire's announcement of share repurchases. People love to second-guess Buffett and read all sorts of things into his actions and statements. These things tend to be like the Rorschach blot; people read into things what they want to see.
In this case, the story is that there are no more interesting investment opportunities in the market anywhere in the world and that's why Buffett is going to buy back Berkshire stock; there is nothing else out there. (Others said that this a a bullish bet on the U.S. economy by Buffett as BRK has exposure to housing and other economically sensitive areas.)
I tend to disagree with that comment. As I said in a post not too long ago, I think Berkshire Hathaway is an incredible bargain and opportunity at book value or slightly more.
The other thing is that I noticed people using different price-to-book value ratios, so I calculated the numbers myself (I might have said that BRK traded at a P/B ratio of 1.7x in the last ten years, but that was wrong.)
Here are the correct figures using book value per share figures published in BRK's own 10-Ks.
Price-to-Book Value Ratio of BRK
BPS BRK price at year-end P/B ratio
1994 9,893 20,400 2.06
1995 14,025 32,100 2.29
1996 19,011 34,100 1.79
1997 25,488 46,000 1.80
1998 37,801 70,000 1.85
1999 37,987 56,100 1.48
2000 40,422 71,000 1.76
2001 37,920 75,600 1.99
2002 41,727 72,750 1.74
2003 50,498 84,250 1.67
2004 55,824 87,900 1.57
2005 59,377 88,620 1.49
2006 70,281 109,990 1.57
2007 78,008 141,600 1.82
2008 70,530 96,600 1.37
2009 84,487 99,200 1.17
2010 95,453 120,450 1.26
Five year average: 1.44x
Ten year average: 1.57x
Average since 1994: 1.69x
So you can see that the p/b ratio of BRK has been around 1.4x, even in the recent past during hard times for the economy. A P/B ratio of 1.5x for BRK would not at all be a stretch.
There are, of course, arguments for a trend towards a lower p/b ratio over time. One is that Buffett is now 81 years old and is not getting any younger. To the extent that it was Buffett's brilliance that made BRK such a success, a post-Buffett BRK would not be treated so kindly. The other is that as BRK gets bigger, it gets harder to find deals to 'move the needle' on intrinsic value.
These are issues to be sure.
But Buffett strongly believes that BRK is worth far more than stated book value per share. Why is that?
The 2010 BRK annual report has a great analysis/explanation of BRK's intrinsic value. This is highly recommended reading even for non-BRK-investors.
I will sum up one quick point here. A long time ago, much of BRK's assets were invested in listed companies so they did sort of look like an equity fund (actually, that's not the best analogy as BRK was an insurance company that invests it's float. There's a big difference, but that's another long post for another day). However, over the past few years BRK has invested in operating businesses and that part of the business has grown rapidly. The annual report shows the percentage gains in each category and it is very interesting. Total investments per share has not grown that fast over the past 10 years while pretax earnings from their non-investment, operating businesses has grown by more than +20%/year.
Anyway, you can argue that the intrinsic value of BRK will exceed the growth in book value in that case. Also, the more closely BRK looks like an equity mutual fund, the closer to book value it should trade at (since BRK's investment holdings are marked-to-market, net of tax liabilities on unrecognized gains).
However, the more the operating businesses grow, the higher the P/B ratio should tend to trend. Why? Because earnings growth of operating businesses will not be reflected on the GAAP balance sheet at all (profits earned will be booked as gains, but the value of the business will not).
So I just grabbed a couple of numbers from the 2010 annual report to illustrate this point.
Per share per share Price of
investments (A) pretax income (B) BRK (C) A/C (Bx10)/C
1990 $7,798 $102.58 $6,675 117% 15%
2000 $50,229 $918.66 $71,000 71% 13%
2010 $94,730 $5,926.04 $120,450 79% 49%
I just pulled per share investments and per share pretax income from the annual report and I just made up the other ratios, A/C and (Bx10)/C.
A/C just represents how much of the investments per share accounts for the share price of BRK. (Bx10)/C represents how much the operating businesses are worth as a percentage of share price. I just used a multiple of 10x pretax earnings to value the non-listed, operating business of BRK.
So you see that back in 1990, investments per share represented an amount exceeding the value of BRK stock, and the value of the operating businesses represented only 15% of the share price.
This continued into 2000 where the value of the operating business was still only 13% of the share price; you can see how the investments per share was really the driver of the value of BRK.
However, if you look at the figures for 2010, investments per share still represented 79%, or a large portion of the share price of BRK, but the operating business pretax income has grown substantially to account for 49% of the share price.
One can argue that the market has failed, over the years since 2000, to take into account the tremendous growth in BRK's operating businesses.
Now that the stock is trading at close to book value per share, you can see why it is such an incredible value, and Buffett thinks so too.
This is the reason why BRK has announced a share repurchase; the value is just too compelling.
In this case, the story is that there are no more interesting investment opportunities in the market anywhere in the world and that's why Buffett is going to buy back Berkshire stock; there is nothing else out there. (Others said that this a a bullish bet on the U.S. economy by Buffett as BRK has exposure to housing and other economically sensitive areas.)
I tend to disagree with that comment. As I said in a post not too long ago, I think Berkshire Hathaway is an incredible bargain and opportunity at book value or slightly more.
The other thing is that I noticed people using different price-to-book value ratios, so I calculated the numbers myself (I might have said that BRK traded at a P/B ratio of 1.7x in the last ten years, but that was wrong.)
Here are the correct figures using book value per share figures published in BRK's own 10-Ks.
Price-to-Book Value Ratio of BRK
BPS BRK price at year-end P/B ratio
1994 9,893 20,400 2.06
1995 14,025 32,100 2.29
1996 19,011 34,100 1.79
1997 25,488 46,000 1.80
1998 37,801 70,000 1.85
1999 37,987 56,100 1.48
2000 40,422 71,000 1.76
2001 37,920 75,600 1.99
2002 41,727 72,750 1.74
2003 50,498 84,250 1.67
2004 55,824 87,900 1.57
2005 59,377 88,620 1.49
2006 70,281 109,990 1.57
2007 78,008 141,600 1.82
2008 70,530 96,600 1.37
2009 84,487 99,200 1.17
2010 95,453 120,450 1.26
Five year average: 1.44x
Ten year average: 1.57x
Average since 1994: 1.69x
So you can see that the p/b ratio of BRK has been around 1.4x, even in the recent past during hard times for the economy. A P/B ratio of 1.5x for BRK would not at all be a stretch.
There are, of course, arguments for a trend towards a lower p/b ratio over time. One is that Buffett is now 81 years old and is not getting any younger. To the extent that it was Buffett's brilliance that made BRK such a success, a post-Buffett BRK would not be treated so kindly. The other is that as BRK gets bigger, it gets harder to find deals to 'move the needle' on intrinsic value.
These are issues to be sure.
But Buffett strongly believes that BRK is worth far more than stated book value per share. Why is that?
The 2010 BRK annual report has a great analysis/explanation of BRK's intrinsic value. This is highly recommended reading even for non-BRK-investors.
I will sum up one quick point here. A long time ago, much of BRK's assets were invested in listed companies so they did sort of look like an equity fund (actually, that's not the best analogy as BRK was an insurance company that invests it's float. There's a big difference, but that's another long post for another day). However, over the past few years BRK has invested in operating businesses and that part of the business has grown rapidly. The annual report shows the percentage gains in each category and it is very interesting. Total investments per share has not grown that fast over the past 10 years while pretax earnings from their non-investment, operating businesses has grown by more than +20%/year.
Anyway, you can argue that the intrinsic value of BRK will exceed the growth in book value in that case. Also, the more closely BRK looks like an equity mutual fund, the closer to book value it should trade at (since BRK's investment holdings are marked-to-market, net of tax liabilities on unrecognized gains).
However, the more the operating businesses grow, the higher the P/B ratio should tend to trend. Why? Because earnings growth of operating businesses will not be reflected on the GAAP balance sheet at all (profits earned will be booked as gains, but the value of the business will not).
So I just grabbed a couple of numbers from the 2010 annual report to illustrate this point.
Per share per share Price of
investments (A) pretax income (B) BRK (C) A/C (Bx10)/C
1990 $7,798 $102.58 $6,675 117% 15%
2000 $50,229 $918.66 $71,000 71% 13%
2010 $94,730 $5,926.04 $120,450 79% 49%
I just pulled per share investments and per share pretax income from the annual report and I just made up the other ratios, A/C and (Bx10)/C.
A/C just represents how much of the investments per share accounts for the share price of BRK. (Bx10)/C represents how much the operating businesses are worth as a percentage of share price. I just used a multiple of 10x pretax earnings to value the non-listed, operating business of BRK.
So you see that back in 1990, investments per share represented an amount exceeding the value of BRK stock, and the value of the operating businesses represented only 15% of the share price.
This continued into 2000 where the value of the operating business was still only 13% of the share price; you can see how the investments per share was really the driver of the value of BRK.
However, if you look at the figures for 2010, investments per share still represented 79%, or a large portion of the share price of BRK, but the operating business pretax income has grown substantially to account for 49% of the share price.
One can argue that the market has failed, over the years since 2000, to take into account the tremendous growth in BRK's operating businesses.
Now that the stock is trading at close to book value per share, you can see why it is such an incredible value, and Buffett thinks so too.
This is the reason why BRK has announced a share repurchase; the value is just too compelling.
Monday, September 26, 2011
Bank TARP Warrants
One legacy of the financial collapse is the series of long term warrants on the banks that received TARP money. When large U.S. banks received TARP money from the Treasury in 2008, they also issued warrants on the shares of stock to the treasury department. The Treasury then sold the warrants to the public when the markets settled down.
Now that financials are tanking around the world, I thought it might be interesting to take a quick look at some of these warrants. I was going to set up a table with all the listed warrants, their fair values and implied volatilities, but I'm too lazy to do that now so let's just look at a couple of them.
It makes sense to first look at the JPM warrants since I am a fan of the stock at this level, and am a fan of the bank itself. The JPM warrants (listed under ticker JPM-WT) has a strike price of $42.42 and expires on October 28, 2018. JPM's current stock price is $30.30, and the warrants are trading at $9.80. For interest rates, I will use the treasury rate of 1.36% and for dividends I will use 4.0%. I actually have no idea how to think about forward dividend yields as most banks are not paying dividends so as to preserve capital.
Plugging in the above figures and using a fair volatility of 20% shows the warrants to be worth $1.35. With a 30% volatility, the warrants are still worth only $3.52 versus the current warrant price of $9.80. If you back in the current price of the warrants to get an implied volatility figure, that comes to around 56.5%! That is very high. Yes, financial stocks have been volatile in the recent past, but it is highly, highly unlikely that the stock price can maintain a volatility level of 56.5% for seven years.
So from a conventional option model point of view, JPM warrants are trading way off any sense of fair value. You can tweak the interest rates and dividends and get different figures, but I don't think the general conclusion will change.
Looking at WFC, Buffett's favorite big bank, we have a current stock price of $24.31, warrant price of $7.90. This warrant expires on October 28, 2018. Using similar figures as above, the fair value of these warrants at 20% volatility is $1.07, and at 30% volatility it is $2.80 versus the current trading price of $7.90. The implied volatility at $7.90 is around 57%
So these warrants too, from a conventional options model point of view is way off fair value.
Bank of America (BAC) too has warrants out in two series; the class A and class B warrants. They give the same sort of conclusion. The valuations are way off and too expensive. Implied volatilities on those come to 57% for the B and 85% for the As.
Here is a summary of the above:
Stock Warrant Strike Fair values Implied
Price price price Expiration @20% vol @30% vol volatility
JPM-WT $30.30 $9.80 $42.42 10/28/18 $1.35 $3.52 57%
WFC-WT $24.31 $7.90 $34.01 10/28/18 $1.07 $2.80 57%
BAC-WTA $ 6.42 $2.98 $13.39 1/16/19 $0.07 $0.37 85%
BAC-WTB $ 6.42 $0.91 $30.79 10/28/18 $0.06 $0.04 57%
As you can see, based on a standard option model, these warrants are trading way out there.
However, this does not mean that these warrants are no good. There is a flaw in the standard options model. A standard option model is very good at calculating fair values over the short term, but for the long term it can get pretty inaccurate.
Why?
Because of the concept of forward prices. Over the short term, stock prices are pretty random; they will go up and down in something that looks like a normal distribution, maybe with some fat tails. The Black-Scholes option model is very good at capturing that.
However, when the option gets longer and longer term, like out to seven years, the model fails to account for the growth in a company. I suppose in a Chicagoesque efficient market world, the long term interest rate is supposed to represent 'growth'. Of course the interest rate represents the cost of carry in replicating the option position.
But it (the forward price calculated with the interest rate) is also the neutral estimate of where the stock price will be in the future. This forward price is the base price where the normal distribution is applied to calculate the likely range of stock prices at the future date. The forward price is simply the spot price times (1+ interest rate minus dividend yield).
Why can this lead to wild inaccuracies? If the company pays no dividends and the interest rate is 1.4%, but the company grows it's book value at 10% per year and the stock usually trades at around book value, then a long term option model is going to be way off.
Of course, the option model's job is not to incorporate such things. It's only input is to calculate the value without such 'forecasts'. Input can only be dividends and interest rates and some volatility figure, figures that are observable now. And as far as hedging the position is concerned, absent market disruption, in normal markets the hedge costs calculated by these models tend to be accurate. (actually future volatility is not observable in advance, of course, but volatility does tend to be mean reverting over time)
In other words, option models do not incorporate this growth factor, so if a company does grow, long term options models will be more inaccurate the higher growth the company is and the longer term the options are. (Efficient market folks will tell us that we can't predict who will be the winners tommorow, who will grow more etc... So in that sense, the option model is perfectly fine.).
So what is the other way to look at these warrants? Instead of looking at it from a conventional options model point of view, you can look at these things as binary bets, or all or nothing bets. You can of course create any number of different scenarios and plug in your own numbers; it doesn't have to be binary.
But for simplicity, I will use a binary approach. One scenario is for things to totally melt down and the U.S./world won't recover in the next seven years and bank stocks will either go under or stay below the respective strike prices. In this scenario, the warrants are obviously worthless.
The other scenario is that things normalize over time, and the banks do return to 12% return on equity and their book values grow around 8%/year from now until these warrants mature. Book value per share (BPS) growth of 8% is a number I just picked assuming a 12% return-on-equity for the large banks and a 33%-ish dividend payout ratio. I don't take into account potential for share repurchases. Jamie Dimon has stated he wants to get dividends back up to 30-40% payout ratio.
For now, I will just look at what these warrants might be worth in this 'normalization' scenario.
JPM's book value per share is $44.79 (according to Yahoo Finance). Assuming 8% growth in BPS over the next seven years gives us $76 in BPS. If JPM trades at BPS, then the JPM warrants would be worth $33.58 by maturity. If JPM trades at 1.5x book then, that would give a warrant value of $71.58 by 2018. This is versus the current warrant price of $9.80. Is that a stretch? What do you think?
For WFC, the BPS is $23.86. In seven years, that grows to $40.80, and if WFC trades at book, the warrants are worth $6.80 versus the current warrant price of $7.90. If WFC trades at 1.5x book at that point, the stock would be at $61.20 and warrants would be worth $27.20.
What about BAC? BAC gives some insane figures due to it's huge discount to book value now. I have no idea how big future losses will be, but let's just go through the excercise. The BPS of BAC now is $20.30. I can hear the laughter of people reading this. I know, I know. BAC has a bunch of problems. But let's just keep going. BAC BPS would grow to $34.71, and if it just trades at this book value, then the A-warrants would be worth $21.41 (versus the current price of $2.98) and the B-warrants would be worth $3.92 versus the current $0.91. If BAC trades up to 1.5x book, that would be $38.77 in value for the A-warrants and $21.97 for the B-warrants in value.
These are what these warrants can be worth if banks can return 12% on ROE over the next seven years and pays out 33% or so in dividends. To discount this scenario you can give these prices a haircut, say, 20% or 30% by assuming that there is a 20% or 30% chance that this 'normalization' will not happen.
Of course, many people will say that this is much higher; I'm sure many people will tell you that the possibility of a bad scenario is more like 80%.
In that scenario, of course, these warrants would not be attractive.
At this point, I don't own any of these warrants, but I will keep an eye on them. You can't really look at them from an option model point of view. I find it highly unlikely these things will trade at a low implied volatility.
In any case, these warrants will be worth absolutely ZERO in seven years if banks don't recover, so these are obviously highly speculative. If anyone wants to play with these, they should only play it with the speculative portion of their portfolio.
Now that financials are tanking around the world, I thought it might be interesting to take a quick look at some of these warrants. I was going to set up a table with all the listed warrants, their fair values and implied volatilities, but I'm too lazy to do that now so let's just look at a couple of them.
It makes sense to first look at the JPM warrants since I am a fan of the stock at this level, and am a fan of the bank itself. The JPM warrants (listed under ticker JPM-WT) has a strike price of $42.42 and expires on October 28, 2018. JPM's current stock price is $30.30, and the warrants are trading at $9.80. For interest rates, I will use the treasury rate of 1.36% and for dividends I will use 4.0%. I actually have no idea how to think about forward dividend yields as most banks are not paying dividends so as to preserve capital.
Plugging in the above figures and using a fair volatility of 20% shows the warrants to be worth $1.35. With a 30% volatility, the warrants are still worth only $3.52 versus the current warrant price of $9.80. If you back in the current price of the warrants to get an implied volatility figure, that comes to around 56.5%! That is very high. Yes, financial stocks have been volatile in the recent past, but it is highly, highly unlikely that the stock price can maintain a volatility level of 56.5% for seven years.
So from a conventional option model point of view, JPM warrants are trading way off any sense of fair value. You can tweak the interest rates and dividends and get different figures, but I don't think the general conclusion will change.
Looking at WFC, Buffett's favorite big bank, we have a current stock price of $24.31, warrant price of $7.90. This warrant expires on October 28, 2018. Using similar figures as above, the fair value of these warrants at 20% volatility is $1.07, and at 30% volatility it is $2.80 versus the current trading price of $7.90. The implied volatility at $7.90 is around 57%
So these warrants too, from a conventional options model point of view is way off fair value.
Bank of America (BAC) too has warrants out in two series; the class A and class B warrants. They give the same sort of conclusion. The valuations are way off and too expensive. Implied volatilities on those come to 57% for the B and 85% for the As.
Here is a summary of the above:
Stock Warrant Strike Fair values Implied
Price price price Expiration @20% vol @30% vol volatility
JPM-WT $30.30 $9.80 $42.42 10/28/18 $1.35 $3.52 57%
WFC-WT $24.31 $7.90 $34.01 10/28/18 $1.07 $2.80 57%
BAC-WTA $ 6.42 $2.98 $13.39 1/16/19 $0.07 $0.37 85%
BAC-WTB $ 6.42 $0.91 $30.79 10/28/18 $0.06 $0.04 57%
As you can see, based on a standard option model, these warrants are trading way out there.
However, this does not mean that these warrants are no good. There is a flaw in the standard options model. A standard option model is very good at calculating fair values over the short term, but for the long term it can get pretty inaccurate.
Why?
Because of the concept of forward prices. Over the short term, stock prices are pretty random; they will go up and down in something that looks like a normal distribution, maybe with some fat tails. The Black-Scholes option model is very good at capturing that.
However, when the option gets longer and longer term, like out to seven years, the model fails to account for the growth in a company. I suppose in a Chicagoesque efficient market world, the long term interest rate is supposed to represent 'growth'. Of course the interest rate represents the cost of carry in replicating the option position.
But it (the forward price calculated with the interest rate) is also the neutral estimate of where the stock price will be in the future. This forward price is the base price where the normal distribution is applied to calculate the likely range of stock prices at the future date. The forward price is simply the spot price times (1+ interest rate minus dividend yield).
Why can this lead to wild inaccuracies? If the company pays no dividends and the interest rate is 1.4%, but the company grows it's book value at 10% per year and the stock usually trades at around book value, then a long term option model is going to be way off.
Of course, the option model's job is not to incorporate such things. It's only input is to calculate the value without such 'forecasts'. Input can only be dividends and interest rates and some volatility figure, figures that are observable now. And as far as hedging the position is concerned, absent market disruption, in normal markets the hedge costs calculated by these models tend to be accurate. (actually future volatility is not observable in advance, of course, but volatility does tend to be mean reverting over time)
In other words, option models do not incorporate this growth factor, so if a company does grow, long term options models will be more inaccurate the higher growth the company is and the longer term the options are. (Efficient market folks will tell us that we can't predict who will be the winners tommorow, who will grow more etc... So in that sense, the option model is perfectly fine.).
So what is the other way to look at these warrants? Instead of looking at it from a conventional options model point of view, you can look at these things as binary bets, or all or nothing bets. You can of course create any number of different scenarios and plug in your own numbers; it doesn't have to be binary.
But for simplicity, I will use a binary approach. One scenario is for things to totally melt down and the U.S./world won't recover in the next seven years and bank stocks will either go under or stay below the respective strike prices. In this scenario, the warrants are obviously worthless.
The other scenario is that things normalize over time, and the banks do return to 12% return on equity and their book values grow around 8%/year from now until these warrants mature. Book value per share (BPS) growth of 8% is a number I just picked assuming a 12% return-on-equity for the large banks and a 33%-ish dividend payout ratio. I don't take into account potential for share repurchases. Jamie Dimon has stated he wants to get dividends back up to 30-40% payout ratio.
For now, I will just look at what these warrants might be worth in this 'normalization' scenario.
JPM's book value per share is $44.79 (according to Yahoo Finance). Assuming 8% growth in BPS over the next seven years gives us $76 in BPS. If JPM trades at BPS, then the JPM warrants would be worth $33.58 by maturity. If JPM trades at 1.5x book then, that would give a warrant value of $71.58 by 2018. This is versus the current warrant price of $9.80. Is that a stretch? What do you think?
For WFC, the BPS is $23.86. In seven years, that grows to $40.80, and if WFC trades at book, the warrants are worth $6.80 versus the current warrant price of $7.90. If WFC trades at 1.5x book at that point, the stock would be at $61.20 and warrants would be worth $27.20.
What about BAC? BAC gives some insane figures due to it's huge discount to book value now. I have no idea how big future losses will be, but let's just go through the excercise. The BPS of BAC now is $20.30. I can hear the laughter of people reading this. I know, I know. BAC has a bunch of problems. But let's just keep going. BAC BPS would grow to $34.71, and if it just trades at this book value, then the A-warrants would be worth $21.41 (versus the current price of $2.98) and the B-warrants would be worth $3.92 versus the current $0.91. If BAC trades up to 1.5x book, that would be $38.77 in value for the A-warrants and $21.97 for the B-warrants in value.
These are what these warrants can be worth if banks can return 12% on ROE over the next seven years and pays out 33% or so in dividends. To discount this scenario you can give these prices a haircut, say, 20% or 30% by assuming that there is a 20% or 30% chance that this 'normalization' will not happen.
Of course, many people will say that this is much higher; I'm sure many people will tell you that the possibility of a bad scenario is more like 80%.
In that scenario, of course, these warrants would not be attractive.
At this point, I don't own any of these warrants, but I will keep an eye on them. You can't really look at them from an option model point of view. I find it highly unlikely these things will trade at a low implied volatility.
In any case, these warrants will be worth absolutely ZERO in seven years if banks don't recover, so these are obviously highly speculative. If anyone wants to play with these, they should only play it with the speculative portion of their portfolio.
Berkshire Hathaway Share Repurchase!
The unthinkable to long time Buffett followers seems to be happening. Berkshire Hathaway has just announced that they will (or may) buy back shares. Here's the press release: Share repurchase
From the release:
Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.
Note that the release says that the underlying businesses of Berkshire are worth considerably more than 1.1x book value per share.
Why is this unthinkable? For many years, Buffett has said he won't buy back share unless he sees no more opportunities to buy businesses. Long term Buffett fans have said that he will never buy back shares, and if he did that would be bad news as that means BRK can't find any place else to put their money.
This situation seems to be a bit different. BRK shares as I stated in a recent post is very, very cheap. Share repurchases at this point makes a lot of sense to BRK, and as stated in the press release, this action would clearly be accretive to intrinsic value per share.
With this sort of validation/confirmation of value in such a rare statement from such a non-self-promoter and straight shooter as Buffett, you have to think BRK right now is just about the best investment opportunity available in the large cap area right now.
From the release:
Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.
Note that the release says that the underlying businesses of Berkshire are worth considerably more than 1.1x book value per share.
Why is this unthinkable? For many years, Buffett has said he won't buy back share unless he sees no more opportunities to buy businesses. Long term Buffett fans have said that he will never buy back shares, and if he did that would be bad news as that means BRK can't find any place else to put their money.
This situation seems to be a bit different. BRK shares as I stated in a recent post is very, very cheap. Share repurchases at this point makes a lot of sense to BRK, and as stated in the press release, this action would clearly be accretive to intrinsic value per share.
With this sort of validation/confirmation of value in such a rare statement from such a non-self-promoter and straight shooter as Buffett, you have to think BRK right now is just about the best investment opportunity available in the large cap area right now.
Sunday, September 25, 2011
Second-Level Thinking
Howard Marks is a well-known fund manager with very good returns over the long term in the corporate bond market (distressed etc...) and has been writing great memos to investors for a long time. They do float around on the internet so when I do find one I spend time reading it and there is always something to learn from them. He is definitely the real-deal.
He came out with a book recently that is an edited collection of the memos to his investors. I just got it and started reading it and haven't finished yet.
But the first chapter is so dead-on that I wanted to write a post about it. I don't want this blog to be full of investment platitudes and whatnot, but some things are really great and I feel I have to post it. I do seem to spend a lot of time emailing and talking to people about this topic so I can't not mention it, and the way Marks puts it is so perfect.
Anyway, Howard Marks' book is called "The Most Important Thing: Uncommon Sense for the Thoughtful Investor". (There are so many investment books published every month, every week, and most of it is garbage. This is definitely not one of those).
The first chapter is called "Second-Level Thinking".
This is so, so important in the investment world and many people do not seem to understand it.
Marks' contention is that a lot of people do first-level thinking, but very few can or do second-level thinking. First-level thinking is things like, "Gee, this is a nice store and it's crowded; let's buy the stock!" or some such thing.
Here are some of Mark's examples:
First-level thinking says, "It's a good company, let's buy the stock". Second-level thinking says, "It's a good company, but everyone thinks it's a great company, and it's not. So the stock's overrated and overpriced; let's sell.
First-level thinking says, "The outlook calls for low growth and rising inflation. Let's dump our stocks." Second-level thinking says, "The outlook stinks, but everyone else is selling in panic. Buy!
This is what I've always thought for a long time and always warned people against acting on first-level thinking, but I never thought of this problem as first-level thinking and second-level thinking. It's a great way to put it.
Bubbles in the past occur partly due to the masses stuck in first-level thinking: The internet will change the world, let's buy internet stocks! China will grow forever, let's buy Chinese stocks! You can go back and look at all the bubbles (that I've mentioned in other posts too) and you will see a lot of first-level thinking as the cause of many of them.
I posted about theme investing, and that also falls into that category of first-level thinking unless more work is done to determine if an investment idea is sound. Just looking at the bright future of an industry or sector is not enough. Sure, solar energy may be a large part of the answer to our energy problems, but choosing the right solar energy company that will do well is an entirely different question (like trying to pick the internet winners in 1999 or auto company winners in the 1920s, or PC companies in the early 80s etc...).
Right now, I tend to think we are in sort of a macro-calling bubble. After a few people made huge killings in the subprime bubble collapse, everyone seems to be looking for the next great trade. It seems almost like everyone has John Paulson and/or Michael Burry envy. (Paulson and Burry are two of a small group of people who made out really well in the subprime collapse.)
But a lot of this thinking seems to be first-level thinking. Bernanke and Geithner will destroy the dollar, therefore avoid U.S. dollar denominated assets, or buy a lot of gold and commodities. There is way too much debt in the world so sell stocks etc...
Much of the commentary you see in the financial press seems to be full of this first-level thinking.
Gold seems to be in this sort of first-level thinking phase too; the only way to avoid a depression is for the Fed and other central banks around the world to print more money. This is inevitable, and politicians will not cut spending for fear of increasing unemployment. Therefore inflation, if not hyper-inflation is inevitable. But this is still all first-level thinking. Where is the mispricing in the market?
Just because the market validates a view in the short term does not make it correct (internet stocks in the 1990s and Japanese stocks in the 1980s too went up for a while defying common sense).
This is not to say that gold is in the final stages of a bubble like internet stocks were in 2000 (but the fact that more than twice as many people thought gold is a better investment than stocks in a recent survey is a bit worrisome). I have no idea what will happen to gold prices; I just want to make the point that the arguments of the gold bulls, to me, just sound first-level-ish.
Anyway, it's important also to note that Paulson and Burry both did far more than just predict the housing market collapse and financial crisis. There were quite a few people who did predict that. But most people who called the collapse didn't make money on it. This is because they were stuck in fisrt-level thinking and did simple trades like short housing stocks and bank stocks. Even with the collapse in the stock market, it is notoriously difficult to make money shorting stocks; just look at how fast bank stocks rebounded after the March 2009 low.
Paulson and Burry did predict a collapse, but they went on to the second-level thinking and actually found the right trades to put on. Where was the big mispricing in the marketplace? They found that in the subprime mortgage derivatives market. Others didn't. So the difference between the gloom and doomers (that are usually on CNBC often telling us that the end of the world is near) and Paulson/Burry is that Paulson/Burry did enough work to actually find the right trades (second-level thinking).
In any case, when you have an urge to do something, like sell stocks because you read in the papers that Greece will default and French banks will go bust, or you want to sell perfectly good stocks at decent valuations because consumers won't be able to increase spending due to too much debt, or because the economists are lowering their GDP growth estimates for the second half of the year or next year, I would think very hard if you are about to make an investment decision based on first-level thinking or second-level thinking.
I have a feeling that I will be referring back to this post a lot in the future...
He came out with a book recently that is an edited collection of the memos to his investors. I just got it and started reading it and haven't finished yet.
But the first chapter is so dead-on that I wanted to write a post about it. I don't want this blog to be full of investment platitudes and whatnot, but some things are really great and I feel I have to post it. I do seem to spend a lot of time emailing and talking to people about this topic so I can't not mention it, and the way Marks puts it is so perfect.
Anyway, Howard Marks' book is called "The Most Important Thing: Uncommon Sense for the Thoughtful Investor". (There are so many investment books published every month, every week, and most of it is garbage. This is definitely not one of those).
The first chapter is called "Second-Level Thinking".
This is so, so important in the investment world and many people do not seem to understand it.
Marks' contention is that a lot of people do first-level thinking, but very few can or do second-level thinking. First-level thinking is things like, "Gee, this is a nice store and it's crowded; let's buy the stock!" or some such thing.
Here are some of Mark's examples:
First-level thinking says, "It's a good company, let's buy the stock". Second-level thinking says, "It's a good company, but everyone thinks it's a great company, and it's not. So the stock's overrated and overpriced; let's sell.
First-level thinking says, "The outlook calls for low growth and rising inflation. Let's dump our stocks." Second-level thinking says, "The outlook stinks, but everyone else is selling in panic. Buy!
This is what I've always thought for a long time and always warned people against acting on first-level thinking, but I never thought of this problem as first-level thinking and second-level thinking. It's a great way to put it.
Bubbles in the past occur partly due to the masses stuck in first-level thinking: The internet will change the world, let's buy internet stocks! China will grow forever, let's buy Chinese stocks! You can go back and look at all the bubbles (that I've mentioned in other posts too) and you will see a lot of first-level thinking as the cause of many of them.
I posted about theme investing, and that also falls into that category of first-level thinking unless more work is done to determine if an investment idea is sound. Just looking at the bright future of an industry or sector is not enough. Sure, solar energy may be a large part of the answer to our energy problems, but choosing the right solar energy company that will do well is an entirely different question (like trying to pick the internet winners in 1999 or auto company winners in the 1920s, or PC companies in the early 80s etc...).
Right now, I tend to think we are in sort of a macro-calling bubble. After a few people made huge killings in the subprime bubble collapse, everyone seems to be looking for the next great trade. It seems almost like everyone has John Paulson and/or Michael Burry envy. (Paulson and Burry are two of a small group of people who made out really well in the subprime collapse.)
But a lot of this thinking seems to be first-level thinking. Bernanke and Geithner will destroy the dollar, therefore avoid U.S. dollar denominated assets, or buy a lot of gold and commodities. There is way too much debt in the world so sell stocks etc...
Much of the commentary you see in the financial press seems to be full of this first-level thinking.
Gold seems to be in this sort of first-level thinking phase too; the only way to avoid a depression is for the Fed and other central banks around the world to print more money. This is inevitable, and politicians will not cut spending for fear of increasing unemployment. Therefore inflation, if not hyper-inflation is inevitable. But this is still all first-level thinking. Where is the mispricing in the market?
Just because the market validates a view in the short term does not make it correct (internet stocks in the 1990s and Japanese stocks in the 1980s too went up for a while defying common sense).
This is not to say that gold is in the final stages of a bubble like internet stocks were in 2000 (but the fact that more than twice as many people thought gold is a better investment than stocks in a recent survey is a bit worrisome). I have no idea what will happen to gold prices; I just want to make the point that the arguments of the gold bulls, to me, just sound first-level-ish.
Anyway, it's important also to note that Paulson and Burry both did far more than just predict the housing market collapse and financial crisis. There were quite a few people who did predict that. But most people who called the collapse didn't make money on it. This is because they were stuck in fisrt-level thinking and did simple trades like short housing stocks and bank stocks. Even with the collapse in the stock market, it is notoriously difficult to make money shorting stocks; just look at how fast bank stocks rebounded after the March 2009 low.
Paulson and Burry did predict a collapse, but they went on to the second-level thinking and actually found the right trades to put on. Where was the big mispricing in the marketplace? They found that in the subprime mortgage derivatives market. Others didn't. So the difference between the gloom and doomers (that are usually on CNBC often telling us that the end of the world is near) and Paulson/Burry is that Paulson/Burry did enough work to actually find the right trades (second-level thinking).
In any case, when you have an urge to do something, like sell stocks because you read in the papers that Greece will default and French banks will go bust, or you want to sell perfectly good stocks at decent valuations because consumers won't be able to increase spending due to too much debt, or because the economists are lowering their GDP growth estimates for the second half of the year or next year, I would think very hard if you are about to make an investment decision based on first-level thinking or second-level thinking.
I have a feeling that I will be referring back to this post a lot in the future...
Friday, September 23, 2011
Where Will the Market Go?
The S&P 500 index closed at 1136.43 and gold closed at $1642.50 per ounce today. I said before that this is not a market forecasting or predicting blog, and I actually really have no idea where the market will go from here. It certainly doesn't look good.
But I thought I would just highlight a thought I had in the past week or so. There are certainly a lot of problems in the world today, one of them being way too much debt. This debt will certainly dampen demand going forward into the future. The Fed and Congress seem to have used up their silver bullets; interest rates are already at zero, and the budget deficit is already 10%. The two levers of economic management can't be used now.
This has sort of been known for a few years now and is not new. The European sovereign debt problems is not new either. We went through this last year.
The interesting point is that now we are actually discounting the freezing up of the financial markets again just like when Lehman went bust. More and more institutions are refusing to trade with or lend to French banks, for example. This is sort of turning into a panic. Of course, there is a chance that the EU will misplay this and a total disaster may happen, but I doubt that. Europe is where the U.S. was, I think, right in front of TARP.
Strong, decisive action in Europe to draw a line on the financial instutions would put a halt to this current panic. We can't solve the debt troubles right away, but we certainly can put a stop to the fears of liquidity disappearing.
Will the U.S. Follow Japan's Path?
This has been talked about too for many years, and more and more, it looks like the U.S. is following in Japan's footsteps. For years, people denied a Japan bubble-like event can occur here. Time and again, we said, nope. Can't happen here. U.S. regulation and disclosure is better. The Fed is better. The banks are better.
But as time goes on, we seem to follow in Japan's very step. A few years ago, if you said short term rates would go to zero like Japan, people would have thought you're nuts. They would have said that with Greenspan / Bernanke, rates would go into the double digits with inflation.
Nope. We got zero interest rates.
If you said the 10-year treasury yields would go below a Japan-like 2.0%, people would have said the same thing. Nope. Can't happen. Helicopter Ben would see to it that it won't happen. He would print so much money that in fact he would cause a crash in the bond market.
And here we are with ten year treasury bond rates below 2%.
So what will happen to U.S. stock prices? Will we follow Japan and have a 20+ year bear market taking the market down 80%? This is certainly possible, and already, we have gone through two major bear markets in the past ten years. We may be flat for another ten years, who knows?
I don't want to argue that we won't go down the path Japan did, because every time someone denies the possibility of something, it seems to happen.
But I do think it's important to look at some differences too.
Valuations
First of all, when the Japanese stock market peaked in December 1989, the stock market was trading at a p/e ratio of 60-80x, depending on what data you use. Either way, that was a very, very high valuation. Even after the popping of the bubble, the p/e ratio stayed as high as 40-50x for many, many years. Then it drifted down to 30x, and then to 20x which I thought was still too expensive.
I think after more than 20 years and an 80% decline, stock prices are finally down to a more normal 15x p/e ratio.
So much of this stock market decline is due to a large decline in the valuation. The U.S. stock market never got that high even during the internet bubble, and is certainly nowhere near that kind of level now.
ROE
Second, I have been looking for Japanese stocks to invest in for years and I am always baffled at how low the return on capital levels are for the listed companies. ROE is the driver of equity/shareholder returns, so it's no wonder a market full of low ROE companies will perform poorly over time.
This is not the case in the U.S. CEOs are very conscious of ROE and use capital much more effciently.
Also, ROE is low in Japan largely due to the fact that the Japanese capitalist system runs under what I think Canon's CEO, Fujio Mitarai once called "corporate socialism". He said that Japanese companies cannot run efficiently because Japan doesn't have a social safety net (unemployment) like the U.S. so they can't fire people. In the U.S. when times are bad, corporations downsize and the government's safety net takes care of the unemployed.
Since there is no such mechanism in Japan, corporations can't downsize so they have to retain their high cost base even in a shrinking industry or economy. This is bad for the company and for the people. As Jack Welch used to say all the time, you aren't doing anyone a favor by keeping someone employed when they shouldn't be. The sooner you let someone go so they can find some productive work to benefit society, the better. With this sort of inefficient labor market, is it really any wonder that Japan hasn't improved in 20 years? You end up with many large, overstaffed corporations deploying both labor and capital inefficiently! This is not rocket science.
Since there is no such problem in the U.S., corporations can adjust pretty quickly to the changing environment.
(This is one reason why I am not so worried about the U.S. banks and financial institutions. In Japan, zombie banks are left to survive for many years due to the fact they can't reorganize/restructure and become competitive, and the government won't let them fail either for fear of high unemployment and the social instability that may cause. This is bad for the whole sector, of course.)
Global
Also, it is interesting to notice that during the horrible years in Japan, globally competitive businesses tended to do well. Toyota, for example, seemed to trade more in line with the S&P 500 index than the Nikkei. This is due to their international competitiveness.
But the retail sector, financial sector and other areas that had no global competitiveness did horribly. (of course there are brilliant exceptions like Seven-Eleven Japan (now part of Seven and I Holdings), Fast Retailing among others. ).
What does that teach us about the future of the U.S. market?
For one, I think as long as U.S. stocks are bought at reasonable prices, they should perform well over time. Second of all, if they have presence globally and are competitive, that's also very good. A good way to play global growth, or diversify away from what may be slow growth in the U.S. is to invest in the best global companies based here. Of course, the usual suspects are Coca Cola, Proctor and Gamble and the other usual American global blue chips.
A company like Goldman Sachs tends to be pretty competitive internationally, unlike most Japanese financial institutions. YUM Brands and McDonald's have great global presence and is very competitive. Most of these businesses are available here for reasonable prices.
Bottom Line
So to me, the bottom line tends to be that if you invest at a reasonable price in a business that is globally competitive with decent returns on capital, you should do fine. The Japan problem, at least in terms of stock market investing can be avoided by not paying ridiculous prices for any business, and staying away from low ROE, uncompetitive companies.
At the end of the day, it's not really about trying to predict what will happen in the U.S. economy in the next ten years and worrying about the Japan scenario. It's about finding good businesses at reasonable prices (which was hard to do in Japan over the past 20 years, and I argue it's not so hard here in the U.S. now).
Instead of trying to figure out where the markets will go, I think it's more important to understand that good stocks will go up and bad stocks will go down (over time). And that will always be the case no matter the macro scenario.
But I thought I would just highlight a thought I had in the past week or so. There are certainly a lot of problems in the world today, one of them being way too much debt. This debt will certainly dampen demand going forward into the future. The Fed and Congress seem to have used up their silver bullets; interest rates are already at zero, and the budget deficit is already 10%. The two levers of economic management can't be used now.
This has sort of been known for a few years now and is not new. The European sovereign debt problems is not new either. We went through this last year.
The interesting point is that now we are actually discounting the freezing up of the financial markets again just like when Lehman went bust. More and more institutions are refusing to trade with or lend to French banks, for example. This is sort of turning into a panic. Of course, there is a chance that the EU will misplay this and a total disaster may happen, but I doubt that. Europe is where the U.S. was, I think, right in front of TARP.
Strong, decisive action in Europe to draw a line on the financial instutions would put a halt to this current panic. We can't solve the debt troubles right away, but we certainly can put a stop to the fears of liquidity disappearing.
Will the U.S. Follow Japan's Path?
This has been talked about too for many years, and more and more, it looks like the U.S. is following in Japan's footsteps. For years, people denied a Japan bubble-like event can occur here. Time and again, we said, nope. Can't happen here. U.S. regulation and disclosure is better. The Fed is better. The banks are better.
But as time goes on, we seem to follow in Japan's very step. A few years ago, if you said short term rates would go to zero like Japan, people would have thought you're nuts. They would have said that with Greenspan / Bernanke, rates would go into the double digits with inflation.
Nope. We got zero interest rates.
If you said the 10-year treasury yields would go below a Japan-like 2.0%, people would have said the same thing. Nope. Can't happen. Helicopter Ben would see to it that it won't happen. He would print so much money that in fact he would cause a crash in the bond market.
And here we are with ten year treasury bond rates below 2%.
So what will happen to U.S. stock prices? Will we follow Japan and have a 20+ year bear market taking the market down 80%? This is certainly possible, and already, we have gone through two major bear markets in the past ten years. We may be flat for another ten years, who knows?
I don't want to argue that we won't go down the path Japan did, because every time someone denies the possibility of something, it seems to happen.
But I do think it's important to look at some differences too.
Valuations
First of all, when the Japanese stock market peaked in December 1989, the stock market was trading at a p/e ratio of 60-80x, depending on what data you use. Either way, that was a very, very high valuation. Even after the popping of the bubble, the p/e ratio stayed as high as 40-50x for many, many years. Then it drifted down to 30x, and then to 20x which I thought was still too expensive.
I think after more than 20 years and an 80% decline, stock prices are finally down to a more normal 15x p/e ratio.
So much of this stock market decline is due to a large decline in the valuation. The U.S. stock market never got that high even during the internet bubble, and is certainly nowhere near that kind of level now.
ROE
Second, I have been looking for Japanese stocks to invest in for years and I am always baffled at how low the return on capital levels are for the listed companies. ROE is the driver of equity/shareholder returns, so it's no wonder a market full of low ROE companies will perform poorly over time.
This is not the case in the U.S. CEOs are very conscious of ROE and use capital much more effciently.
Also, ROE is low in Japan largely due to the fact that the Japanese capitalist system runs under what I think Canon's CEO, Fujio Mitarai once called "corporate socialism". He said that Japanese companies cannot run efficiently because Japan doesn't have a social safety net (unemployment) like the U.S. so they can't fire people. In the U.S. when times are bad, corporations downsize and the government's safety net takes care of the unemployed.
Since there is no such mechanism in Japan, corporations can't downsize so they have to retain their high cost base even in a shrinking industry or economy. This is bad for the company and for the people. As Jack Welch used to say all the time, you aren't doing anyone a favor by keeping someone employed when they shouldn't be. The sooner you let someone go so they can find some productive work to benefit society, the better. With this sort of inefficient labor market, is it really any wonder that Japan hasn't improved in 20 years? You end up with many large, overstaffed corporations deploying both labor and capital inefficiently! This is not rocket science.
Since there is no such problem in the U.S., corporations can adjust pretty quickly to the changing environment.
(This is one reason why I am not so worried about the U.S. banks and financial institutions. In Japan, zombie banks are left to survive for many years due to the fact they can't reorganize/restructure and become competitive, and the government won't let them fail either for fear of high unemployment and the social instability that may cause. This is bad for the whole sector, of course.)
Global
Also, it is interesting to notice that during the horrible years in Japan, globally competitive businesses tended to do well. Toyota, for example, seemed to trade more in line with the S&P 500 index than the Nikkei. This is due to their international competitiveness.
But the retail sector, financial sector and other areas that had no global competitiveness did horribly. (of course there are brilliant exceptions like Seven-Eleven Japan (now part of Seven and I Holdings), Fast Retailing among others. ).
What does that teach us about the future of the U.S. market?
For one, I think as long as U.S. stocks are bought at reasonable prices, they should perform well over time. Second of all, if they have presence globally and are competitive, that's also very good. A good way to play global growth, or diversify away from what may be slow growth in the U.S. is to invest in the best global companies based here. Of course, the usual suspects are Coca Cola, Proctor and Gamble and the other usual American global blue chips.
A company like Goldman Sachs tends to be pretty competitive internationally, unlike most Japanese financial institutions. YUM Brands and McDonald's have great global presence and is very competitive. Most of these businesses are available here for reasonable prices.
Bottom Line
So to me, the bottom line tends to be that if you invest at a reasonable price in a business that is globally competitive with decent returns on capital, you should do fine. The Japan problem, at least in terms of stock market investing can be avoided by not paying ridiculous prices for any business, and staying away from low ROE, uncompetitive companies.
At the end of the day, it's not really about trying to predict what will happen in the U.S. economy in the next ten years and worrying about the Japan scenario. It's about finding good businesses at reasonable prices (which was hard to do in Japan over the past 20 years, and I argue it's not so hard here in the U.S. now).
Instead of trying to figure out where the markets will go, I think it's more important to understand that good stocks will go up and bad stocks will go down (over time). And that will always be the case no matter the macro scenario.
What is Softbank Worth?
Now that we have a value of $32 billion for all of Alibaba Group (see previous post), we might as well look at the sum-of-the-parts or stub valuation of Softbank Corp.
Softbank Corp. owns 32.6% of the Alibaba Group, and that's worth $10.4 billion or 790 billion yen.
Let's look at all Softbank's holdings.
Softbank's Equity Holdings
Yahoo Japan, 42.6% stake: 559 billion yen
Yahoo Inc., 4% stake: 55.8 billion yen
RenRen Inc., 33.4% stake: 52 billion yen
Alibaba, 32.6% stake: 790 billion yen
All of these holdings together make up a value of 1.46 trillion yen.
Softbank stock closed last night at 2282/share, so the total enterprise value of Softbank is around 3.7 trillion yen. In other words, these equity holdings account for 39% of the total enterprise value of Softbank and around 60% of the total market capitalization of the company.
What does that mean?
The first way to look at it is as a stub trade. Take the away the equity holdings from the value of the total company and see what the rest of the business is worth on a P/E and EV/EBITDA ratio basis. To do this, I deduct the value of the investments from the market capitalization and total enterprise value respectively and then divide it by EPS and EBITDA, both with Yahoo Japan's contribution excluded (and any equity income).
First, if you deduct 1.46 trillion yen from the enterprise value of 3.7 trillion yen, you have 2.2 trillion yen for Softbank's mobile phone and telecommunication and other businesses (excluding income generated by the above investments).
EBITDA and net earnings on that basis were 767 billion yen and 230 billion respectively.
This means that excluding the equity investments, Softbank's telecommunication business is trading for 2.9x EV/EBITDA and 4.6x p/e.
That is pretty cheap, although Softbank's telecommunication business is not the best in Japan (they do have iPhone/iPad exclusivity now, but that will end soon and people wonder how good Softbank can be after that as they have by far the worst network).
As comparison, NTT Docomo was recently trading at 11.6x p/e and 3.6x EV/EBITDA ratio and KDDI was trading at 4x EV/EBITDA and 9.9x p/e.
For all of these figures, I used the full year 2010 numbers. These valuation figures for Softbank may be way lower if they continue the high growth they have acheived recently.
An important point, however, is that I haven't deducted taxes on their equity investments. If I apply a 40% tax rate to the above holdings (because most of their value is unrealized profits), the after tax value of their investments would be 876 billion yen. And the respective valuations for the rest of Softbank, their telecommunications business would be 3.7x EV/EBITDA and 7.1x p/e.
So what is Softbank worth?
It really depends on your assumptions, but from the above we know that the investments are worth either 1300 yen/share of Softbank, or 800 yen depending on tax treatment (some people use 20% or 30% discounts to account for taxes and liquidity issues).
From there, you can apply a valuation measure you like for the telecommunications business. For example, if you think 10x p/e is fair, the telecom business is worth 2100 yen per share. Combining that with the gross value of investments gives you 3,400 yen/share value versus the current price of around 2,300 yen/share.
Being more conservative and accounting for taxes, the same figure would be 2,900 yen per share, not too far off where it is trading now.
Using an EV/EBITDA ratio of 5x would give a total value of 300 or 400 yen per share higher than the above.
So What do I think?
This is certainly and interesting play, but so much of the value is based on value of the telecommuncation business. I tend not to like the mobile/telecommunication business because it always seems to me that they have to spend tons of money on capex to keep the network up to date. They look great when they are growing or when they are taking market share, but when that growth period ends, they tend to trade cheaply. And then the competitors price cut each other and it turns into a brutal scene.
I actually don't know much about the mobile phone/telecommunication business, these are just my impressions.
So although this looks like an interesting opportunity, it is not one of my favorite ideas at the moment.
Softbank Corp. owns 32.6% of the Alibaba Group, and that's worth $10.4 billion or 790 billion yen.
Let's look at all Softbank's holdings.
Softbank's Equity Holdings
Yahoo Japan, 42.6% stake: 559 billion yen
Yahoo Inc., 4% stake: 55.8 billion yen
RenRen Inc., 33.4% stake: 52 billion yen
Alibaba, 32.6% stake: 790 billion yen
All of these holdings together make up a value of 1.46 trillion yen.
Softbank stock closed last night at 2282/share, so the total enterprise value of Softbank is around 3.7 trillion yen. In other words, these equity holdings account for 39% of the total enterprise value of Softbank and around 60% of the total market capitalization of the company.
What does that mean?
The first way to look at it is as a stub trade. Take the away the equity holdings from the value of the total company and see what the rest of the business is worth on a P/E and EV/EBITDA ratio basis. To do this, I deduct the value of the investments from the market capitalization and total enterprise value respectively and then divide it by EPS and EBITDA, both with Yahoo Japan's contribution excluded (and any equity income).
First, if you deduct 1.46 trillion yen from the enterprise value of 3.7 trillion yen, you have 2.2 trillion yen for Softbank's mobile phone and telecommunication and other businesses (excluding income generated by the above investments).
EBITDA and net earnings on that basis were 767 billion yen and 230 billion respectively.
This means that excluding the equity investments, Softbank's telecommunication business is trading for 2.9x EV/EBITDA and 4.6x p/e.
That is pretty cheap, although Softbank's telecommunication business is not the best in Japan (they do have iPhone/iPad exclusivity now, but that will end soon and people wonder how good Softbank can be after that as they have by far the worst network).
As comparison, NTT Docomo was recently trading at 11.6x p/e and 3.6x EV/EBITDA ratio and KDDI was trading at 4x EV/EBITDA and 9.9x p/e.
For all of these figures, I used the full year 2010 numbers. These valuation figures for Softbank may be way lower if they continue the high growth they have acheived recently.
An important point, however, is that I haven't deducted taxes on their equity investments. If I apply a 40% tax rate to the above holdings (because most of their value is unrealized profits), the after tax value of their investments would be 876 billion yen. And the respective valuations for the rest of Softbank, their telecommunications business would be 3.7x EV/EBITDA and 7.1x p/e.
So what is Softbank worth?
It really depends on your assumptions, but from the above we know that the investments are worth either 1300 yen/share of Softbank, or 800 yen depending on tax treatment (some people use 20% or 30% discounts to account for taxes and liquidity issues).
From there, you can apply a valuation measure you like for the telecommunications business. For example, if you think 10x p/e is fair, the telecom business is worth 2100 yen per share. Combining that with the gross value of investments gives you 3,400 yen/share value versus the current price of around 2,300 yen/share.
Being more conservative and accounting for taxes, the same figure would be 2,900 yen per share, not too far off where it is trading now.
Using an EV/EBITDA ratio of 5x would give a total value of 300 or 400 yen per share higher than the above.
So What do I think?
This is certainly and interesting play, but so much of the value is based on value of the telecommuncation business. I tend not to like the mobile/telecommunication business because it always seems to me that they have to spend tons of money on capex to keep the network up to date. They look great when they are growing or when they are taking market share, but when that growth period ends, they tend to trade cheaply. And then the competitors price cut each other and it turns into a brutal scene.
I actually don't know much about the mobile phone/telecommunication business, these are just my impressions.
So although this looks like an interesting opportunity, it is not one of my favorite ideas at the moment.
Alibaba Worth $32 Billion, Yahoo Worth?
Figuring out the value of Alibaba Group was a bit of a parlor game as Alibaba Group has dominant businesses that are not listed. Alibaba.com is the only listed entity in the group.
The value of Alibaba Group is a crucial factor in determining the value of Yahoo Inc. (YHOO) stock. I posted Dan Loeb's analysis here. This is based on his letter to the YHOO board in September 2011 so the values are still pretty fresh.
Anyway, it was reported last night that DST Global and Silver Lake Partners will invest up to $1.6 billion in Alibaba Group, valuing the whole group at $32 billion. The buying group includes Yunfeng Capital which Jack Ma owns.
This is interesting in a couple of ways. First of all, the fact that Jack Ma's Yunfeng Capital is in the buying group is encouraging in that it means Ma thinks this is a good price (to buy Alibaba Group). It's nice when the founder and owner validates a valuation by purchasing a stake at that price. This is the opposite of owner/founders selling into an IPO, for example.
Second of all, the fact that Silver Lake Partners and other institutions are buying into this also starts the clock on an IPO or some sort of exit strategy for Alibaba Group. Private equity firms typically buy unlisted companies looking to get out via a sale or IPO. In this case, the exit is likely to be an IPO as large high growth technology companies typically do an IPO instead of sell itself privately to another entity.
Why is this interesting? When Yahoo Inc. and Softbank were arguing with Jack Ma about their stake in Alibaba Group and Alipay, Ma has stated that he has no intention of doing an IPO for Alibaba Group. He said it was completely off the table and not even on the horizon.
The fact that private equity money is coming in changes that a bit. I doubt Silver Lake would invest in an open-ended situation. The clock is going to run now like it hasn't before. Also, the fact that a private equity firm has bought into Alibaba at a $32 billion valuation implies that Alibaba is worth far more than that. Private Equity firms don't buy stakes at fair value. They only buy with an expectation of high return.
This, of course, is good for YHOO, as they now have 'allies' with interests in seeing their Alibaba stake monetized. And of course, an IPO would be the best way for YHOO to monetize the position if they can spin it off tax free(as opposed to selling their Alibaba stake in a private transaction that might give YHOO a hefty tax bill).
So what is YHOO worth now? I still think Loeb's analysis is not far off and is a very conservative view.
But let's take a look at a simple view assuming they can spin off these positions tax efficiently at some point.
Here are the big peices of YHOO's value:
Yahoo Japan stake: $6 billion
Alibaba Group: $12.8 billion (40% of $32 billion)
Total: $18.8 billion
Yahoo also has a lot of cash, cash equivalents, short term debt securities and long term debt securities. The total of that is $3.26 billion.
All of that together gives you $22.06 billion in value before considering YHOO's operating business. This $22 billion comes out to $17.51/share, versus a stock price in the $14.70.
What is Yahoo's operating business worth? Nothing? I think not. In the first half of 2011, YHOO's operating business generated net income of $272 million. This excludes income on investments and equity income and is after tax.
Annualize that and you get $544 million. That comes out to $0.43/share of eps. At 10x p/e, that comes to $4.30/share in value.
Add that to $17.51 of cash, investments and their Asian holdings, that comes out to $21.80/share.
If you assume a 40% tax rate on their Asian holdings, the total number would be a bit lower. Total investments and cash would be $11.56/share. Deduct that from the current stock price of $14.70 and you get $3.14 price for the operating business that is earning $0.43/share. So that's a p/e of 7.3x p/e.
In any case, that's just a quick look at Yahoo. There is a chance that YHOO is worth far higher, as Loeb says, due to the growth of Alibaba and even slight operational improvements in YHOO's main, U.S. business.
The value of Alibaba Group is a crucial factor in determining the value of Yahoo Inc. (YHOO) stock. I posted Dan Loeb's analysis here. This is based on his letter to the YHOO board in September 2011 so the values are still pretty fresh.
Anyway, it was reported last night that DST Global and Silver Lake Partners will invest up to $1.6 billion in Alibaba Group, valuing the whole group at $32 billion. The buying group includes Yunfeng Capital which Jack Ma owns.
This is interesting in a couple of ways. First of all, the fact that Jack Ma's Yunfeng Capital is in the buying group is encouraging in that it means Ma thinks this is a good price (to buy Alibaba Group). It's nice when the founder and owner validates a valuation by purchasing a stake at that price. This is the opposite of owner/founders selling into an IPO, for example.
Second of all, the fact that Silver Lake Partners and other institutions are buying into this also starts the clock on an IPO or some sort of exit strategy for Alibaba Group. Private equity firms typically buy unlisted companies looking to get out via a sale or IPO. In this case, the exit is likely to be an IPO as large high growth technology companies typically do an IPO instead of sell itself privately to another entity.
Why is this interesting? When Yahoo Inc. and Softbank were arguing with Jack Ma about their stake in Alibaba Group and Alipay, Ma has stated that he has no intention of doing an IPO for Alibaba Group. He said it was completely off the table and not even on the horizon.
The fact that private equity money is coming in changes that a bit. I doubt Silver Lake would invest in an open-ended situation. The clock is going to run now like it hasn't before. Also, the fact that a private equity firm has bought into Alibaba at a $32 billion valuation implies that Alibaba is worth far more than that. Private Equity firms don't buy stakes at fair value. They only buy with an expectation of high return.
This, of course, is good for YHOO, as they now have 'allies' with interests in seeing their Alibaba stake monetized. And of course, an IPO would be the best way for YHOO to monetize the position if they can spin it off tax free(as opposed to selling their Alibaba stake in a private transaction that might give YHOO a hefty tax bill).
So what is YHOO worth now? I still think Loeb's analysis is not far off and is a very conservative view.
But let's take a look at a simple view assuming they can spin off these positions tax efficiently at some point.
Here are the big peices of YHOO's value:
Yahoo Japan stake: $6 billion
Alibaba Group: $12.8 billion (40% of $32 billion)
Total: $18.8 billion
Yahoo also has a lot of cash, cash equivalents, short term debt securities and long term debt securities. The total of that is $3.26 billion.
All of that together gives you $22.06 billion in value before considering YHOO's operating business. This $22 billion comes out to $17.51/share, versus a stock price in the $14.70.
What is Yahoo's operating business worth? Nothing? I think not. In the first half of 2011, YHOO's operating business generated net income of $272 million. This excludes income on investments and equity income and is after tax.
Annualize that and you get $544 million. That comes out to $0.43/share of eps. At 10x p/e, that comes to $4.30/share in value.
Add that to $17.51 of cash, investments and their Asian holdings, that comes out to $21.80/share.
If you assume a 40% tax rate on their Asian holdings, the total number would be a bit lower. Total investments and cash would be $11.56/share. Deduct that from the current stock price of $14.70 and you get $3.14 price for the operating business that is earning $0.43/share. So that's a p/e of 7.3x p/e.
In any case, that's just a quick look at Yahoo. There is a chance that YHOO is worth far higher, as Loeb says, due to the growth of Alibaba and even slight operational improvements in YHOO's main, U.S. business.
LUK Buys More Jeffries Group Stock
The CEO of Jefferies Group, Richard Handler sold 2 million of his shares to Leucadia National Corporation (LUK). This is not that particularly noteworthy but it does illustrate the sort of advantage a firm like Leucadia has. Although the price looks around market price and anyone could have bought JEF shares in the public market, it is firms like LUK that often gets a call on deals when there is size to be offered.
Of course this sort of thing happens all the time between broker-dealers and mutual funds and other institutional investors.
But the difference is that people do know that LUK is a very smart, long term investor and not subject to the ups and downs of the market (like mutual funds and hedge funds that are whipsawed by redemptions etc...) so are very reliable investors.
The kind of calls that LUK gets, presumably on a daily basis, on deals and investment ideas will tend to be high quality ideas as compared to what a typical mutual fund manager might get.
This is also true of Berkshire Hathaway, of course. If you look at the history of their acquisitions, they have done deals that would have not come to any individual investor or even a large mutual fund or other institutional investor. This means they get a great opportunity at a very good price. For example, look at their most recent Bank of America deal. It is an incredibly attractive deal compared to what is available to the rest of us. BRK has done similar deals with GE, GS and others.
This is why it is such a great opportunity to be able to buy into organizations like this at book value or less: You don't just get the current collection of businesses at fair value, but you get all the future deals that come too and you have the smartest guys on the planet making the decisions. What's not to like about that?
You can also make the same argument about JPM and GS, which I have posted about recently. These guys will also get 'first look' or early looks into potential deals. JPM's purchase of Washington Mutual and Bear Stearns may not have been as good as it looked at first, but they were deals that only JPM could have closed. There will be more in the future.
GS too, gets to invest in all sorts of opportunities that most people will never get a chance to look at. I think they even own a stake in Facebook, for example.
Sometimes people lament the fact that they don't have any more cash to buy stocks to take advantage when the markets go wild like it is now. It is important to remember, though, that if an investor is 'fully' invested, that doesn't mean that the companies they own are.
LUK has more than a billion of cash and short term investments on it's balance sheet. GS has been pretty conservative in the past year or so in terms of using the balance sheet. They have said repeatedly on conference calls that this has simply been a function of waiting for the right opportunities to deploy their capital and it really doesn't have anything to do with new regulations.
BRK, of course, is generating cash every single day. So even if someone had 100% of their net worth invested in BRK, that doesn't mean they can't take advantage of this current panic in the markets, because BRK will do that. And who better to deploy the ever increasing free cash flow into attractively priced investments than that old man in Omaha?
Of course this sort of thing happens all the time between broker-dealers and mutual funds and other institutional investors.
But the difference is that people do know that LUK is a very smart, long term investor and not subject to the ups and downs of the market (like mutual funds and hedge funds that are whipsawed by redemptions etc...) so are very reliable investors.
The kind of calls that LUK gets, presumably on a daily basis, on deals and investment ideas will tend to be high quality ideas as compared to what a typical mutual fund manager might get.
This is also true of Berkshire Hathaway, of course. If you look at the history of their acquisitions, they have done deals that would have not come to any individual investor or even a large mutual fund or other institutional investor. This means they get a great opportunity at a very good price. For example, look at their most recent Bank of America deal. It is an incredibly attractive deal compared to what is available to the rest of us. BRK has done similar deals with GE, GS and others.
This is why it is such a great opportunity to be able to buy into organizations like this at book value or less: You don't just get the current collection of businesses at fair value, but you get all the future deals that come too and you have the smartest guys on the planet making the decisions. What's not to like about that?
You can also make the same argument about JPM and GS, which I have posted about recently. These guys will also get 'first look' or early looks into potential deals. JPM's purchase of Washington Mutual and Bear Stearns may not have been as good as it looked at first, but they were deals that only JPM could have closed. There will be more in the future.
GS too, gets to invest in all sorts of opportunities that most people will never get a chance to look at. I think they even own a stake in Facebook, for example.
Sometimes people lament the fact that they don't have any more cash to buy stocks to take advantage when the markets go wild like it is now. It is important to remember, though, that if an investor is 'fully' invested, that doesn't mean that the companies they own are.
LUK has more than a billion of cash and short term investments on it's balance sheet. GS has been pretty conservative in the past year or so in terms of using the balance sheet. They have said repeatedly on conference calls that this has simply been a function of waiting for the right opportunities to deploy their capital and it really doesn't have anything to do with new regulations.
BRK, of course, is generating cash every single day. So even if someone had 100% of their net worth invested in BRK, that doesn't mean they can't take advantage of this current panic in the markets, because BRK will do that. And who better to deploy the ever increasing free cash flow into attractively priced investments than that old man in Omaha?