Monday, November 28, 2011

Alleghany - Transatlantic Merger

On November 21, Alleghany (Y) and Transatlantic (TRH) announced a merger.  Since I mentioned Y here, I feel obliged to make a comment.   I haven't really ever looked at TRH in detail so I don't know, but assuming that the folks at Y know what they're doing (which has been my contention) then this is probably a pretty good deal.  The folks at Y are super conservative and has created a lot of shareholder value over time and they have a long history of making rational decisions.

The basic idea of this merger is that Y is not only a good manager of insurance, but also are very good capital allocators.  TRH brings to the table a bunch of new 'float' and a global insurance organization. 

So combining Y's asset management skills with the scale of TRH's global business has great potential for turning the new company into a really great organization.

Of course, the risk is that TRH has a bunch of underreserved, bad risks in their book.  TRH used to be an AIG company, so obviously this is a risk.

But again, Y has been known to be really conservative and thorough.  If you read their annual reports going back, you will understand that these guys are not trigger-happy at all and are very slow to move and really kick the tires on their investments.

An added layer of safety on the insurance aspect is the fact that they will have Joe Brandon run the combined insurance business of the new entity.  Joe Brandon is basically a 'star' in the insurance business.

(You can read my original post on Y here)

Anyway, from the Y-TRH merger presentation, here are some basic facts:

Alleghany Creates Value
Here is an updated chart of Y's book value per share and stock price versus the S&P 500 index going back to the year 2000.   They have added value over time very nicely, even with an awful stock market, horrible insurance market and the great recession and all that other stuff.  So Y has grown book value through the 2000-2002 bear market and the recent financial crisis.

Alleghany is a Good Insurance Underwriter
This is the combined ratio of Alleghany's insurance business compared to peers.  This shows that they are good underwriters and do walk the talk.

Alleghany is a Good Fund Manager
Alleghany has proven to be good equity portfolio managers too.  One of the positives of this deal is that Alleghany will be able to manage the combined float for possibly higher returns than TRH has been able to until now.  Of course, investing in equities is risky, but if Alleghany can keep the equity allocation limited to their shareholders equity or something like that, it should be fine (like Markel and Berkshire Hathaway).

Transatlantic Has Also Grown Value Over Time
Transatlantic, being a former AIG company has some baggage.  They had some serious underreserving problems back in the early 2000s so I have no idea how good their reserves are now.  But again, Alleghany are very good managers and the fact that Joe Brandon is coming on board to run the combined insurance company is a very good thing.  Joe Brandon is highly regarded by Warren Buffett; he ran and turned around Gen Re back in the 2000s until he got caught up in the AIG investigation (which turned up nothing against Brandon).

Here is the combined ratio history of TRH since 1999:

The average combined ratio since 1999 is 101.14%.  The ten year average is 101% and the five year average is 96.3%.  Anything less than 100% means that the insurance company is making money after paying all loss claims and underwriting costs.  A figure above 100% means the underwriting business is losing money.   These figures show a respectable insurance business with the cost of float at around 1% and much better in the recent past despite very large insured catastrophes in the recent past.

The combined ratio for the first nine months of 2011 is 114%, due to the Japanese and New Zealand earthquakes, Australian floods etc...   (The above combined ratios would be 101.9% for the whole period, 101.8% for the last ten years, 0.99% for five years if you add the nine months)

Book value per share (including accumulated dividends) in the above table still show growth, from $75.66 as of the end of December 2010 to $77.13/share at the end of September 2011.  They were able to grow BPS even after the huge losses in Japan, New Zealand and Australia.

Quality of Transatlantic's Insurance business?
I don't know and haven't followed TRH over the years, but it's safe to say that Y would not be buying into a crappy or low quality business.  Also, Berkshire Hathaway did make a one-time take-it-or-leave-it bid for TRH in August of this year (offering $54/share) and BRK is not known to buy crappy businesses.

So just on that, we can assume that TRH is a decent quality business.

But more important than that is who is going to run the combined insurance business after the merger.  This may be the most exciting part of this deal.

Who is Joe Brandon?
Joe Brandon was a 'star' manager at Berkshire Hathaway who ran Gen Re from 2001 to 2008 or so.  
Here is the float of the various BRK insurance businesses from the 2008 annual report.  You can see that Gen Re had $21 billion in float at the end of 2008 and accounted for a large part of BRK's entire float.  Of course, Ajit Jain is the big insurance star over at BRK (he manages BH Reinsurance) but Brandon handled pretty much a simliar amount in float.

Here is Buffett's comments about Brandon in the 2001 annual report:

Joe Brandon's job was to 'fix' Gen Re, and he did.  Here is Buffett one year later in the 2002 annual report:

Here is Buffett on Brandon in the 2007 annual report, six years after Brandon took over Gen Re:

And again in 2008 after Brandon stepped down (after pressure from the government):

So as you can see, Brandon was a star at BRK.  Buffett doesn't mention too many people in his annual reports, and not many of them get mentioned so often (OK, he did mention David Sokol very often and that turned out not too well).  Who better to run an insurance operation than someone who did it so well under Buffett?  In that sense, this merger is a great opportunity; an opportunity for investors and for Brandon to get back into the insurance business.

Proforma Look at Combined Company

Here is a look at the combined company from the merger presentation:

The deal will add 7% to Y's book value per share.  The investment leverage will go up from Y's current conservative 1.7x to 3.0x.  If Y can boost investment returns by increasing allocation to equities (and they will do this conservatively), this can really boost book value per share growth of the combined company.  In other words, the combined Y-TRH will grow faster on a BPS basis than on their own due to Y's investment skill and TRH's float.

How Much Does Owning Equities Improve Investment Returns?
So let's take a quick look at this.  One side of the story is that Y will be able to increase returns on float investments of the combined company.  At this point, TRH had very little in equities investments of their float. Equities was less than 5% of TRH's investments and accounted for 13% of the company's shareholders' equity.  Compared to this, Y had 31% of total investments in equities and equities was 52% of Y's shareholders' equity.

The pretax yield on investments at TRH for the period 2006-2010 were:

2006  4.2%
2007  3.9%
2008  3.8%
2009  4.1%
2010  3.7%

They don't break out returns on equity investments, but I assume it's not significant.

What can happen to this return if the combined Y increases equity investments?

We can get a hint of that from Y's 2010 annual report where it shows how equity investments have increased investment returns for Y:

We can see from the above table that owning equities, even during the worst financial crisis added about 2.9% to investment returns versus a fixed income benchmark.

First of all, let's look at the effect of increased investment leverage. From the above proforma table (of combined Y and TRH), we see that Y's current investment leverage (total investments divided by shareholders equity) is 1.7x.   Book value per share (BPS) has grown around 9%/year since 2000 at Y.  Investment leverage has changed over the years, but for simplicity, let's assume that it was around 1.7x (I don't think it was ever that much higher).  If the recent total investment returns were 7.9% (from above table), then we can figure out what BPS growth might have been if investment leverage was 3.0x, which is what it will be post-merger.

All else equal, if investment leverage in the past was 3.0x instead of 1.7x and investment total return was 7.9%, then BPS growth might have been more like 19%/year.   I just added incremental investment gains that come from increased leverage to the 9%/year BPS growth that Y achieved (yes, time periods here are not consistent, but this is just a quick analysis to visualize what might happen to returns going forward).   This was done by simply taking the returns of additional investments as a ratio to shareholders equity:  3.0x - 1.7x = 1.3x, so Y would have 1.3x shareholders equity in incremental returns.  That would lead to 1.3 x 7.9% = 10.3%.  This is incremental to the 9% BPS growth that Y actually achieved, so add that back for a total BPS growth of 19%.

In other words, in this simple scenario, if Y had investment leverage of 3.0x instead of 1.7x, BPS growth might have been 19%/year instead of 9%/year.  (There are a whole lot of other issues here not addressed so this, again, is a very rough approximation).

How about going the other way?  What if TRH had higher equity allocation, or if their investment returns were more like Y's than TRH's actual investment returns?

Again, this is very, very rough, but if we assume that TRH earned the benchmark fixed income index return of say, 5%, then Y's management might have added 2.9% to that investment return by holding more in equities.

Assuming TRH's investment leverage is 3.4x, that would be 9.9% in incremental investment returns on shareholders equity.  A 2.9% improvement in investment returns leveraged 3.4x is 9.9% (2.9% x 3.4).

So instead of the 12%-like increase in BPS for TRH over the years (again, from the above BPS growth chart of TRH), Y's improvement in investment returns might have made that more like 22%/year.

Of course, this is a very simple analysis and things won't work out so straightforwardly.

There will also be constraints to equity investments.  Y currently has 52% or so of shareholders equity in stocks and around 1/3 of total investments.  I doubt they will bump up equity investments to this level on the combined entity, even though I think it's possible.  I think one rule of thumb as a maximum is to limit equity investments to the total shareholders equity of the company itself; in other words invest net worth of the company in stocks, but keep all 'float' invested in fixed income.  This is sort of the model of Berkshire Hathaway and Markel.

From that point of view, there is plenty of room for the combined Y-TRH to increase equity investments to even above the current level of Y.

Knowing and understanding the superconservatisim of Y's management, I don't think that will happen very quickly.  Also, if you read the annual reports of Y over the past few years, you will know that they are pretty bearish on the world economy and markets.

But in any case, from the simple analysis here, I think it's safe to say that the merger between Y and TRH may add 10% to BPS growth of the combined entity just from the combination of increased investment returns and investment leverage.  This doesn't even begin to take into account any improvement in the insurance business itself, which may be a big story here.

So what do we have here?   It looks like a pretty darn good deal when you look at it the way I've looked at it above. You have:
  • Y getting increased leverage from TRH's float (combined entity investment leverage of 3.0x versus Y's current 1.7x)
  • TRH getting increased investment returns on it's float (from Y's own analysis, their equity investments increase returns by 2.9%/year, even in this horrible environment)
  • Deal is accretive to Y's BPS; just closing the deal will add 7% to Y's BPS
  • Both companies have decent underwriting histories according to their historical combined ratios
  • A one-time bid for TRH by Berkshire Hathaway sort of serves as a due diligence by the best in the business on TRH; BRK would not bid for a subpar business even at a cheap price (plus Y would not buy a crappy business)
  • Whatever risk and problems that might come with the insurance business, the fact that 'star' Joe Brandon will run the combined insurance operations sounds like a great deal for investors; this may be the biggest positive in the whole deal
Thinking about it this way makes the Y-TRH merger sound like a great idea and either Y or TRH great investments.

You can get into Y via TRH; instead of buying Y, you can buy TRH here and you will get Y shares when this deal closes. 

Merger-arb Trade
The deal is expected to close in the first quarter of 2012, so that's less than four months from now at most (if the deal actually closes).

In the first quarter of 2012, TRH shareholders will receive $14.22/share in cash and 0.145 shares of Y.  Here are the current prices:

Y:      $288/share
TRH: $54.60/share

If you own TRH now, the deal would be worth at current prices:

$14.22/share in cash plus 0.145 share of Y, now worth $41.76/share for a total value of $55.98/share of TRH stock.

With the stock trading at $54.60, that's a 2.47% discount.  If the deal closes at the end of the first quarter, the annualized return on the discount would be 2.47% x 12 / 4 (to annualize a four month return) = 7.4%.

So by buying TRH shares now versus Y, you will have a 7.4% added annualized bonus due to the merger discount plus whatever dividend TRH pays out until then.

Tuesday, November 22, 2011

Fairfax Financial's Interesting Bet

Fairfax Financial Holdings is yet another financial company (insurance) that is run by an incredible manager that has done really well over the years.  I know, I know. This is getting boring.  Just talking about well-run financial institutions trading at book value is not interesting or exciting at all.  I'd rather write about some interesting special situation with more analysis involved.

But I can't not mention stuff that looks interesting just because the bottom line is not that exciting: another financial trading at book value. 

Anyway, there is actually an interesting angle to this one that is more than just another cheap financial.

But first, a little background (but only a little).  Fairfax Financial Holdings is basically an insurance holding company that runs so-so insurance companies but grows through astute acquisitions and unconventional management of 'float' (in the case of Berkshire Hathaway, they manage top quality insurance business with top notch investing results).

Fairfax Holdings is run by Prem Watsa and his letter to shareholders are well worth reading going all the way back. (I really have to set up a link page or post on these "must reads").

Anyway, Fairfax was started 25 years ago and since then the growth in book value per share has been +25%/year.  This is astounding, of course.  It's right up there with Berkshire Hathaway, Leucadia and very few others (actually better).

Here is the history of their book value growth:

You can see, though, that most of the great growth occured in the early years as is often the case with these companies.

Here are the growth in book values over various time periods through December 2010:

Their returns since 2000 hasn't been that bad at all either, despite a flat stock market. We will see what earned those returns later.

How is their investment performance?
As an insurance company, Fairfax receives insurance premiums which they invest.  If their investment returns exceed their cost of float (payouts on insurance losses) they make a profit.

Watsa is known as a very good equity value manager.  Their bond returns are also pretty good.  From the 2010 annual report:

The interesting thing about Fairfax is that unlike Buffett and other value investors, they do actively hedge their equity exposure by using swaps and futures contracts.  I think they have been 100% hedged on their equity holdings in the recent past (meaning that although they own stocks, they are short a like amount so they will not get hurt in a declining market).

Even with stock market hedging (or maybe because of it, even though most people will hurt their performance by trying to hedge), they have earned very good returns in their equity portfolio, gaining +14.2%/year in the past five years versus only 2.3% for the S&P 500 index.

This is slightly different than what David Einhorn does at Greenlight Re; they run an active long/short fund.  It is simliar, though, in that they are not fully exposed to stock market volatility.

Just for the record, here is their large equity holdings which doesn't change all that often. It's always good to see what people with great track records own right now:

How are they as an insurance company?

Here is the long term performance of their insurance business:

Berkshire Hathaway, I think, has a cost of float of around zero over the years.  Fairfax, though, loses around 2.3% per year over time on their insurance businesses. This is what you can call the cost of float.  If you can get investment returns that exceed your cost of float, then you are making a profit. 

This is why Fairfax compares their long term cost of float with long term bond yields (which is a risk free cost of capital indicator).  The fact that their cost of float is less than the Canadian government bond yield means that the insurance business is in fact adding value despite underwriting losses over time.

So what's the big, interesting bet?

OK, so now that we took a quick look at Fairfax, the company, we will take a quick look at the big bet.

First, let's take a look at their recent big bet.  Fairfax recently hit a home run during the 2007-2008 crisis by having a big position in credit default swaps.  For a few years, they were criticized for putting on credit default swaps as a short against the credit bubble.  It did cost them money for a few years.  They also lost money on equity market hedges too, for a few years until those bets paid off big.

Below is a table they included in the 2008 annual report to illustrate this:

They lost money from 2003-2006 in these credit default swaps and equity hedges, but when the sh*t hit the fan, they paid off in a big way. (A credit default swap is a contract that pays out when there is a default on a debt; sort of like an insurance contract on credit; Fairfax bet heavily that there would be a lot of defaults)

Now, I have to say that I don't like insurance companies generally making big bets like this.  An insurance company shouldn't be acting like a hedge fund. But what is interesting here is that they weren't really taking huge directional risk as I think they were paying very little for some of these hedges, especially the credit default swaps which we now know was grossly mispriced.

As long as they don't spend too much capital or take too much risk, it's OK for them to take these asymmetric risk/return bets.  They weren't going to go out of business if their bets didn't pan out.  This is not how the bets were structured.

Also, it's important to remember that Fairfax put on these bets long before Michael Burry became a hero of sorts, and John Paulson's hedge fund made billions shorting subprime loans CDOs.  A lot of hedge funds and others, it seems to me, is rushing into these 'black swan'-type trades and I think a lot of that is driven by Burry/Paulson envy; they all want to find that next big trade.

However, Fairfax was looking for and found this before it has become trendy lately.

Anyway, enough of that.


So what's the trade, already?!  If you read Watsa's annual reports over the past few years, you know that Watsa is expecting a Japan-like balance sheet recession/depression in the U.S. if not the whole world.  He has been hugely influenced by the Japanese economist Richard Koo and his concept of the "balance sheet recession".  (A balance sheet recession is simply a recession driven by all economic actors' rushing to repair their balance sheet by paying down debt as opposed to a traditional cyclical recession where inventory adjustments are made.  A balance sheet recession cannot be exited by traditional easy money policies of lower interest rates as everyone is trying to pay down debt at the same time).

Much of the world seems to be betting on inflation; gold and other commodities are through the roof as continuing easy money from global central banks is seen as inevitable.  They see inflation as inevitable.  Ironically, this is happening at the same time as everyone seems to be rushing into U.S. treasuries in a flight to safety.  

Here's the trade:  Fairfax Financial has put on a huge short trade on the CPI (Consumer Price Index). 

If the U.S. / world follows the pattern of a Japan-like balance sheet recession, then the CPI can go down by 14% over ten years.  This is Watsa's analysis of Japan and the U.S. in the 1930s.

This is not news, actually.  Fairfax put on this trade in 2010 and mentioned it in the 2010 annual report.  But as of the end of December 2010, this trade had a notional value of $34 billion, but as of the end of September 30, 2011, that has increased to $47.4 billion.  The weighted average maturity of these contracts is 8.9 years.   (This trade was set up by entering into an agreement with counterparties (presumably large, global investment banks) whereby Fairfax pays a premium up front and the bank has to pay Fairfax the amount of deflation over the next ten years (if the CPI goes down 10% in ten years, banks will pay Fairfax $47 billion x 10% = $4.7 billion)

For the $34 billion notional position in 2010, Watsa says they paid $302.3 million, or about 0.9% of the amount.  I think we can assume he paid a similar amount in 2011 to increase the position. 

So, if Watsa is correct and there is 10-14% deflation over the next ten years, this trade can potentially make $4.7 billion - $6.6 billion!  That's a huge win if that happens.  If there is no deflation, then they lose $430 million or so.  In a sense, the market is only giving a 7-10% chance of Japan-like deflation occuring.  If you believe there is a greater chance than that, then this can be a homerun.

The beauty of this trade is that the upside potential is huge but the downside is limited to the initial payout of 0.9% of the notional amount.

Also, the shareholders equity of Fairfax Financial was $8.2 billion so you can see how big a trade this is, even though, again, the risk is limited to around 5% or so of Fairfax Financial's net worth.  This is a trade that isn't going to blow up Fairfax if it doesn't turn out well.  This is not the same as, say, buying tons of European soveriegn debt, CDO (collateralized debt obligations) or CMBS (commercial mortgage-backed securities) on leverage.

I am usually not a big fan of these big bets; when money managers veer away from what they know and have become good at, things often don't work out.  There are countless managers who started out as great stockpickers but got distracted into macro-investing and went on to lose boatloads of money.  

But some of these bets seem to be low risk situations.  Another example is David Einhorn at Greenlight who bought a ton of default swaps on Japanese government debt.  I find it highly unlikely that Japan would actually default since they can just print money to repay yen-denominated government debt, but the beauty of the trade is that the market also is not pricing in much of a possibility.  Which means that it is or was a very cheap trade to put on.   Seth Klarman has bought out-of-the-money long dated puts on U.S. treasuries at low prices as he sees higher long term interest rates as a result of all this pump priming as inevitable.   All of these are low cost trades that won't hurt them if things don't pan out.

Yes, this sort of smells like a little bit of Burry envy; trying to find that next big, black swan, outlier trade where the market is not pricing in a certain scenario.  But again, Watsa has already done this before with the credit default swaps.

As long as not much capital is burned in the trade, I suppose it's not such a bad thing (although I would still prefer these guys to focus more on their stock analysis skills!).


Fairfax Financial has done really well over time and has done well recently too.  Their insurance operations tend not to be the best, but that's the game plan; Watsa seems to like to buy not-so-great businesses on the cheap and then try to fix them up.

Their investments have done really well too, but what might bother some people is Watsa's active hedging and unconventional bets.  It sort of makes me scratch my head too, but he has been successful with it, and it doesn't look like he does anything 'reckless' with big downside exposure.

Most people who try to hedge their stocks using futures tend not to do too well and most of the time, it's better to simply reduce equity holdings to lower risk than to adjust using futures, but again, Watsa had done well with this.

This deflation trade is certainly a big one, but it has the potential to earn a huge amount of money and if it's wrong, the cost is minimal; at 5% of net worth, that comes out to only 0.5%/year expense.

Fairfax, with this sort of performance history is certainly interesting at around book value. 

Fairfax is trading at $406/share (U.S. ADR: FRFHF) versus a book value per share as of the end of September of $402.66.

Their equity holdings are 100% hedged out, so Fairfax doesn't have much market exposure.

This may appeal to those with a bearish view on U.S. and global economy and markets and believe there is a good chance of a Japan-like deflation.

It's also not at all a bad idea for those that are not necessarily bearish.

Of course, at book value or modest premium, I would tend to prefer Berkshire Hathaway.

Anyway, as usual, this is just another idea.  It is a financial so is subject to all sorts of risks of other financials and insurance companies.  Also, you have to take into consideration counterparty risk: who exactly are the counterparties to the CPI deflation trade?  If we do go down the path of Japan or 1930s in the U.S., will the investment bank counterparties still be around to pay off the bet?

As with any financials, there's a whole bunch of risks, so one should really get to know the company and get comfortable with it before buying into it.

And again, as I keep saying, I do keep talking about financials, but that doesn't mean one should have a whole bunch of financials in their portfolio.  Portfolios shouldn't be overly diversified (with many different stocks), but they shouldn't be overly concentrated in any single industry/sector either.

The Problem with Sony

There was a decent article on Sony in Businessweek this week (read here). 

As I said before in another post, Sony is a company/stock that I would love to love.  I grew up with the brand and I think it still has a very strong presence in Japan and globally and does have strong brand value even though that seems to be eroding every year.

That's why I keep an eye on Sony and will keep watching it (maybe I will read their annual reports every year for fifty years and then finally buy some stock decades from now).  It also is a good window into corporate Japan because what ails Sony is not industry specific but more Japan culture specific.

The article lays out pretty well what has gone wrong at Sony over that past couple of decades.  I have no idea if they will recover or not and if I will ever buy their stock.

But there are some things that still bother me about it that keeps me away.  Actually, the fact that Sony is on the front cover of Businessweek with a negative headline ("What is Sony Now?") is a big BUY signal (the contrarian front page indicator).

The problem is how little progress Sony seems to be making even with a foreign CEO.  You would think things would change, but I guess Stringer is way too respectful of his collegues in Japan that he can't take drastic action.  What Sony needs, really, is a Lou Gerstner-like character (this name popped up in my mind because I just finished reading all of IBM's annual reports from 1994; fascinating reading).

Anyway, here's a a little snip from the Businessweek article that really shows what is wrong with corporate Japan.  I nearly fell out of my chair when I read this:

Stringer can't sell or dump the TV business because it's the Sony legacy?  Because everybody at Sony is very proud of the hardware they create?  Clearly, Stringer has been Japan-ized more than Sony has been Westernized.  Stringer doesn't want to hurt anyone's feelings.  Sigh.

A comment like that from a U.S. corporate CEO would be shocking.

I can imagine the internal lobbying, screaming, yelling and crying that must have happened when IBM decided to sell it's PC business (smart move).  I can also imagine what it must have been like with a hurricane of internal emails when GE tried to sell it's light bulb and appliance businesses.

You can't run a corporation on pride of past accomplishments.  Can you imagine where Intel would be today if they didn't decide to exit the commodity memory chip business?  

This is the sort of thing that really destroys corporate value.  I think CEOs and managers feel that they are doing the right thing for the long haul by not rocking the boat and preserving the legacy and protecting the 'pride' of employees but if there is no change when the world is changing the endgame is ultimate failure/bankruptcy.    It does nobody any good in the end to take the easy course and try to keep everyone happy (which is what it seems like Stringer is trying to do).

I used to be excited that Kazuo Hirai might become the next Sony CEO (Japanese executive with substantial overseas experience), but now I'm not so sure.  I think Sony really needs someone like Gerstner; someone from the outside with no emotional baggage and no internal political considerations.

Unfortunately, that is highly unlikely.

Seth Klarman Buys Hewlett Packard?

Seth Klarman is definitely one of the all time great investors so people should definitely pay attention to what he does.  He has a great track record over a long period of time and has written one of the great books on investing ("Margin of Safety", which is out of print).

He is also a hard core value investor and is the real deal (versus many value investors who look more like closet index funds).

Anyway, it looks like Seth Klarman's Baupost Group bought a large stake in Hewlett Packard (they already own a bunch of Microsoft). 

This is interesting on many fronts, one of which is that this comes right after news that Warren Buffett has taken a huge stake in IBM in one of the biggest stock market purchases by Berkshire Hathaway ever (in a sector that Buffett has said for years that he has no interest in investing in!).

Contrast this with what the public is doing.  I'm not going to dig up and post figures here, but it seems that retail investors have been redeeming out of stock mutual funds over the past few years since the crisis; I think there was another stampede OUT of them in the last couple of months.

I have also talked about how the private equity and alternative asset managers are seeing a lot of inflows and interest in investing in their investment 'alternatives' because stocks and bonds just don't meet the return needs of these institutions (pensions not being able to achieve their 8%/year return goals etc...).

So it makes me go, hmmm....    Retail investors are rushing out of stocks.  Pensions and other institutional investors are piling out of stocks and into alternative assets.

And then old, boring guys like Buffett and Klarman move into stocks like IBM, HPQ and MSFT.  (In fact, Buffett's purchases of stocks this year are huge.  I don't know if they are record levels, but they are pretty big).

Neither of these guys are traders or market-timers, so their actions tell nothing of what the market or stocks they own may do in a week, month or even a year (Klarman too says that one must look at what a company can earn in five years in a more normal environment and see what it might be worth by then and then buy the stock at a significant discount to that), but they do tell you that there are very good valuations and opportunities out there now.

Anyway, I think it does serve as a hint for us.

I might take a look at HPQ to see what is going on there.  It is certainly cheap and unloved.  Negative sentiment is pretty unanimous.  I don't think I've read anything positive about HPQ in years (except for a brief period when Hurd was cleaning up the business).  Meg Whitman's selection as CEO was also pretty much unanimously panned; it was received very, very poorly by the business community.  PC's are dead and will never recover and that is pretty unanimously agreed to too.  The board of directors are incredibly incompetent; the worst board in the history of corporate America etc...

There is not one thing positive that I can think of anyone saying about HPQ.

As I type this out, it becomes clearer and clearer why Klarman would be interested in this, and now I am a bit more motivated to take a look at this thing.  Of course, being hated and being cheap isn't enough.  Sometimes things stay cheap forever, or eventually go away (like Eastman Kodak).  But maybe HPQ generates so much cash that all it needs is a bit more rational capital allocation to give it a boost.

If I find anything interesting, I may write a post about it.  Otherwise, I may just conclude that it's a piece of crap and it trades cheap and that's all there is to it.  But maybe not.

Tweedy Browne on Johnson & Johnson

Tweedy Browne is an old school value investing shop that goes way back.  I really do respect them even though their performance recently hasn't been the best.  They are a low turnover fund investing with old-fashioned value investing principles and they are very fad-proof; they don't jump on the latest investment fads.  That alone may keep many out of trouble over the long term. 

At the very least, it is very educational and informative to read the annual and semi-annual reports of good fund managers. 

Here's is a snippet from their latest annual report that takes a look at Johnson and Johnson (JNJ) that illustrates the sort of opportunities there are in the market today:

Here is some of the text that goes with that:

Tweedy Browne doesn't mention some of the problems that J&J had over the past few years, from McNeil Consumer products (Children's Tylenol etc.), hip replacement recalls.  They have managed to grow earnings despite all of that, and yet the stock is trading much cheaper than ever.  It is amazing that JNJ stock still managed a positive return since 1999, but again that just goes to show you that you want to own good, solid businesses that will grow over time and it can do well even during bad times.

Anyway, as usual I don't want to put too many links on this blog as I tend to think it's a pain in the butt to read blogs that put too many links; it takes too much time to go from one link to the next.  I personally prefer original thought/content right on the blog instead of being directed to all sorts of ideas all over the internet.

But Tweedy Browne letters are defintely worth the read so here's the link to the latest letter:

Letter to Shareholders

Since there are a few managers and companies that I think the annual reports/letter to shareholders is "must" reading for any investor, maybe I should collect them in a "links" section or in a post one of these days.

Friday, November 18, 2011

Bill Miller Steps Down

I can already hear it:  "Value investing doesn't work!  Look at Bill Miller!  Told ya so!".

Yes, Bill Miller does look sort of like a bull market genius.  He was a mutual fund hero for outperforming the S&P 500 index for 15 years in a row from 1990 through 2005.

I was never a big fan of Miller, though.  One quote that scared me years ago attributed to him is "The one with the lowest cost wins", or some such thing.  If he likes something, he just keeps buying it as it goes down, almost to a reckless extent.  The problem with this approach is that you have to really be right.  Of course, if you are right, then buying something for less is good.

Anyway, Bill Miller became the lead manager of the Legg Mason Value Trust back in 1990, and since then the average annual return has been +9.39%/year versus +9.14% for the S&P 500 index.  So he did beat the index over the long haul, but just barely.  And this was after a hefty 1.8% expense (according to this morning's WSJ article). 

The assets under management for this fund went from $20.8 billion down to $2.8 billion, which is an astounding drop.  (By the way, this to me is more of an argument of what happens when a fund gets too big rather than the validity or invalidity of value investing).

This supports John Bogle's view that people should just stick to low cost index funds (which I tend to agree with for the most part).

Here are some more figures for the fund from Morningstar:

Over the past five years, the fund underperformed the index by 9.3% per year and underperformed by 4.3% per year over the past ten years.  That's a pretty huge underperformance.

Compare this to the book value per share growth of Berkshire Hathaway (BRK), another old guy that people often call a 'bull market genius':  Book value per share grew 10%/year in the five years through December 2010 and +9%/year over ten years.  Yes, it's a different endpoint, but it won't make much difference.  And yes, BRK is not a mutual fund but a corporation with cash flow etc...  But BRK does own a heck of a lot of financials (Wells Fargo, American Express, U.S. Bank etc...) and has a bunch of operating businesses in the housing related sector, and is big into the insurance business which has been an awful business in the recent past.

Looking back at Miller's error, this exactly makes my point about good management.  I remember when Miller was asked about his poor performance during the crisis.  His response was that the crisis got a bit worse than they expected.

At the time, my reaction was that this is not acceptable! 

A while back on a conference call, Jamie Dimon talked about having a fortress balance sheet.  Analysts were bothered by Dimon's conservatism and his response was something to the effect that if they take too much risk and try to maximize profits and then the economy gets much worse than they expect, he doesn't want to go back to investors and say, "Sorry guys, things got worse than we thought so your stock is worth zero".  Dimon said that that is totally unacceptable.

(This is why JPM got through the crisis without a loss in any quarter).

This is also why Warren Buffett got through the crisis with decent returns even if his stock picks were suboptimal (he was buying Wells Fargo right before the crisis too).  Buffett doesn't put himself in the position that things will hurt him too much if things get worse than he thinks (and he has admitted that the crisis was much worse than he thought; he did say that the Fed drew the line in the sand when they brokered the Bear Stearns/JPM deal. He said at the time that the worst of the financial crisis was over, at least in terms of the financial markets).

Buffett was totally wrong about that but didn't put himself in a position that it would hurt BRK too much if he was wrong.  THIS is the key difference between Buffett and Dimon versus many others like Bill Miller.

Here's another thought.  With this Bill Miller comedown, many will conclude that value investing doesn't work, or that active investing doesn't work and nobody can outperform the markets.

This reminds me, again, of trying to learn the right lesson from something and not the wrong one.

When so many people lost money on subprime loans, people concluded simple-mindedly that subprime loans are just no good.   Is this correct? 

As usual, I think bad subprime loans area bad, and good subprime loans are good.  Leucadia made good money by being able to distinguish that when they bought Americredit (and then sold it not too soon after to GM for a nice gain).

But most people will not distinguish that.  They will simply conclude that subprime loans are bad, period.  (Just like many people seem to conclude that all derivatives are bad, all corporations are evil, all banks are bad etc...).

Here's an example of why subprime loans on it's own is not bad at all.

Mobile home, low credit loans are probably the worst category in terms of image.   But here's Berkshire Hathaway's loan loss history of their mobile home loans:

This is a cut-and-paste from BRK's 2010 annual report.   So a good half of the portfolio are loans to people with credit scores below 640, pretty subprime.

And yet, look at the loan losses.  Very low.  Why?  Because they made "good" loans, not "bad" ones (high loan-to-value etc...).

This serves to illustrate yet again that it's not the category that is important so much, but how something is done. 

Good banking is a good business.  Banking done badly is a horrible business.  Investment banking done well is a good business.  Investment banking done badly is a horrible business. 

Value investing, too, falls into that category.  I suppose history will record Miller as a bad example of value investing (reckless) but some others will go down as good value investors.

Cheap and Cheaper

I know, this is a broken record blog.  We all know financials are cheap and we all know there are plenty of reasons why they are cheap and why they might be right to be priced cheap.

However, I tend to still like the well-managed financials.

This is laughable and I don't mean to suggest financials should trade at over 3x tangible book value, but here's a valuation of historic deals in the investment banking sector I pulled out from the Merrill Lynch merger proxy (merger proxies are great sources of information; investment banks do a lot of valuation work to validate deal values and you get all that stuff for free in the filings):

OK, that came out pretty small but historic investment bank acquisitions have happened at an average of around 3x tangible book value with a median valuation of 3.4x.

Of course, this is pre-crisis so the world is quite a bit different now.

But I do think investment banks are certainly worth more than tangible book, if not a multiple of it.  Right now, people are worried about a complete European implosion and financial blowup that may be worse than what we saw in 2008/2009 in the U.S. 

Anyway, here's a list of price-to-tangible book values that was in the "Heard on the Street" page of the Wall Street Journal this morning:

                                   PTBV ratio
J.P. Morgan                95%
Goldman Sachs          76%
Jefferies Group            76%
Citigroup                    52%
Morgan Stanley          51%
Bank of America        44%

As I mentioned before, I really do like J.P. Morgan (JPM) and Goldman Sachs (GS).  I do think they are both very well managed.  JPM is a huge bank so will be subject to macro forces, but management has proven they can handle once in a hundred year events.

GS, too, has managed the crisis pretty well but they may be more flexible and agile than JPM since they are not a major bank.  Investment banks tend to be pretty nimble.  GS doesn't have a large physical presence (bank branches) or a large retail sales force (retail brokers) so don't have a large fixed cost base burden.  If things don't recover, you can be sure they will cut costs quickly and will move capital to where they can earn an adequate return.

At this point, according to the recent earnings conference call, GS is waiting for things to clear up a bit since things are in a sort of 'crisis' situation.  They do think that when things stabilize they will be able to deploy capital profitably.  If they thought this downturn is permanent, they would then use their excess capital to repurchase shares (and will probably cut more costs).

An interesting play here too is Jefferies Group (JEF).  I don't own JEF, but tend to really like it especially so cheap.  They are a small investment bank which has good sides and bad.  Right now, they are seeing the bad side of it.  JEF shares have tumbled alot after the MF Global blowup; people are now concerned about smaller firms that are too small to survive (versus too big to fail firms).

Some of my favorite value managers at Leucadia (LUK) bought into JEF stock on this decline as they are confident in the management of Richard Handler.  I think JEF will be able to pull through this as they do have a great reputation and Handler is known to be a conservative CEO (unlike the more risk-taking, reckless Corzine).

But in finance, you never know.  Good firms will go down in crisis situations, sometimes (although I don't think that happened in the 2008/2009 crisis; I think the firms that went down in that crisis weren't really good, well managed, conservative firms.  They were reckless, aggressive, overleveraged, horribly managed firms (BSC, LEH etc...)).

The good side of a smaller investment bank like JEF is that they may have more opportunities if they have a good niche (many smaller investment banks like Cowen haven't made money in years) and are well-managed.  The good thing is that they don't depend on mega-deals.  Bigger investment banks have to do bigger and bigger deals to increase revenues, just like larger and growing private equity funds have to do bigger and bigger deals to deploy bigger and bigger amounts of capital.

Anyway, all of these are financial companies and as I keep saying, one should be very careful how much exposure they have in any single sector (otherwise, I would be buying JEF too, but I have enough financial exposure now).

If Europe does really implode, financials can certainly go down more.  By their very nature, they are risky and another financial crisis of bigger than 2008 proportions is not a zero probability.

I do talk a lot about financials here now just because I do tend to think they are cheap, and because of my experience in the industry I tend to be more comfortable with some of them than most other investors and the general public (that seem to resent/hate financials!).

But that doesn't mean investors should pile into these things too much!

Olympus Continued

So the story continues to unfold and it doens't sound too good.  In my earlier post, I said that on the face of it there might be 459 billion yen or 1,700/yen per share in value at Olympus just by valuing the medical equipment business at 8.0x EBITDA, adding up the cash and securities and deducting long term debt (see here)

I also did say, though, that financial statements are in question with such a fraud of massive scale.  Who knows what is going on there?  Since the scandal broke, they said that financial statements will have to be restated going back 20 years.

Still, if the loss was a billion dollars or so and if the phony payments and recent writedowns were related to the earlier losses and that was all there is, there was a chance that Olympus may have plenty of equity value for shareholders.

However, today's New York Times article about an investigator's memo raises questions about that.

From the article today (read here: NYT Olympus article, November 18, 2011)

"Olympus paid a total of 481 billion yen, or $6.25 billion, through questionable acquisition payments, investments and advisory fees from 2000 to 2009, according to the memo, but only 105 billion yen has been written down or otherwise accounted for in its financial statements.  That leaves 376 billion yen, or $4.9 billion, unaccounted for, according to the memo"

Well, if this is true, there goes the 459 billion in equity value that might have existed at Olympus.  Also, this memo only mentions the period 2000 to 2009.  If the losses occured in the early 1990s, there may be more from 1990 - 1999. 

Anyway, I guess this is a speculation that certain types of investors like, but with such a potential black hole, the wise thing to do might be to stay away. 


Again, the scary thing is that I find it hard to believe that Olympus is a single, rogue company.  I think this is a systemic problem with many large corporations in Japan.  Of course it's silly to think this is going on at all Japanese corporations, but I find it hard to believe that this is the only company that has done this.

Tuesday, November 15, 2011


That's the hint Warren Buffett offered to CNBC Monday morning when he said he will tell viewers which stock he has been buying this year.  None of the CNBC folks were able to guess (I had no idea) what stock it was. 

Harold's short name is Hal, of course, and Hal is the computer in the movie "Space Odyssey"; the letters following each of H-A-L are I-B-M.

This is a surprise on many fronts.  For many years, Buffett spoke of not wanting to invest in technology because it's hard to know what the industry will look like in five, ten, or twenty years.  Buffett really does continue to surprise. 

He always talked about how he doesn't like capital intensive businesses but then bought Mid-American, a capital intensive, regulated utility.  He also bought Burlington Northern more recently, both capital intensive and cyclical.  He has spoken about derivatives as weapons of mass destruction and then wrote $34 billion in notional amount of global stock index put options.  He speaks up against investment banks and then buys a large stake in Goldman Sachs (via preferred shares with warrants).

Now, after years of avoiding technology, he makes his largest public equity purchase ever and buys IBM.  What is great about Buffett is that he evolves.

Anyway, let's take a quick look at this.

Big Bet: Focus / Concentration
Buffett bought 64 million shares for $10.7 billion, starting in March of this year.  That's a huge buy.  To see how big it is, take a look at these figures.

as of September 2011:
Berkshire Hathaway Shareholder's Equity:   $160 billion
Stock holdings at Market:                              $67 billion

So he made a purchase that was 6.7% of the total net worth of Berkshire, and 16% of it's entire stock portfolio.  Now, that's focused investing.  How many people put 16% of their stocks into a single idea?

For reference, here is Berkshire's largest equity holdings as of December 2010:

If you look at the "cost" column here, you will see that this $10.7 billion purchase of IBM stock is the largest purchase ever for Berkshire.  After IBM, the next largest purchase is $8 billion in Wells Fargo and after that, nothing even comes close.  Kraft Foods comes in at $3.2 billion.

Of course, this table only includes stocks that BRK still owns, and not ones that were sold or were taken over completely (like GEICO, Burlington Northern, Gen Re etc...).

But still, there's no question this is a big purchase.   Only Coca-Cola would be worth more at this point than IBM.  Even the companies that he really likes, like Walmart, Procter & Gamble, Johnson and Johnson and others come in at only $2-3 billion.  Wow.

Reading Annual Reports
The other striking thing about this is that Buffett was triggered to move on IBM after reading the 2010 annual report in early March.  He said he read the report, did some work on it and then started buying in late March.

What is amazing is that he said he has been reading IBM annual reports every year for the past 50 years.  He said the same thing when he bought Annheuser-Busch too.  So even though Buffett wasn't interested in technology and thought he'd never buy tech company stocks, he kept reading IBM annual reports every single year anyway.  *This* is why he has such a strong understanding of business and good feel of the stock market.  This is why he is such a great investor.  Can you imagine the information stored in his head from reading tons of annual reports over the decades?  Even of stocks you never bought or thought of buying?  Incredible.

(Not to belabor the point, but next time you talk to someone who has lost money (or keeps losing money) in the stock market and blames the market, Wall Street or anything else, ask them how many annual reports they have read in the past month, year, lifetime?)

Due Diligence/ BRK Advantage
The other thing that struck me was yet again how BRK being a large conglomerate can be a big advantage.  I keep saying that Buffett may not be an economist and his predictions may be no better than anyone else, but with so many businesses reporting to him on a daily basis, he has a real time finger on the 'pulse' of the economy so he knows what's going on.  He doesn't have to wait for government statistics and he doesn't have to plug them into econometric models or comments/predictions from economists.  He knows what is going on every single day.

And here, for kicking the tires on IBM, he researched IBM's competitive position by asking all his companies about their IT.  He realized how sticky IBM really is and entrenched in corporate IT systems (and high cost of switching out), and how businesses will have to rely on IBM more over time as the need to process information increases.

He realized, apparently, that IBM is not your typical tech stocks subject to changing trends.  It would be very difficult to displace IBM with their strong position, much stronger than say a software company that writes limited applications and things like that.

Buying at the Highs
As usual, people focus on superficial things like the nominal stock price.  But IBM is trading at it's all time highs, they say.  It's not cheap.  These people would rather buy a crappy stock on their lows, like airline stocks in front of bankruptcy.  A good stock is a good stock because it's a great business trading at a decent valuation.  It doesn't matter if the stock is at an all-time high or low.

Of course, we value investors typically like to look for things on the new lows list to see if there are any babies in the bathwater, but Buffett has since been more interested in paying fair prices for great businesses rather than great prices for fair businesses (or something to that effect; I'll never get these things exactly right).

Some people analogize this to his Coca-Cola (KO) purchase too, which from a value investor standpoint wasn't a 'cheap' price nor was it on the new low list.  But it has done tremendously well.  I think people do tend to overemphasize this 'nominal' price.  This, by the way, extends to the overall market too.  Some only want to buy stocks during panic periods, like in early 2009 and think it's not a good time to buy stocks otherwise.  However, the KO purchase was not done at a depressed valuation for either KO or the stock market, and yet it is one of Buffett's biggest winners.

His Burlington Northern purchase also was at a high and the valuation was not even that attractive (I think 20x p/e or some such), and yet this holding (now completely owned by BRK so no market price) has been estimated to be worth 30 or 40% more than the acquisition price already (looking at earnings growth and using multiples of other listed railroad stocks).   A huge winner already.

So what's so great about IBM?  Buffett was impressed with the management even though he couldn't even pronounce the CEO's name (he said, "Palmi...", looked uncertainly at Quick who said "Palmisano").  He has been reading the annuals for years and was impressed with the change that they have undergone recently.  He said he was impressed by how they outlined exactly what they were going to do five years ago and achieved it. 

He said the 2010 annual report really details why he likes the company so much, and he can't think of any other management team that has laid out a roadmap with so much detail/specifics on exactly what they are going to do.  They did this before five years ago and achieved it so he feels they will continue to be able to meet their plans.

IBM 2010 Annual Report
OK, so what's the big deal about the 2010 annual report?  I took a quick look and here are some notes.

From the letter to shareholders:
Since 2002, IBM has:
  • added $14 billion in pretax profit base to IBM
  • Increased pretax income 3.4x and EPS 4.7x and free cash flow 2.8x
  • had cumulative free cash flow of $96 billion
  • Gross margins improved 9.4 points to 46.1%
  • Pretax margin improvement to 19.7%
  • 90% of profits in 2010 from software, services and financing

In 2010,
  • Earned EPS of $11.52, up 15% for eight consecutive years of double digit growth (revenues were up +4%, pretax income +9%)
  • Free cash flow was $16.3 billion
  • Use of cash in 2010 was $6 billion in acquisitions, $4 billion in net capex, returned $18 billion to stockholders via $15.4 billion in share repurchases and $3.2 billion in dividends.

Over the past decade, IBM has returned $107 billion to shareholders through dividends and share repurchases after $70 billion in capex and $60 billion in R&D.   They also earned free cash flow of $109 billion, tripled software profits and increased share of revenues from growth markets to 21% from 11%.

In 2006, IBM introduced the Road Map 2010.  In this, one of the goals was for EPS of $10-11/share by 2010 (they achieved $11.52).

For the 2015 Road Map IBM expects $50 billion in share repurchases and $20 billion in dividends to be paid out.

Over the next five years through 2015, IBM will:
  • earn at last $20/share in EPS
  • generate $100 billion in free cash
  • return $70 billion to shareholders
  • grow revenues from growth markets to 30% (from 21% in 2010)

 Over the past ten years, free cash flow was $109 billion and $107 billion of that was returned to shareholders so we know that IBM is shareholder friendly.  Also, net income over those years were $95.6 billion so net income may be a conservative proxy for free cash flow so looking at the p/e ratio won't lead you too far off course here.  (In other words, they really do earn their EPS and they do convert that to distributable/returnable cash, and then they actually do return it to shareholders! This is very unlike other companies that put up positive accounting earnings but generate no cash, or even if they do, spend it unwisely and destroy shareholder value.)

So having said that, what is IBM worth?  What does Buffett see?  His average purchase price, he said, is $170/share.

That comes to 14.8x last year's earnings, 12.7x current year and 11.4x next year's earnings estimates.  That's pretty cheap for a company that plans to grow EPS by 11%/year (to at least $20/share by 2015), and that has grown 10%/year over the past ten years. 

(Yahoo finance earnings estimates for IBM were: 
  12/2011:  $13.38
  12/2012:  $14.85)

Even at the current price of $189/share, it is trading at  14.1x this year and 12.7x next year's estimate.

Buffett wouldn't have bought IBM if he thought IBM's competitive position would decay over the next few years.  If this is true, then IBM should manage at least a market multiple as their growth prospects are better than the average company. 

Given management's $20/share EPS target by 2015 (this is a low-end target as they say they will earn at least $20) and putting a 15 P/E multiple on that gives a target price of $300/share for IBM.

Buying it now at $189/share gives a return of 12% or so per year by 2015, not bad at all.

Should We Follow Buffett Into IBM?
In general, you can't really go wrong copying Buffett's stock buys.  He knows more about businesses and stocks than most others and his decisions will obviously be superior to others.

So for those looking for large, blue chip companies that they can own for a long time, I would recommend IBM and other BRK holdings for sure.

What's great about recent purchases is that the prices are still pretty close to where Buffett bought it, and the circumstances is going to be the same; fundamentals haven't changed much over the year.

This may not necessarily be true for Buffett's other holdings.  For example, people followed Buffett into Coca-Cola back in the late 90s calling it a Buffett stock, but they paid 40-50x P/E.  This did not turn out well for them (Buffett paid way lower prices back in the late 80s).

Buffett would not pay 40x P/E, even for Coke.   

Finding the right stock is only part of the equation.  A good price is the other side, and this is trickier to determine for Buffett's longtime holdings (again, since they may be overvalued at any given point in time).

Buffett put $10 billion+ of fresh BRK capital into IBM at these prices, so that's a different story than trying to figure out whether the other holdings are good buys now or not.

Having said that, for full-time investors and pros, IBM is not going to be the most attractive investment.  BRK can only buy stocks in the largest corporations in the world.  This reduces his universe dramatically from what is available to everyone else.  There are thousands of companies listed in the U.S. (actually, probably tens of thousands).

Joel Greenblatt, in a speech a while ago, recommended to investors, don't invest like you're managing $10 billion.  That means to go look for other opportunities where big players can't look (smaller cap stocks).

Anyway, I haven't even really dug into the IBM annual report for 2010 (10K etc...) so don't really have a good feel of the business.  I will take a look at it and may post an update if I find interesting things to say about it.

And a By the Way About Microsoft (and Intel)
Some people might have been surprised that Buffett bought IBM and not Microsoft (MSFT) given the cheapness of MSFT versus IBM and his close friendship and presumably good understanding of MSFT's business and future.

Buffett did say in the CNBC interview that he or anyone at BRK will never buy MSFT because he is just too close to Bill Gates.  If he or anyone at BRK (including the two new investment manager hires he told that MSFT was off limits) buys MSFT and then there is a positive development at the company, nobody would believe that Buffett didn't have inside knowledge of such development.  He also did say that it was an attractive stock.

Todd Combs, one of Buffett's two new investment management hires also bought a bunch of Intel stock (INTC) according to the latest filing.  This is also very interesting.

The argument against Microsoft and Intel is quite simply that the Wintel era is over and PC's are dead.  This is why we aren't supposed to like these companies even if they are cheap.  The suggestion is that these are value traps.

Perhaps they are.  I actually don't have a strong view on the future of PC's.  But I am inclined to think that maybe assuming the PC era is over and MSFT and INTC are not interesting investments may go into what Howard Marks calls "first level thinking" and not "second level thinking".  (Speaking of which, it wasn't too long ago that IBM was supposed to be dead because the PC was going to kill their mainframe business).

Anyway, Buffett's comment on the attractiveness of MSFT and Comb's purchase of INTC stock is a counterpoint to the "PC is dead so stay away from MSFT and INTC" argument.

Thursday, November 10, 2011

Kraft Split-up Valuation?

OK, so Kraft announced that it will split into two; a slow growing U.S. grocery business and a fast growth global snack company. 

First of all, let me just say that Kraft is a decent looking company trading at a decent valuation so it's not a bad stock to own by itself.  Warren Buffett owns it and likes the business and has said that Irene Rosenfeld (Kraft CEO) is a terrific manager and that her operational skills are very good.  What Buffett didn't like is the use of an undervalued stock to pay up for Cadbury, and the fact that Kraft sold the frozen pizza business for a low valuation.  So Buffett doesn't like the financial skills of Rosenfeld and has reduced his stake in Kraft.

But anyway, back to the topic.   What kind of value can be realized by Kraft splitting up into two?  First of all, let me just say that a lot of information hasn't been released yet so an accurate valuation can't be done on the post-split pieces.  How the debt and corporate overhead will be split, etc...

An analyst on a conference call asked Rosenfeld how to look at a post-split valuation of the global snack business, and who the comparables were.  Well, she seemed pretty giddy and said that she will let us figure that out ourselves.  So I did scratch my head.  Is a comparable Hershey?  Cadbury is gone, but can we use the valuation of Cadbury at the time of Kraft's purchase?  That would be 37x the last year's EPS!  37x is too high, but there are lower, reasonable numbers.

Anyway, to keep it simple I will make a very simple assumption.  I will simply assume that whatever operating earnings split between the two segments is will remain the same for the EPS.  In other words, if both businesses account for 50%-50% of operating earnings, then I will just use that to figure out what the eps of each post-split company is.  This is not accurate as there are items below the operating earnings line that we don't know how will be allocated between the two companies.  I assume that a lot of the debt will be carried by the U.S. grocery business.  I think Rosenfeld did say that (but I'm not exactly sure).

I just took the segment revenues and operating earnings from the 2010 10K and divided up the segments myself into what I think roughly approximates the two split companies.  Here is the table:

This is not entirely accurate as there may be some segments that are within these big groups that might go to one or the other.  In their September 2011 presentation using full year 2010 figures, they said the U.S. grocery business had $16 billion in revenues and the global snacks business had $32 billion.  That compares to my above quick shifting around that gives $13 billion and $36 billion respectively, so it's a little off but I figure good enough for what we are trying to do here.

This is a free blog so that is close enough.  Perhaps if this was an $2,000/year newsletter, I would need to be more accurate.

OK.  So we notice that the operating earnings split is going to be 61% global snacks and 39% U.S. grocery.

Now we continue to make huge leaps for simplicity's sake and take the full year guidance of eps for 2011, which is $2.27. 

So using my rule that the eps split is the same as the operating earnings split, the U.S. grocery company will have an eps of $0.89, and the global snacks business will have an eps of $1.38.

 Let's not stop there. The year is almost over, so let's use next year's estimates. Analysts estimate Kraft EPS for the year to December 2012 to be $2.52.  So applying the same as above (which is not correct as the global snacks business is supposed to grow faster, but again, good enough for a rough estimate), we get a U.S. grocery business EPS of $0.98 and the global snacks business will earn $1.54.

OK, I like tables, so here are the EPS figures:

                                                   2011e             2012e
U.S. Grocery Company EPS:     $0.89             $0.98
Global Snacks Business EPS:    $1.38              $1.54

You can also use revenue growth assumptions to come up with different EPS estimates for 2012, but I'll keep it simple here.

Now comes the interesting part.  How do you value each side of the business?  For simplicity, I will just focus on p/e ratios here.  Here is a table of comparables.  I got the list of comparable businesses from the Wrigley's merger document from April 2008, but I added Tootsie Roll Industries as there wasn't enough snack businesses.  Tootsie Roll may be too small to be a relevant comp, though.  The valuations are from Yahoo Finance as of now (or a few minutes ago):

The average p/e ratio on a trailing twelve month basis (excluding Kraft) is 16.7x and 15.5x forward p/e (forward p/e is mostly for fiscal year ended December 2012).

On a forward basis, it seems like Kraft is selling for less than the average p/e.  Excluding Hershey and Tootsie Roll, 13-15x p/e looks to be a reasonable range for Kraft Foods.  Since many of the other companies are U.S. grocery type businesses and not global snack-like, maybe 13-15x p/e is a reasonable range for the U.S. grocery business.  To be safe, let's use the lower end of that: 13x.

From the above EPS, we can see that the U.S. grocery business (to be apples and apples, I will use the 2012 estimate),  $0.98/share.  At 13x p/e, the U.S. grocery business is worth $12.74.

Kraft is now trading at around $35/share.  So using a stub approach, the global snacks business is now being valued at $22.26/share.  Since it can earn $1.54/share next year, the market is valuing it at only 14.5x p/e.   I think this is the essence of the story.  The global snacks business will grow revenues and earnings at a double digit pace, which is not what the above comparables are doing performance-wise.  And yet, the market is only giving it the same sort of valuation, within the 13-15x valuation range in the table above.

Now, the question is what exactly is it worth?  One comparable may be Hershey.  And maybe Tootsie Roll Industries.  Hershey, though, has only grown sales at 3.3%/year for the past five years and EPS has only grown 2.3%/year over that time.  So despite Hershey's high valuation, it hasn't grown at all and I don't know that growth prospects is any better going forward.

Tootsie Roll Industries is highly valued too, even though it's a lot smaller.  But despite valuation of 25.2x p/e, Tootsie Roll has only grown sales +1%/year over the past four years and EPS has actually declined -3.6%/year over the same time period.

If these no growth snack companies can get a valuation of 20-25x p/e, why can't Kraft's global snack business? 

At 20x p/e, the global snack business is worth $30.80, and at 25x p/e, it's worth $38.50.

Combined with the U.S. grocery business which we valued at $12.74/share, that values Kraft Foods in total at between $43.54 - $51.24/share.

Is this what the activist agitators have been seeing?  Is this why Rosenfeld is smiling when she talks about the split?

In sum, here's the valuation assumptions for KFT.
Value of U.S. grocery business:       $0.98/share eps x 13 p/e =  $12.74

                           Value of global snacks                      TOTAL VALUE                                 
20x p/e:              $1.54 eps x 20 p/e = $30.80              $43.54/share
25x p/e:              $1.54 eps x 25 p/e = $38.50              $51.24/share
30x p/e:              $1.54 eps x 30 p/e = $46.20              $58.94/share

OK, I added the 30x p/e and that might be a bit aggressive.  Or is it? 

A Higher Target
Yes, 30x p/e in this day and age seems quite a bit aggressive.   I was looking at the Wrigley merger document from April 2008 for merger/acquisition valuation reference points.  Wrigley itself was bought out at 32.1x then current year expected EPS and 29.2x forward p/e.  Of course, Cadbury itself was acquired for what looks like 37x p/e by Kraft.

I do think a p/e ratio of 30x is highly unlikely to be achieved by the global snack business, but it does make sense to assume that it will be higher than 15x or so.  20x p/e may be a conservative valuation if they do have high growth potential.

Anyway, that's just a quick sanity check on what Kraft might be valued at post split.    Of course I left out a lot of stuff; how the debt and SGA is allocated etc... and assumptions of higher expenses due to reverse synergy (although I assume some of that will be offset by efficiency gains/cost cuts).

Olympus Kills Japanese Stock Market?

Olympus was down again the limit and I don't think any shares traded, having been offered down the limit all day at 484 yen/share.

Olympus, on it's own is not a big problem.  These things do happen.  The U.S. had it's Enron, Worldcom and others. 

But the problem is that Olympus is an old, stodgy blue-chip company, not some aggressive, MBA-led startup.  If you can't trust Olympus, who can you trust in Japan?  What other companies have similar problems?  If this sort of cover-up is culturally acceptable are any of the income statements and balance sheets in Japan reliable?  Is there something wrong with the auditing system in Japan?  The scary part is not what happened to Olympus itself, but the suspicion that this is not uncommon (as I said, sadly, I was not surprised by what happened).

This is a scary thought for investors.  This is especially true now with sentiment so fragile after the big, global financial blowup.

My fear is that this will turn people off to stocks in Japan for many years.  This is not like the financial crisis in the U.S. where the collapse is easy to understand.  It was a standard bubble and collapse.  People now trust banks quite a bit less and are afraid of leveraged balance sheets and risk-taking financial institutions.  But nobody is worried about Coca-Cola, Starbucks or Google.  Yes, stocks aren't that popular after such a long period of subpar performance. 

But that's different than what is going to happen in Japan going forward post-Olympus.  Olympus was not a subprime lender or bank.  What happened is not industry specific, so people won't just be able to avoid certain risky industries, they will have to avoid Japan overall.

The Japanese handling of the Fukushima crisis also doesn't inspire confidence.  If they can't tell the truth about that, how can we trust the regulators of Japanese corporations?  Would they not also lie and help cover things up for the sake of a bigger, social good?

Back in 2006 there was a Livedoor/Murakami scandal that rocked the Japanese financial markets and that really killed the Japanese OTC market, I think.

You will see that the market peaked in early 2006 just as the Livedoor scandal broke.  This really turned people off to the OTC market (even though Livedoor was Tokyo Stock Exchange listed).  I think it changed the perception of the market as a rigged thing with no chance for outside investors.

Why is this important?  You will say that lower valuations will be good for investors and they can make good returns.  This is true, but in the case of the Japanese OTC market, I think the problem is that with a bad market, low valuations and no liquidity, companies can't raise capital.  If companies can't raise capital at reasonable prices, the market won't develop.  I think the Japanese OTC market is stuck in the vicious cycle and can't get out of it, and it seems to me it is largely due to the Livedoor/ Murakami scandal.  At least it seems like that to me.

You can see that the JASDAQ market did top out earlier than the Nikkei 225 Index.  The Nikkei didn't top out until the financial crisis began to unfold.

The problem here is that any chance of people coming back to stocks in Japan may be set back for years due to this Olympus problem.  Who is next?  As for foreign investors, they will realize that they have no mechanism to resolve these Olympus-type problems as they do in the U.S.  This means that at the margin, foreign investors will be less likely to invest in Japan.

Of course, value investors need not worry about what other people do and whether stocks are popular or not.  But what it does tell you is that Japanese stocks will probably have to get a lot cheaper on a valuation basis before people get interested.

With this lack of transparency, shakey accounting/auditing, no recourse when trouble occurs, rational investors will demand a discount to invest in such a place.

For many years, Japanese stocks traded at a premium to U.S. and other global stocks.  This really made no sense to me as returns on capital, margins and other productivity measures were usually far lower than Western counterparts. 

The premium has disappeared in the past couple of years making people bullish on Japan again, but Olympus, I think, will change that somewhat.  Parity valuation will not be a reason to go to Japan anymore (unless there are other factors that make a specific investment interesting.  All of these things have to be evaluated on a case-by-case basis).

Couple that with the incompetence of the Japanese government in dealing with the economic situation and government finances, this is a recipe for a long, extended bear market far longer than has already occurred.

This is very unfortunate as I have been interested in Japan for many, many years and have been waiting for some sort of bottoming out over there.

It now looks like there won't be a true bottom for a long time.

I will continue to look for interesting situations over there, but things are not looking too good at all.

I do also understand that I may be putting in a low in the Japanese stock market by making such a negative post!