Leucadia-Jefferies Merger

So this is what it comes down to.  Leucadia (LUK) buys Jefferies (JEF) and solves some problems with one deal:

• Succession:  since Handler will become CEO of the post-merger Leucadia, succession is no longer an issue.  Handler is well regarded and is known to be a very solid, conservative manager.  I have no problem with Handler at all.
• JEF Liquidity Problem:  Actually, I don't think JEF has a liquidity problem and I don't think they had one last year.  But clients and markets have gotten much flakier post-crisis, and ratings agencies seem trigger-happy (and sloppy), so there was a risk that JEF had to manage over-conservatively to compensate for this.  In fact, I think most of the industry is in this situation, and that's why I think the JPM investment bank has higher ROE than the independents (GS, MS etc...).  As long as JEF resides inside of LUK and LUK has plenty of liquidity, this will reduce the risk of "runs" and impact of bad ratings agency opinions. (The fact that LUK is junk rated doesn't matter as long as they have the cash/liquidity)
• Deferred Tax Assets (DTA):  I didn't do the math on this yet, but this really accelerates the realization of the DTA since JEF earns $300-400 mn/year in operating earnings.  Whatever discount factor we applied to the DTA on the balance sheet can be reduced as it will now be realized much more quickly than before.  I may take a look at that later (but maybe not).

Anyway, here is a presentation on the merger from LUK's website:

Leucadia-Jefferies Merger Presentation

Here are some quick highlights:

The New LUK (no pun intended)
This is what LUK will look like after the merger.





44% of the value (at book) of LUK will be in JEF.  This does change materially the nature of this business.  I know some folks who are fans of BRK, L, LUK and other of these value investing conglomerates don't like investment banks.  So just because of that, I can see why many LUK shareholders are not happy with this deal and would sell their shares.

I am not allergic to investment banks as readers here know.   So I have no problem. 

Past Performance
Here is the long term performance of both of these entities over the long term. 

 

Since both of these entities are more or less trading near book, stock price is a reasonable proxy of performance (as opposed to looking at something that might have been grossly undervalued at the beginning of the period and way overvalued at the end of the period, like looking at the S&P 500 index performance between 1982 and 2000, for example)

JEF Long Term Performance versus Peers



Of course, one can argue, "but they needed to be bailed out during the crisis...".  They did lose money during the crisis and did get an equity infusion from LUK.  This is true.  But the fact is that they were able to raise the needed capital, and their business model was sound.  Of course it will bother many that they actually needed to raise capital, regardless of how well it was done.  That is enough for some people to not want to be involved in this kind of business.  Fair enough.

BPS Growth Versus the Usual Suspects
So just how good is this guy Handler, though?  He became CEO in 2000/2001 but since we have data for JEF going back to 1996, let's look at how book value per share has grown over that time versus the S&P 500 index, Berkshire Hathaway (BRK) and Leucadia (LUK) itself.  I just put some charts together quickly to take a look.  These are not from the merger presentation.

This chart is the BPS growth (indexed to 100) of the various companies since 1996 (December 1996 - December 2011).  The S&P 500 index figure is just the total return of the index.

 

It is remarkable how well JEF has done over this time period.  Keep in mind that this chart understates returns because it doesn't include the ITG spinoff from JEF back in 1999.

Judging from this, JEF has done way better than even LUK and BRK.    So it makes sense that this is a sort of reverse takeover of LUK by Handler!

Just to make sure this isn't due coincidentally to two lucky data points, I looked at the same figures starting at the end of 1999 which was the peak of the bubble in the stock market (at least in year-end terms).  Here is how the usual suspects have grown their BPS over that time:

Again, JEF outdoes everyone, including BRK.

I also did the same for the period 2007-2011, but didn't bother with creating a chart.

Here is a table that summarizes the above stuff:

BPS Growth Including Dividends (S&P 500 index is just total return), annualized

Period:                 JEF               BRK          LUK         S&P 500
1996 - 2011:        +15.4%         +11.7%       +9.9%       +5.5%
1999 - 2011:        +13.9%           +8.4%     +11.8%       +0.6%
2007 - 2011:         + 5.6%           +6.4%       +0.2%        -1.6%



 

It's pretty impressive.  I didn't think I would get this result before I put these charts together.  But there it is.

I read somewhere that LUK is no BRK as BRK would never do such a deal as this or some such.  Well, maybe LUK is better than BRK judging from these figures!

Keep in mind that this JEF performance was accomplished in a pretty horrible environment with two big bear markets, financial crisis etc. in an industry that was the epicenter of the crisis.   And of course it includes the loss and equity infusion during the financial crisis.  You will notice that this was done with barely visible damage.

Contrast that with the real bailouts (as opposed to JEF's proactive, preemptive capital raising) of say, Citigroup, Bank of America and AIG.  The book value growth graphs and stock price charts of those would show a very different picture.

Anyway, with JEF, what's not to like?  (unless you are bancophobic)


After the Merger: Different Business

So here's an interesting slide from the presentation.  They actually set parameters for the new LUK.

After the merger, the largest equity investment (excluding JEF) will be no greater than 20% of book value, and no other investment can be greater than 10% of book value at the time of investment.  Also, there is a new leverage limit (as shown above).

 

This may be due partly to make sure no post Cumming/Steinberg CEO blows LUK up, and partly to stabilize the non-JEF part of LUK as liquidity may be needed to support JEF in times of stress.   

 

In a sense, this may be the opposite of the Berkshire Hathaway (BRK) model:  BRK owns insurance companies that provide float that BRK can use to make investments while LUK may now have to hold excess cash/liquidity at low returns as reserve in case JEF needs it.

 

But there would be some advantages from this in terms of capital efficiency that is similar to BRK.  When JEF has business with decent return potential, LUK can inject more capital.  When the opposite is true, they can transfer capital out of JEF into the non-JEF part of LUK.  Of course, this can't be done without the approval of regulators as capital regulations are very strict when it comes to transferring cash in and out of a regulated subsidiary to and from a non-regulated parent.  But this is true with BRK and the heavily regulated insurance companies too.

 

It is capital efficient in the sense that if JEF was independent and they wanted to maximize capital efficiency, they may buy back a ton of stock during slow times and then have to raise equity capital when things start to pick up.  This can be costly and very inefficient, not to mention the problem of having to raise capital possibly during times of crisis when an independent JEF's stock price may get really cheap (and therefore expensive to raise capital). 

 

You can get a sense of this capital inefficiency of independents when you listen to Goldman Sachs conference calls.  On the one hand, they want to buy back a ton of stock as they are underutilizing their capital.  But on the other hand, they don't want to be left short of capital when things start moving, the markets come back and business picks up again.  For GS, it's pay dividends and buy back stock, or sit on their capital and wait.

 

With a JEF/LUK combination, there would be more choices to choose from.  There are more levers to pull in terms of optimizing capital efficiency. 

This added flexibility really does enhance the opportunity for value creation of the combined entity.

 

LUK is Cheap

Anyway, moving on.  So what happens to LUK post-merger?  If you own LUK stock now, what is it going to be worth after the merger?

 

After the deal (which includes the pre-merger LUK spinning off Crimson Wine), LUK will have total assets of $42.1 billion, total shareholders equity of $9.3 billion and a book value per share of $24.69/share.

 

The stock closed today at $20.75.  The above $24.59 post-merger BPS excludes Crimson Wine, which will be spun off before the merger.  That is worth $0.81/share.  I have no idea what Crimson Wine will trade at after the spinoff, but assuming it trades at $0.81/share, the post merger value of LUK and Crimson together would be $25.40/share, so LUK is trading at a 18% discount.

 

That's pretty cheap.  But to be fair, so are most other financial companies and after the merger, LUK is going to be half an investment bank.

 

Merger Arb

This is an all stock deal.  JEF shareholders will receive 0.81 shares of LUK and they expect the deal to close in the first quarter of 2013.  Before the deal closes, though, LUK will spin off Crimson Wine, which has a value (at book) of $0.81/LUK share. 

 

The current LUK price is $20.75, and less $0.81/share (Crimson spin), that gives a value of $19.94/share of LUK that JEF holders will receive.  They get 0.81 shares per JEF share, so that's $16.15/share in value to JEF holders.  JEF closed today at $16.00/share, so that's a $0.15 discount.

 

LUK has a dividend of $0.25/share and JEF is $0.30/share (both annualized).  Since there will be only one dividend payment (according to last year's dates for JEF), that's a net dividend of $0.0125 for the long JEF/short LUK position.

With 138 days until March 31, 2013, a $0.15 discount plus $0.0125 net dividend works out to a 2.7% annualized return; not much.

If you are an institutional investor and get cheap leverage and can finance this long/short at 40 bps (Fed+20 bps to finance long, receive Fed-20 bps on short) and can get 6x leverage (15% capital), I guess that works out to 13.8% annualized return (2.7% annualized return less 40 bps financing cost times 6x).

I don't do this sort of thing, usually, so I may have missed something in the above calculation.  It looks pretty tight.  If you can only make 14% with 6x leverage, that's not very exciting.

In any case, this isn't the main point of this post.  

Why All Stock Deal?
Of course the question is going to be, why would LUK issue cheap shares (below book value) to pay for JEF (at book value, or over tangible book).  

The reason they would do this is as a stock transaction is that it would be tax free to JEF shareholders (Richard Handler being one of the large ones) and it will allow JEF shareholders to benefit from the future value creation of the combined entity.

LUK went out of it's way to liquify their portfolio before announcing the deal, so it seems they are more comfortable with the deal with this excess liquidity.  This means that they wouldn't have considered the deal if they were going to issue debt costing 8%, or if they had to use up all of their cash and liquidity to pay for the deal.

OK, Fine. But How Dilutive Is This Deal?
From page 32 of the presentation, we can see that LUK had BPS as of the end of September of $26.71/share.  After the merger, LUK will have BPS of $24.69/share.  Adjusting the first figure for the Crimson Wine spinoff, you get a September-end BPS of $25.90/share.  So that's a $1.21/share dilution to current LUK shareholders.  That's a 4.7% dilution right there.

Is it worth it?  Well, like anything else, you will have plenty of varying opinions.

I think the big thing about this deal is the succession issue.  Richard Handler is a highly regarded CEO and this would seem to be a small price to pay to get this deal done and in such a way that many JEF shareholders will roll into LUK.

Given that Handler helped find some of LUK's investments in the past (Fortescue etc.), he may be instrumental in finding other ideas.  Which leads to the next question:

Potential Conflicts?
Now, I do think this is a great deal and LUK shareholders, unless they are allergic to financials, should be comfortable.  People who hate investment banks and financials in general should probably sell out (maybe at a better price once this cliff nonsense clears).

But having said that, I do wonder about the issue of conflicts here.  LUK was a client of JEF; JEF brought ideas to LUK for them to look at.  I am thinking about the potential conflicts that people raise with Goldman Sachs.  On the one hand, they have investment bankers looking for deals and matching buyers with sellers.  And on the investment side, GS have their own people looking for deals to do too.  When a deal is found, how do you decide if it's OK for GS to go ahead and buy, or do they have to show it to a client that was looking for something like it before doing the deal themselves?

In the case of GS, I guess you can make the case that the private equity funds inside GS operate independently and the CEO doesn't see these deals.   At least there is some sort of Chinese wall there.  (There have always been walls between trading and investment banking even though many seem to believe they don't actually exist.  In my experience, they actually do exist even though it may leak from time to time).

But if Handler is CEO of both JEF the investment bank and LUK the opportunistic value investor where the CEO plays a major role, how do you reconcile this conflict?

When an energy company client is talking to JEF investment bankers, how do they know or not know what information Handler will get to use for LUK's energy business, acquisition opportunities etc.?

At big banks like GS and JPM, the CEO is not involved as key decision makers in deals that the private equity arms do.  They may know what's going on, but they are not the deal makers.  At the new LUK, it seems like Handler will be the key decision maker on deals at the non-JEF LUK, basically replacing Cumming as CEO.

I don't have any doubt about the honesty and integrity of the folks at LUK and JEF so this is not a question about that.  It's just a practical question that comes to my mind.

So What Do I think?
My first impression from looking at all this stuff on first pass is that I like it.  I understand that many probably won't.  There may be some disappointment that the merger is with an investment bank that is prone to the booms and busts we have seen recently, and that is not something to look forward to.

One great thing is that if investment banking is in fact dead and won't ever recover, this deal can still work out because Handler can reallocate capital out of the investment bank into other LUK areas, just like BRK does with their insurance business.  This internal capital fluidity, I think, is a huge advantage.  In that sense, owning the combined LUK/JEF is probably better than owning an independent investment bank.

I like and respect all of the parties involved and see no problem with the people, intent of the deal or anything like that. 

I do own LUK and will be looking to buy more (maybe through JEF) as I do think it's cheap.  JEF is also small and nimble enough to be able to take advantage of the changes going on in the industry (European banks scaling back etc.)

Buffett on CNBC

Buffett was on CNBC this morning.  Who has time to sit in front of the TV from 7:00 - 9:00 am?  And only the hardcore Buffett-heads would click through and watch all the videos or read the full transcript.   (Also, I tell people to listen to Buffett but I know most don't have the time to (who are not full time value investors, not that they would read the blog))

So here are some of my notes (may not be in any particular order):

First I'll put one of the last things he said first as it is most relevant to investors.

Stocks

• Bad news from Europe, macro news and other headlines would not cause you to sell a farm run by capable people, or an apartment house where you had rents rising.  You wouldn't sell it just because there is some bad news.  A McDonald franchisee that has a good business wouldn't sell the business because of what is in the news.  You know you will do well over time and that should be the same with stocks.
• To buy and sell stocks on current news is just crazy.  Dancing in and out of markets based on the news is a terrible mistake.
• You have to treat owning stock like owning a business.  The above farmers, landlords and MCD franchisees wouldn't buy and sell their businesses depending on what's in the newspapers.
• Buffett bought his first stock when he was 11 years old and that was three months after Pearl Harbor and the death march of Bataan was going on etc.  All the news was terrible, but it was a great time to buy stocks.
• [ As an aside, Julian Robertson was on CNBC too this week and he said something similar.  He said now is the time to invest.  He knows a lot of very good investors that lost their way by being worried about Europe, QE2, QE3 etc, not realizing that there are a lot of marvelous companies at reasonable prices.  He likes AAPL, Ryan Air, OCN, COF; doesn't like steel ]

QE3

• Asked if he would have voted for QE3 (if he was on the Fed board), Buffett said that his instincts would have been against it.  There is only so much the Fed can do.
• Bernanke has done an "absolutely superb" job.  What he did in 2008 was the right thing and saved the economy.
• Buffett is worried about the continuously expanding balance sheet of the Fed.  The Fed has unlimited buying power, but not unlimited selling power (the Fed can buy all the paper it wants, but when it's time to sell they'll need cooperation (from buyers)).
• 3% of revenues of the U.S. government is profits from the Fed.  The Fed is the fourth largest source of revenues for the government (after personal income tax, payroll tax and corporate income tax).  The Fed pays $70-80 billion dividend to the government (of the $2.4-2.5 trillion total revenues)

Verizon/ATT

• Asked why he doesn't buy Verizon and ATT with their 5% dividend yields and toll bridge-like business, he said that he doesn't know what they'll look like five to ten years from now. 
• He explained that he buys stocks for their future earnings (and not dividends). 
• He mentioned that ATT/Verizon would be better off buying back shares instead of paying dividends (Buffett is a big fan of share repurchases as it reduces share count and increases ownership of current stockholders and increases intrinsic value per share if repurchases occur at attractive levels).
• Mentioned that IBM has bought back $3 billion per quarter this year.

The Economy/Employment

• Berkshire Hathaway (BRK) has at least 50 companies out of the 75 businesses they own that would fit the middle market definition (sales between $10 million - $1 billion) so he gets a sense of what business is like for them.
• BRK will add 8,000 jobs organically this year off of a 275,000 employee base and they will add another 10,000 - 15,000 employees through acquisitions (mostly bolt-on acquisitions).
• Clayton Homes will sell 15% more homes this year than last year.
• Furniture, carpets and other housing related businesses doing well. 

Cash / Elephants

• BRK has at least $40 billion cash on the balance sheet (he has said in the past that he wants at least $20 billion cash on the balance sheet for liquidity).  He has looked at two deals this year in the $20 billion range (plus or minus) where the CEO wanted to do a deal, but it didn't get done due to price.
• BRK is an unlevered buyer so often can't meet the price of levered competitive bidders who get cheap financing now with rates so low. 
• Prices for that reason now are too tough.  Cheap money is a factor.  (This is exactly what Leucadia said in their annual report).
• When he gets home he will look at a $6 billion deal he was offered but he hasn't seen the financials yet.
• BRK has done many deals this year; 15 deals that add up to around $2 billion, but those are bolt-on acquisitions.  Buffett wants elephants.

Stock Market Weakness this Week

• Has has added some Wells Fargo (WFC) in the past week, but not the past couple of days.  IBM was added this year.  $1 billion or so of WFC was added this year and hundreds of millions of IBM was added this year.

IBM

• Learned more about IBM by asking BRK managers.  They are IBM clients and asked them about their future plans, alternatives and the managers said they had no plans in changing providers, convincing Buffett that IBM had a sticky client-base.

Insurance

• The insurance business has been good this year.  There were some big events last year, but not much this year.
• I'm surprised Buffett didn't mention anything (unless I missed it) about premiums.  James Tisch said recently on Bloomberg or CNBC that there is a 5-8% inflation story going on now in insurance.  More than underwriting profits/losses (which is volatile and not very indicative of anything in the short term), the industry has been waiting for a hardening market (higher premium prices), and that seems to be happening.  Anyway, Buffett didn't say anything about that.

Coke

• Has been around since 1886
• Physical volume is up +4% in the first nine months of this year in a world that is growing 1%. 
• Per capita usage has gone up almost every year since 1886.
• Coke is a huge distribution machine.
• Mexico has 600+ 8 ounce servings per capita, 50% higher than in the U.S. and it grows every year.
• This comment was in response to a question about inflation and higher input costs.  He never got there but I guess he was going to say that great businesses with great products will be able to price their products profitably (pass through costs).

Proctor and Gamble

• Sold some PG stocks over the years on valuation.  He said he sold some during the Lafley (former CEO) years and the McDonald (current CEO) years.
• Earnings have been disappointing for a few years.
• What mistakes they made, what happens inside of PG, what the plans are, Buffett has no idea.  The jury is out on that and he doesn't know what will happen.

Election

• Election comes down to who has a better ground game in Ohio.
• The better organized one will win; Democrats need a lot of work because their election day turnout is lower than the Republicans, so they really need to work hard to get their constituents to vote.
• Buffett has no particular insight on who will win; his views no better than Intrade (online bookie).
• American business and economy will do better in the next four years no matter who wins.

Bloomberg Soda Ban

• When asked about NYC Mayor Bloomberg's ban on large sodas, Buffett said it makes no sense to ban just one type of drink.  A 16 ounce serving of Coke has 200 calories, but other drinks and foods have 200 calories too.   Why just soda?
• He mentioned that Dairy Queen's same store sales was up +5.8% in September; much better than McDonalds.
• He said he drinks five 12 ounce cans of Cherry Coke every day, and that's 750 calories.  His doctor told him to drink a lot of fluids.  He asked, "How about Cherry Coke?" and the doctor said that's fine.

Europe

• Europe has a banking problem (he has said many times recently that U.S. banks are in great shape).
• It's tough to have austerity and try to grow GDP at the same time.  Europe will be tough for some time.
• Monetary union without discipline is not sustainable.  They will have to become closer.
• Printing money has consequences and we have yet to see what that will be. 
• The movie in Europe is not over.

Homes

• Buffett said that it's a terrible mistake if you don't buy a home now, if you know where you are going to live for a long time and if you have a stable job/income.
• Get a 30 year mortgage, it's a "golden opportunity" that won't be around in a few years.  No chance like this five years from now (has Buffett spoken to any Japanese homeowners in the past 20 years?).

Stock Activity at BRK

• Most stock buying and selling activity at BRK is not Buffett but his two new portfolio manager hires.
• Buffett oversees very few stocks, like IBM, WFC, KO etc.  So other than activity in those names, most other stock trading is done by Ted and Todd.  They will buy $500 million at a time.
• He mentioned that both Ted and Todd used to run hedge funds with a very low tax rate for themselves and yet they came to BRK happily for lower compensation and a much higher tax rate and they are happy.  This is an "indictment" of the current tax system (and argument against claims that a higher tax rate will reduce incentive to work in this country).

Greg Smith

• He was asked about Greg Smith's book/op-ed Why I Left Goldman Sachs.
• Buffett said he didn't read the book but saw the interview with Greg Smith.
• He said that publishing an op-ed by a single disgruntled employee (out of 30,000 employees) who wasn't happy making only $500,000/year and not $1,000,000/year where in other industries he would be making only $75,000/year with no details other than the word "muppets" didn't reflect great editorial judgement.

Facebook

• Buffett wouldn't invest in Facebook.   He doesn't understand the business.
• He's not even a member even though FB has a billion members.

Global Economy

• The economy came up again and he said there is no question economy is slowing around the world.
• In the U.S., residential housing is picking up and it will have a significant impact.  Nothing big yet in housing, but it has turned.
• General economy better in the U.S. than Europe.  Slope of slowdown is steep in Asia.  U.S. has steadiest trajectory (inching ahead) and Buffett sees no change in that unless there is chaos somewhere. 
• U.S. economy is not tanking
• Clayton Homes growing 10-15% in terms of units.
• Real estate brokerage is seeing 15% increase with median prices up (a little) all over the country.
• U.S. has adapted to what's happening around the world.
• BRK invested $6 billion in plant and equipment in 2010, a record.  In 2011 they invested $8 billion and in 2012, it will be $9 billion.  So there are things to do (capex is mostly rails and energy).
• BRK's railroad business carry 15% of all U.S. freight measured in ton miles.  Burlington Northern alone carries almost 1/2 the ton miles that all trucks carry. 
• There has been small gains in freight volumes (coal down but oil up etc.); July-August had misleadingly strong figures due to floods last year.

Banks

• Likes WFC and bought more in the past week.
• Banks can't be as profitable as it used to be in the past.
• Banks business model has two factors: Return-on-assets (ROA) and assets-to-equity (leverage).
• Return on assets won't go up.  WFC earns 1.4%-1.5% ROA and USB does 1.7%.  This won't change.
• In the past, (some) banks had 20x assets to equity.  With an ROA of 1.5%, 20x leverage gives you a ROE of 30%.  This won't happen in the future.
• Banks used to earn 25% return on tangible equity and that's a crazy number.  We won't be going back to that.
• But banking is still a good business.

Crash!!?

This is not a market-timing blog or anything like that, but every now and then I get the itch to make a post about it even when I have no real information or analysis to offer.  So most can skip reading this post.

Anyway, last October and November, I made a bunch of bullish posts on the stock market.  When there was a lot of fear of a real European implosion, I wrote that a crash is unlikely (read here).

I was thinking about this again recently, and if someone asked me now if a crash may happen, I would say it is much more likely now than last year; I wouldn't so strongly make a call against a crash.

One obvious reason is that the market is up a bunch since then and things aren't as cheap as it was. 

Here are some charts:

S&P 500 Index, Past Two Years

 

Volatility Index

 

You can see it wasn't so hard to be bullish last fall; there was so much fear and hysteria in the market.  Now the market is much higher and the VIX shows no fear at all.  I am not one of those people calling for a crash every time the VIX goes below 20% or near 15% or whatever, but the market is much more ready for a correction than it was last year (when the market was already in a correction).

Credit spreads seem to be at historical lows too, and that's also usually a sign of compacency.

This doesn't change my long term favorable view of stocks and this shouldn't make any different to true value investors; value investors don't make money getting in and out of markets.  As a long term value investor, I would clean house and dump things that are luke warm and make sure what's in the portfolio are good, solid longs.   Other than that, I wouldn't advocate doing anything about this; just sit tight, come what may.

Shorts Give Up, Longs Lag
I don't have any data, but it sort of feels like this market just went up and blew out the shorts all year, and the underinvested longs lagged severely and had to jump in.   I think as shorts throw in the towel, it's probably a good time to start looking for good shorts (if that's what you do).


Apple
Apple has been nagging at me too for a while.    Apple is still cheap excluding cash on the balance sheet, but at this point it sort of feels like this Apple fever is sort of peaking out.   What bothers me is that I can't really analyze this in a meaningful way.  It's just a gut feel sort of thing.  It just feels like Apple had a parabolic run and peaked out even though the business continues to do well and there is still probably a good runway for growth going forward.  And the stock is still cheap.

One thing that is worrisome is how Apple was so much a product of Steve Jobs.  Reading about Apple and Steve Jobs, you realize how important he was to the success and dominance of Apple.

I read quite a bit about Sony recently and it is interesting to note that Sony also lost it's way after the passing (or retirement) of Akio Morita, the charismatic co-founder of Sony.

When you have a strong leader like that who is a founder, things can get done that can't happen in a regular company (not run by the founder).  In fact, in the book Sony versus Samsung,  the author states that one reason Samsung was able to clobber Sony was because Samsung was still run by the founder who was able to get things done.  No successor CEO can possibly have the same kind of power (even if they have the authority).   When Morita wanted something done, it got done.  When Idei wanted something done, it often didn't get done.

Steve Jobs can ask for a lot, and ask for things people say is impossible.   No successor CEO will have that kind of power because no CEO will have that sort of credibility and loyalty; people will just quit if pushed or treated the way Jobs treated them; it just won't be the same.

And yes, I understand Apple is not just about the gadgets; it's the eco-system.  Other tech/gadget companies didn't have the same synergistic thing that tied everything together.   The iPod is no Sony Walkman, and the iPhone is no Razr. 

Here too, I think online app stores and things will eventually catch up to Apple;  tablet computers too will eventually become commoditized with more or less similar features and similar apps avalailable online.

But what really haunted me was the fact that Apple is building all these expensive stores all over the place at the best locations.    This positive lollapalooza can work wonders when there are great products to sell, but what if the run in hits runs it's course?  What will they sell at these spectacular retail locations?  Maybe it doesn't matter; they might make so much money and get their investments back so quickly that closing them if needed may not be a problem at all.

 

 

Apple had a really good run after the passing of Steve Jobs.   It's almost as if they were worried, and then decided after the fact that it just doesn't matter that Jobs is no longer there. 

 

The biggest worry, though, is that Apple seems to be the favorite of so many different people; hedge funds, mutual funds, retail investors etc. 

 

There have been some articles written here and there about how over-owned Apple stock is.  I haven't done any of my own work on that, but it does seem to be a very popular holding.  And no matter who you ask, they all say "it's cheap".

 

I don't know.   You don't get rich shorting low p/e stocks,  but this one might actually be one to look at.  Of course, like any short, if it runs against you you can't sit on it for long as these things can really go parabolic and you can lose tons of money.  And a lot of very smart people are long this thing and I am definitely not smarter or more informed than them (in fact, I have very little information on Apple).  It's just one of those intuitive things.

 

Anyway, I know this post is a little different than what I usually post (my gosh, I sound like a day-trader), but it's something that has been on my mind recently.

 

And yes, I will dabble, perhaps foolishly, in Apple on the short side.

 

 

 



 

Recapitalizing Berkshire Hathaway

So I had a conversation recently and I mentioned LEAPS and leveraged recapitalizations (or synthetic recapitalizations) as one idea mentioned in Greenblatt's You Can Be a Stock Market Genius  (see the book here). 

Actually, Greenblatt calls this "creating your own stub stock".  A stub stock is the post recapitalized shares of a company that borrowed a bunch of money and paid it out to shareholders (or swapped debt for equity in some combination;  see chapter six, page 201, "'Baby Needs New Shoes' Meets 'Other People's Money': Recapitalizations and Stub Stocks, LEAPS, Warrants and Options")

I thought I wrote this up before but can't seem to find it.  I probably mentioned it within some post somewhere, but I'll take a look at this idea again, maybe in more detail than when I wrote it up last time.  I also know that buying LEAPS on BRK is not a new idea; people have been doing this and talking about it for years.

But anyway, when you listen to Berkshire Hathaway (BRK) shareholders, the two biggest complaints I tend to hear are:

1. BRK should pay dividends!
2. BRK is underleveraged; all that cash and bonds are holding down returns; why doesn't BRK buy back a ton of stock?!

Dividends
This gets debated to death on the internet and I don't want to get into that.  Buffett has said quite simply that he won't pay dividends as long as he thinks he can outdo the S&P 500 index with the retained earnings.   

For people who want dividends, the answer is easy.  They can just sell 2% or 4% of their BRK holding every year as a 'synthetic', self-created dividend.  With intrinsic value growing 10%/year over time, the value of their holdings should increase over time too.

I guess the problem with that is people hate the idea of selling BRK stock below what they consider intrinsic value.  But then again, if BRK pays out a dividend, that reduces book value on a dollar for dollar basis and at the same price-to-book ratio, the value of BRK goes down a like amount.

At least BRK is trading at above book value, so selling shares may be better than getting a payout at book value (which is what happens when you get a dividend; $1.00 valued at 1.2x by the market ($1.20) held at BRK becomes $1.00 (at 1.0x) in your pocket).

For now, dividends have a low tax rate but in normal times selling stock over time can be better too.  Most of the time (at least in my time), capital gains tax rates were lower than ordinary income rates (which is what dividends are usually taxed at until the Bush tax cuts).

Plus, you have to pay the entire amount of tax on dividends received but only on the 'gain' in the case of capital gains realized when you create your own dividend.

Anyway, that's just my thought; I am no tax expert so I may have missed something.  In any case, this is not really the topic of this post.

Recapitalization
For those who haven't read Greenblatt's book, I would encourage you to go and read it.  Readers here know by now that I am a big fan of his work.  I do really put You Can Be a Stock Market Genius as probably the worst titled book ever, but one of the best investment books ever written.

It goes right up there with Securities Analysis and Intelligent Investor (and Seth Klarman's Margin of Safety).  But it's more like Intelligent Investor in the readability than Securities Analysis, which tends to intimidate people; it's a big, heavy book. 

Most people would be able to read the Genius book over a single weekend (and it's funny).

Anyway, in that book Greenblatt talks about a special situation that was popular in the 1980s.  It was the recapitalization trade.  Sometimes it's called leveraged recapitalization.  The idea is that if a company borrows a ton of money and pays it out to shareholders (or repurchases stock), the value of the left over (called the stub) increases in value.  This is due to the tax effect; interest payments on the debt reduce pretax income but also reduces the tax burden so at the same multiple, the post recap firm would have a higher value (excluding the paid out cash).

Even if the post recap P/E ratio is somewhat lower (due to higher leverage), the value of the stub (and of course the value of the combined cash + stub) is higher than before the recap.

Greenblatt pointed out that recaps were no long popular (he wrote this in 1997) due to the bankruptcies of many highly leveraged companies in the late 1980s and early 1990s.

But he said, not to worry!  There are hundreds of LEAPS listed on the exchanges so we can create our own stub stocks.

So, this is what we're going to do.  I will take a quick look at creating our own BRK stub stock.

Stubbing BRK
OK, so here's the deal.  BRK, as of June-end 2012 had $182 billion in shareholders equity.  Of that, $36.8 billion was in cash and $30.5 billion was in fixed income investments.   That's a total of $67.3 billion in low return assets.   So 37% of BRK's net worth is invested at very low rates.  No wonder why the P/B ratio has come down so much (compared to when BRK was highly levered to the stock market long ago.  I took a look at that a while ago; you can just look for posts labeled BRK for that).

Wouldn't it be great if we can just have BRK pay that 37% out?  Yes, of course it would.  But we know that they can't do that.  BRK is an insurance company with a lot of obligations.  One of BRK's strengths is their rock solid balance sheet and high credit rating.  So much of the fixed income and cash is not really pay outable.  Buffett has said he wants $20 billion cash, minimum, so there is maybe a bit more than $16 billion usable, though.

And the fixed income portfolio is also pretty much mandated by insurance regulation to support the 'float'.

So it's clear that the insurance companies will have to hold a lot of these cash and bonds, so let's just fantasize for a second and ignore credit ratings and reality.

Let's Dream For a Moment
Since the insurance companies can't pay out the cash and bonds, let's look at the holding company.  Let's say BRK can just borrow, say, $70 billion at the holding company level and then pay that out to shareholders.  Wow, that would be huge.  And yes, I know, impossible.  A $70 billion debt offering is insane too.

But we are just trying to get our arms around what leverage can do.

BRK borrows $70 billion and pays that out to shareholders.  What will that do?  Of course, it will reduce shareholders equity by $70 billion (and leaves $70 billion new debt on the balance sheet). 

So BRK's net worth goes down to $112 billion.   BRK's structure, earnings and balance sheet is complicated, but to keep it simple, let's just say that BRK earns around 10% on book every year (including all the businesses and increases in value of stock holdings etc.).

BRK was able to earn 10% before the recap, so that's a $18.2 billion run rate.  With $70 billion in new debt on the balance sheet, BRK will incur interest expense.

A quick search tells me that BRK's credit spreads versus governments and funding costs were:

              BRK credit spread                Treasury yld                  BRK cost of funds
5 year        T+49 bps                             0.6%                           1.1%
10 year      T+105 bps                           1.6%                           2.7%
30 year      T+131 bps                           2.8%                           4.1%

So let's use the really long term rate since this is a complete recapitalization.  We don't want to have to worry about refinancing and stuff like that.

At 4.1%, that's an after tax interest cost of 2.5%.   On $70 billion of debt, that's an annual interest expense of $1.75 billion.

We said that BRK earns, at 10% return on book, around $18.2 billion/year on the $182 billion in book value.  After the recap, BRK would earn $16.5 billion (accounting for the $1.75 billion after tax interest expense).

But the new book value is $112 billion so the post recap return at BRK is 14.7%, almost 1.5x what it would do before the recap.  The stub would be worth 1.5x what is was before the recap (excluding the cash paid out) if we assume a 10% discount rate for fair value.  Actually, you would have to value it a little lower as the market would demand a discount due to the leverage.

Still, that's not bad at all.

But of course, if BRK really had $70 billion of debt on the balance sheet, the credit rating would not be the same, and it probably wouldn't be the preferred provider of reinsurance etc.  This would be a very different animal.

Creating Your Own Stub
Of course, this will never happen but let's see what happens if we create our own stub.  We do this by buying LEAPS.  What are LEAPS?  A LEAPS is an acronym (presumably trademarked) for Long Term Equity AnticiPation Securities.  They are just long term options on stocks.  Maturities tend to go out two years.

The bottom line is that if the company isn't going to go out and borrow money to lever up (and enhance the value of the firm), the stockholder can add leverage at the stockholders' level to create leverage.  Leverage is leverage, right?

So if we bought stock on margin, for example, we are creating our own leverage.  The final economics of the position can be similar (although there will be plenty of differences too).   But margin can be tricky as you can get margin calls, be sold out (what if we have another flash crash or worse?) and who knows what margin rates will be over time.

With LEAPS, once you buy an option, you don't have to worry about anything else; you can only lose your initial investment.

Let's look at the above recap and see what it looks like when we do it ourselves. 

In the above example, BRK borrowed 40% of it's net worth to pay it out.  BRK is now trading at close to $90/share, so if we wanted to create our own stub (post-recap stock), we would go out and buy the $36 ($90 x 40%) strike price LEAPS as far out as is available, which happens to be January 14, 2014.   Since there is no $36 strike, we will just use the $40 strike price.  Close enough.

So what happens when we buy a $40 strike call?

Here are the facts:

$40 strike call price:    $49.38  (mid-point of truck-wide spread)
BRK/B share price:      $88.70

Intrinsic value of call:  $48.70  (current stock price minus strike price)
Premium:                      $ 0.68

Intrinsic value of the call option is simply the amount the option is in-the-money.  If a stock price is $50 and the strike price is $40, then the intrinsic value is $10 (the value realized if option is exercised right now).

So what happens when you buy a LEAPS now at $49.38 is:

1. You are borrowing $40/share worth from the market as you only have to pay that when you exercise the option and
2. You are buying downside protection on BRK because if BRK goes to below $40/share, the option is worth zero and you can't lose more whereas the stockholder will continue to lose money beyond a decline below $40/share.

So compared to just buying BRK/B today at $88.70/share, when you own the above LEAPS, you essentially have a loan and a put option (exercisable at $40/share).

Let's break that down:

BRK/B share value:       $88.70

BRK/B LEAPS value:   $49.38
Implied Loan:                $40.00  (strike price)
Premium:                       $0.68   (includes interest on loan and put option value)

So the 'loan' on your balance sheet is 40% of the full value of BRK/B shares, similar to the above dream recap when BRK borrowed $70 billion.

Pricing the LEAPS
So the intrinsic value of the January 2014 $40 strike call is $48.70, but it is trading now at $49.38, a little higher.  This premium includes: the financing cost of the $40 strike price (which is the amount you are borrowing until expiration:  a call buyer puts up $40 less than the buyer of the stock) and the put option value of a $40 strike put.

Since the put option is so out of the money, let's just ignore that and see what the implied financing cost is on our $40 loan (or we can see it as a loan that includes this insurance).

The difference between the current LEAPS price and intrinsic value is $0.68.  If that is the interest cost on the $40 loan, that comes to 1.7%.  But wait, that's not annualized.

Since the option expires 473 days away, that's 1.3 years away.  So the 1.7% interest expense is actually just 1.3%/year.

So by buying the LEAP, you are essentially buying a $88.70 stock by putting up only $49.38 and borrowing $40 at an interest rate of 1.3%/year with insurance (you can walk away from the loan if the stock is under $40 at expiration).

That's not a bad deal at all.

If we do the above return analysis, you can see that the stockholder can expect to earn $8.9/share (10% increase in value per year; we assume 10% growth in book value per share and constant P/B ratio.  I initially used the increase in book value per share for these calculations, but realized that that would understate the return to shareholders if they assume a constant P/B ratio since BRK is trading at around 1.2x book).  You can do the same using 10% increase in book value per share as a proxy for EPS instead of 10% increase in share price and the results would be a little lower). 

What will the LEAPS holder earn on an equivalent basis?  Since he only put up $49.38/share, he will get a levered return.  But he is also paying interest on the loan (premium on the LEAPS).  The loan costs 1.3%/year on the $40 loan, so that comes to $0.52/share.  If the BRK stockholder can earn $8.9/share, then the LEAPS holder is earning $8.4/share.  $8.4/share on $49.38/share investment is a return of 17%.

So by levering up with LEAPS, the BRK holder has created his own stub stock and bumped up his return from 10%/year to 17%/year.

Of course, these returns assume that the P/B ratio of BRK remains the same and BRK increases book value at 10%/year.

Some upside can be had if the P/B ratio expands too for some upside kicker (and of course, it would be lower if P/B contracts, but most Berkshire holders aren't expecting that).

And what's really great about this self-stubbing or synthetic leveraged recapping or whatever you want to call it is that it does nothing to BRK's credit rating!  And BRK doesn't scare the credit markets (and compete with the Feds) with a $70 billion bond offering.

Of course, there is a big downside too.  Options have maturities, so if the stock does nothing until January, you lose 1.0%/year right off the bat (that doesn't sound too bad, actually.  You are essentially betting 1.0% to earn 7% extra, not a bad risk/return?   But not really; you do have leverage to the downside, so the 1% is the cost of the leverage (and you get it both ways).   The 1% comes from the premium (implied interest expense) of $0.52/year against the $49.38/share price of the LEAPS, which is around 1%).

If the stock goes to below $40/share by expiration, the LEAPS will expire worthless but BRK owners will still own the stock so if it comes back up, they can still be OK.

I looked at this from the point of view of a fundamental analyst looking at earnings;  pre and post recap earnings and returns.

But let's just look at it from the point of view of an investor/trader. What is the difference in returns between owning the stock and the LEAPS?

Returns Comparison for $40 Strike LEAPS

This table is pretty self explanatory.  The left column is the stock price at expiration of the LEAPS and the following column is the intrinsic value of the LEAPS (or value of LEAPS at expiration given stock price levels).  The two columns that follow just look at what the returns would be assuming various levels for the LEAPS and BRK stock.  The last column is just the leverage you get on the LEAPS compared to just buying the stock.

Of course, this ratio is similar to the above "return on book" calculation above, which is similar to the "dream recap" scenario above that.  

Let's Look at Another Strike
OK, so that one is really deep in the money.   What about getting even more leverage?  We all really like BRK and think it's really undervalued and it's a coiled spring ready to jump up 30-40% to intrinsic value very soon.  (OK, maybe that's a bit much.  But it does look OK around here, doesn't it?)

So let's look at a more realistic, higher strike price for a LEAPS, which actually makes it more leveraged.  I say 'realistic' because it's a litte more liquid at the higher strikes.

Let's look at the $60 strike, January 18, 2014 calls.  This should give us almost triple leverage since we are borrowing $60 against a $89 stock price.

Here is the relevant information:

Stock price:       $88.52  (yes, it has moved while I'm writing this)
LEAPS price:    $30.50
Intrinsic value:  $28.52
Premium:            $1.98  (LEAPS price minus intrinsic value (of LEAPS))

So again, ignoring the put option value, the implied financing cost on our $60 loan would be ($1.98 / 1.3 (annualize it) / $60) 2.5%.

At 10% return on unleveraged BRK, the BRK shareholder earns $8.9/share.  The annualized cost of the loan (including put option value) is $1.52, so the LEAPS holder would earn $7.38/share ($8.90 - $1.52).  Against the purchase price of the LEAPS of $30.50, the return for the LEAPS holder is 24%.

So with this self-stubbing of BRK, we created a security with an implied rate of return of 24% from a stock with an expected return of around 10%.

Again, let's look at a table of this for those who only care about what the LEAPS will do according to various stock price scenarios:

Returns Comparison For $60 Strike LEAPS

The above table shows that we get substantial upside leverage by creating our own stub stock.  We turn a $90 stock into a $30 leveraged stub stock and the returns shows how the earnings can be geared up.

Of course, leverage is a double-edge sword so you lose a lot more on the downside too.  If the stock goes down 10%, the LEAPS value goes down more than 30%.   If the stock goes down to $70, the stockholder loses only 21% but a LEAPS holder loses 67%.

But this would be true if BRK did a real leveraged recap too. The net worth of the company would go down much faster post-recap than as it is currently as a conservative-balance-sheet high grade credit (but this would be driven by company fundamentals, not the stock price).

Rolling LEAPS over time can be quite expensive if the stock stays flat over long time periods.  I know that BRK LEAPS have been popular in the past few years.  One value investor owned LEAPS and long term OTC call options, and I wonder how that worked out as the stock price of BRK has been flat over the years.

The cost, though, is easily calculable.  Your carry cost is basically the premium you pay above and beyond the intrinsic value of the option.  The more deep-in-the-money the option is, the less premium you pay and the less cost of carry (due to lower interest cost on smaller implied loan and lower value of the put option).  This is offset, of course, by the lower leverage you get.   You can think of an option with a zero strike price as being similar to a stock (even though you wouldn't have stockholders' rights and other things).

Also, there may be tax implications even if the stock does well; if you roll LEAPS, you will have to realize gains and pay taxes on each roll etc.  

Conclusion
So with this simple idea, we can take a stock with expected returns of 10% and turn it into one that earns 17% or 24% (depending on which strike price).  And the cost seems very reasonable. The interest expense (which includes the put option value) was 1.3% and 2.4% for the 40 strike and 60 strike call options.  Who would lend you money at those rates?  (I have seen margin loans advertised at very low rates but margin rates seem to be pretty high).

If you buy LEAPS, you do borrow and lock in those rates for the term of the option; margin loan rates can change at any time.

So, the benefits are:

• Even if Buffett doesn't want to lever up BRK, we can do it ourselves at very attractive rates.
• We can turn a 10% returning stock into a 17% or 24% returning leveraged stub.  The risk is the initial investment so there is no margin call worries.
• Buy doing the recap at the investor level, it doesn't impact BRK's credit rating and won't impact the credit markets.

Of course, there are cons:

• If the stock goes down, you get leveraged downside too.  If it stays flat over the years, this may be costly, even though it seems at current levels the 'cost' seems cheap (and therefore attractive?)
• Even if BRK does well, the stock market can be irrational.  This can obviously be bad for the  LEAPS holder (but this could be bad for BRK holders too if it did a real recapitalization).
• LEAPS do expire, so that's an issue.  A real recapitalized firm has to deal with rolling debt, but not expiration every two or three years.
• There is some risk in owning LEAPS; if BRK starts to pay a regular dividend the strike price isn't adjusted so LEAPS holders would lose out on unexpected dividends.  Special cash dividends and other corporate actions are adjusted, though.
• There are tax issues; you may have to realize gains every time you roll your LEAPS whereas long time BRK shareholders can compound continuosly without paying taxes (until they sell).

These are just some of the things that immediately come to mind.  I'm sure there are other things.   But this is just a quick sketch of this concept.  It can work with any other company, of course.  You can take a stock you like, lever it up and create your very own, personal stub stock.   You can also do all of the above with other strike prices too.

I should say that leverage is dangerous.  Buffett always says don't risk something you need for something you don't need.  Why lever up if you don't have to?   So it feels funny to make a post about levering up by using options on BRK.  But hey, this is an idea out of Greenblatt's book.  Don't blame me!  (Greenblatt didn't mention BRK, though).

They say most options expire worthless (well, that's not true for deep in-the-money options, of course); you can really piss away a lot of capital being long options so I would caution people to be very careful with these things. 

As usual, do your own work and only do something if you really understand it!

The Deep Value Cycle (and the Case for Value Investing)

OK, so this is sort of a continuation of my PZN post.  Listening to conference calls, you can tell that Pzena spends a lot of time thinking about value and deep value investing.  I guess that's because he spends a lot of time talking to potential clients and he has to sell them on the idea of deep value investing.

Deep Value Cycle
Anyway, in one of the calls, he discussed a cycle he discovered that recurred over the past 40+ years.  He said there have been four deep value cycles. 

First, I should say that he defines deep value as the lowest quintile by price-to-book value of the 1,000 largest capitalization names.  A 'naive' deep value strategy is to own those (I don't know how often it is rebalanced, though).

Anyway, here is what he said on the 1Q 2012 conference call (April 2012):

• During the last four value cycles spanning over 40 years, on average, five years after a value cycle peak, a naive deep value benchmark was still 12% behind the S&P 500 index and yet ended up with a 500 bps/year  (basis points) advantage over the S&P 500 index over the length of the cycle, which lasted an average 10 years.
• This includes 7 years of outperformance during the cycle.
• Today (April 2012), exactly five years after the peak of the last value cycle, the deep value benchmark is 12% behind the S&P 500 index

He said that investors are caught in a "disaster myopia"; having exaggerated fears of the most recent fearful event (or some such).

He first described this deep value cycle in depth on the conference call held in February 2012.  This is what he said:

1. Cycles are long, 10 years on average with deep value outperforming in 7 of those years.
2. Over the past four value cycles, deep value outperformed by 480 bps/year.
3. Recent experience is consistent with these past cycles.
4. Last peak was 58 months ago (as of February 2012) and deep value is 11.8% behind the S&P 500 index, almost exactly the same as the average in past cycles.
5. The recent deep value upcycle started in December 2008, but was interrupted for six months in 2011, but this too is consistent with past cycles.
6. There is significant pent up opportunity in the value category due to flight-to-safety and across the board, indiscriminate selling of cyclical businesses.

Anyway, I am not much into cycles; I don't want to buy into things and sell things for cyclical reasons.  I know many people try to do that and it often doesn't work out too well.  But as Howard Marks reminds us in his book, even though you won't be able to time cycles right (know when it turns), it is important to be aware of them and where we are in the various cycles (credit cycle etc...).  Large mistakes can be avoided by being aware of them.   This is something I totally agree with.  You can tell when a cycle is nearing an end; when credit spreads shrink too much or blow out too far etc...

This deep value cycle, to me, is similar.  You don't want to try to time in and out of it.  But if you know that the deep value cycle is at a low or in the early stages of outperformance, you want to be aware of it.

Businesses Can Manage in Bad Times Too
In one of his calls, he also reminded investors that even during the high inflation, low growth period of 1975-1982, corporate ROE averaged 13.5%.  Corporations are businesses run by people and not static entities.  If there is low growth, they will manage for low growth.  If there is inflation, businesses will manage for inflation.  So whatever comes our way, businesses will manage through it.


Value Investing Makes Sense
At the PZN website, there is some interesting research.  He has something posted there called the "White Paper".  You can see it here. This was posted in July 2011, so it's a little old, but the story is still relevant.  I will cut and paste some relevant charts here (without permission, but since I am spreading the gospel, I hope they won't mind).

First, people hate stocks now because it has done poorly over the past decade:

Pzena talks about how people measure risk with volatility, Sharpe ratios and other things that measure price movements over the short term.  But as we know, stocks are less risky over the longer term.  Here is how he illustrates the benefit of holdings stocks for the longer term:

OK, so we've all seen this before.   But let's look at how this compares to the favorite asset class of the moment, bonds:

Pzena points out that on an inflation adjusted basis, bonds are really risky.
Here is a frequency distribution:

The range of possible outcomes is narrower for bonds.  This is why people tend to think bonds are less risky than stocks.  Stocks have a much wider range of possible outcomes, therefore it's risky (according to conventional thinking).  But which distribution would you rather own?

Also, Pzena points out that hard assets and commodities are popular now, but here is the true long term story of commodities:

So stocks are looking good, but can we do better than stocks?  Pzena points out that one of the big risks in the stock market is overpaying.  If you stick to value, that is a great risk mitigator for stocks:

So owning cheap stocks not only outperformed the S&P 500 index, but it did it with less volatility than the index, with a lower worst ten year loss and much lower probability of loss.  What's not to like here?

This next step of eliminating the most volatile stocks seems a bit like a post-crisis over-optimization, but still, it's pretty interesting.

Next, he takes a look at the very popular hedge funds.  It has lower volatility but not so good returns compared to cheap stocks:

And he notes that people are running to alternatives such as hedge funds post-crisis, but points out that hedge funds didn't really protect the downside.  I think these returns are from the 2007 peak in the markets through some point in 2011.

 

 

So there is Pzena's case for value (or deep value) investing.  The risk/return profile looks very favorable compared to bonds, hedge funds and commodities. 

I know there is going to a be lot of "But..."s, but I do find this a compelling argument.

Current Opportunities
His second quarter 2012 Investment Analysis (July 2012) is also on the website here.

This may not be news to anyone, but he does point out that Europe is cheap now, and buying Europe doesn't necessarily mean Europe has to do well going forward; he points out the global nature of many European companies.

But here's the more interesting chart:

 

 

The valuation gap between low beta and high beta stocks is as high as ever.  This sort of value differential is a great opportunity for deep value investors.  Stock investors seem to be rushing to safety; low beta, high yield stocks, consumer staples etc.  while running from the cyclical, high beta names.   Of course this includes financials (and we all know financials are cheap).

It is a pretty stunning chart.  If there is any valuation normalization going forward (this may take time), this would be pretty exciting for deep value investors.

PZN
And to close the loop in this post and connecting it to the other PZN post, PZN is a pure play deep value investor.   

If you like the idea of deep value, and think it really is in a cyclically interesting position (poised to outperform), then PZN can be a really interesting play.

Pzena Investment Management (PZN)

OK, so here's another nail that we can hammer down with our asset management company valuation model.  I have been following this company since the IPO but haven't really taken a close look at it recently.

This is a pure, deep-value investment company run by Richard Pzena.  In case you are wondering, this is the "Rich" in Joel Greenblatt's You Can Be a Stock Market Genius book.  Greenblatt talks about how large institutional investors are at a disadvantage compared to individual investors and smaller investors like himself that can seek the special situations described in the book .

From the book:

I spoke with a professional whom I consider one of the best in the business, a friend I'll call Bob (even though his real name is Rich).  Bob is in charge of $12 billion of U.S. equity funds at a major investment firm.    -  page 18

"Bob" outperformed the S&P 500 index by 2-3%/year over the past decade, and Greenblatt goes on to describe how hard that is with a multi-billion dollar portfolio.

Anyway, so this is Rich's investment management company.

Performance (Pre-crisis)
According to the 2007 prospectus, Pzena was doing really well.  Here are some charts:

AUM grew a bunch during the bull market into March 2007.

And here's the return for the Value Service portfolio from 1995.

This return is before fees, but 6.7%/year of outperformance is pretty impressive over this time period.

And then the crisis happened.   They had a bunch of really awful financial stocks in their portfolio, including Freddie Mac that he really talked up in presentations, as I remember (only read about it on the internet).

Here's the performance through June 30, 2012:

This may be too small to see.  You can try to click on it and see the table a little bigger.  If not, this is in the 2nd quarter 10Q.

In any case, it's not pretty.  They have done horribly in the recent past;  Value Service having lost 5.6%/year in the past five years versus a flat market.

But remarkably, even with this bad short term result, Value Service has outperformed the S&P 500 index (net of fees) with a return since inception (January 1996) of +8.7%/year versus +6.9%/year.  Small Cap Value has outperformed the Russell 2000 by 12.0%/year (net of fees) versus +9.0%.  Small Cap Value seems to have done well even in the shorter time periods.

Anyway, I think it's a really tough time for deep value investors so I don't know that you would want to evaluate managers on just their short term performance.

Many are turned off by Pzena's investments in some of the financials that had problems (including Lehman), but they are deep value investors so things they invest in will go bad every now and then.  I wouldn't write off a manager just because they made a few mistakes; performance over the long term is going to be what matters.

Pzena has regretted putting as much as 4% of the funds into leveraged institutions such as FNM and FRE, and I think he has said he won't put more than 2% into such vulnerable, leveraged institutions going forward.

I know there's a lot of people who will say that they can never trust someone who bought FNM, FRE and other financials going into the crisis.   But Pzena has said that in the last cycle, his largest holding went bust (I think it's Fruit of the Loom), but they still managed to outperform through the cycle.

Mistake?
If you have a situation that might double or go to zero, but you think the odds of zero is even as high as 20%,  you are still looking at a 60% expected return.  On this bet, one out of five times, the thing will go to zero.  If you made this bet and lost money, it's clearly not a mistake.  I would take this bet all day.

But in the stock market, people will call it a mistake.  They don't see the math and the assumptions; all they see is someone buying a stock before it went to zero.  That just doesn't look good. 

The trick is not putting yourself in a situation where if the 20% chance event occurs, you would be out of business.  That's a money management issue (how much of a stock to buy).

I think Pzena said his mistake was to own too much in financials, not so much that he invested in them.

The Bad Years
Anyway here is how the Value Service account did on a net basis during the trouble years compared to the S&P 500:

             Value Service (net)       S&P 500
2007      -12.7%                           +5.5%
2008      -44.4%                          -37.0%
2009     +38.2%                         +26.5%
2010     +15.7%                         +15.1%
2011        -4.4%                           +2.1%

Despite this, Value Service and Large Cap Value has maintained their outperformance on an initial-to-date basis.  

From January 1996 - June 2012:

Value Service (gross):    +9.5%/year     
Value Service (net):       +8.7%/year
S&P 500:                        +6.8%/year

From October 2000 - Junee 2012:

Large Cap Value  (gross):   +4.2%  
Large Cap Value (net):        +3.7%
S&P 500:                             +1.5%


Here are some of the fundamental metrics of PZN during those years:

PZN Fundamentals 

PZN's AUM has plunged to $13.5 billion as of the end of 2011 from a high of over $28 billion in the spring of 2007.  Obviously, revenues and earnings are down too along with AUM.

Vanguard Windsor Fund
PZN got a new mandate recently as the co-manager of the Windsor Fund, which I think is a big deal.  The Windsor Fund is a legendary value fund and is one of Vanguards biggest and oldest funds (since 1958).   According to the August press release, they will manage 28% of the $12 billion fund.   The Windsor Fund was run by the legendary John Neff for 31 years between 1964-1995.  According to Wikipedia (if it's on the internet, it' got to be true, right?), the fund gained +13.7%/year versus +10.6%/year for the S&P 500 index during those years.

Anyway, 28% of $12 billion is over $3 billion, so even just on that, that's a big win.  I'm sure this will help in marketing PZN to other institutions.

So What's PZN Worth?
OK, so what is this thing worth? 

It looks like management fees have been steady in the 0.55% area.  For AUM, the latest figure as of the end of August 2012 is $16.4 billion.  For operating margin, let's use 50%.   They have been able to maintain 45-50% throughout this bear market and Pzena has cut costs, so I think it's OK to assume that they can keep a 50% operating margin going forward, which can very well go up if AUM rises from here.  The cost cutting of the recent past may give a nice operating leverage kicker if that happens.

But anyway, let's use 50%.  You may notice that it seems a little higher than the other asset managers.  I attribute this to the fact that PZN has very few funds and a small team that manages a pretty big portfolio.  

Anyway, plugging in these figures, we get an operating earnings figure of $45.1 million.  For shares outstanding, I will just use the total of the class A and B shares (the way the financials are presented in the filings are confusing; they use only the A shares and deduct earnings attributable to the B unit holders etc... For analyzing the company, that is not necessary).

PZN had a total of 10.5 million class A shares and 54.3 million class B shares for a total of 64.8 million shares.  Let's call it 65 million shares. 

So the above $45.1 million operating income comes to $0.69/share.  Using the 10x pretax valuation, that would value PZN at $6.90/share.  But this excludes any adjustments for balance sheet items.

On the balance sheet as of the end of June 2012, there was $36.5 million of cash and investments.  There are some accounts payables and accrued expenses, but I assume that is an offset to advisory fees receivable.  I also ignore the deferred tax assets and the liability to selling and converting shareholders as they are pretty much offsets (even though I don't know exactly what accounts for the small differences;  85% of realized deferred tax savings is payable to the selling/converting shareholders so I look at it as pretty much an offset).

So that $36.5 million of cash and investments come to $0.56/share.

Adding that to the above $6.90/share value of the business gives a total value for PZN of 7.46/share.   PZN is now trading at $5.24/share, a 30% discount.

What if AUM keeps going up and margins improve?  Pzena has said margins would improve on increased AUM because costs (compensation/bonuses) won't go up as quickly as revenue.  He did say before that the 70% operating margin they achieved in the recent peak (2007) was unsustainable.  He never guided to any specific figure, but we know 70% is too high, so maybe 60% is reasonable.

Here is a table of what PZN might be worth depending on AUM levels and operating margins.  I assume 0.55% average fees and 65 million shares outstanding (there were no dilutive shares as of the end of the 2Q so I didn't include any; there are close to 5 million total options outstanding but many have higher exercise prices.  To be conservative, you can give a haircut for that, though (even though options exercise will increase cash).

Also, this table excludes balance sheet items (like cash and investments), so you can add $0.56/share yourself.

PZN Value Matrix:  AUM and Operating Margin (OM)

So according to this table, if PZN can get their AUM up to $18 billion and operating margins to 60%, it would be worth $9.14/share (excluding cash/investments on b/s).

If they get their AUM back up to where it was at the peak, which was around $28 billion (according to the chart at the top of the post) and they maintain 60% margins, PZN would be worth $14.22/share.

Deep Value Investing Cycle
Anyway, as I was looking at PZN, I found an interesting thing that Pzena said on one of his conference calls describing the cycle of deep value investing and it was really interesting.  He also has some great information on his website regarding value investing and why it will continue to work.

It is so interesting, in fact, that I was going to put it into this post, but I think it's worth a whole separate post so I'll make that post later.

The bottom line is that deep value has been hugely out of favor, but this pattern of being out of favor is consistent with past cycles.  And if past cycles is any guide, there will be many years of outperformance going forward from here.

Conclusion
This is really an interesting situation and I didn't realize how undervalued it was.  It has always seemed a little expensive to me, but having gone through the above analysis (and seeing that AUM is coming back up), it is looking pretty good now.

In the case of PZN, I would not worry about the board and management at all.  These guys are solid, deep value guys and I like that they don't veer away from what they're good at.  Everyone else seems to be style-drifting to accomodate the increasing risk aversive and market-neutral bias of institutional clients, but I like how they stick to their guns.

Also, they are not pushing funds out left and right to increase AUM at all costs.  They are disciplined and seem to really want to do a good job on the few strategies they run.

As you will see in my next post, deep value and even regular value is hugely out of favor, and despite new highs in the market, it still feels like the stock market is kind of out of favor too.

So what do we have?

• Stocks may be an underappreciated asset class (bond/hedge fund bubble), even though I am aware of the "stocks are overvalued" argument.
• Stocks will do well over time, and particularly value will do well, I think.  Pzena demonstrates that deep value may be at a low point (or in the early stages of deep value outperformance) with years of substantial outperformance ahead (see my next post on the deep value cycle).
• PZN is a small shop with significant operating leverage so if this pans out, they can do really, really well.  And as I said, asset managers will often outperform the asset class due to this leverage etc.  PZN is a small, very manageable operation run by a solid guy.
• PZN stock is cheap, given the above assumptions.  The simplicity of the business model, of their investment strategy, the transparency etc.  makes this really an easy stock to own (unless of course, you are calling for a multi-year bear market or depression).

The big negative (other than the usual risk of the stock market), of course, is PZN's performance during the crisis.

As I said, I too scratch my head at people jumping into financials in front of the biggest crisis in history, but I also understand that just because someone buys something that doesn't work out shouldn't automatically disqualify them; if they can outperform over time, that is going to be the key issue and PZN has a good chance of doing that.