The Market is Fairly Valued!

So this valuation thing has been nagging at me all weekend so I just decided to take a quick look at something.  Since the S&P 500 index is too big and unwieldy and I don't have access to data, I just decided to take a look at the Dow.  Last time I looked at margins (to see if margins are too high and unsustainable), I picked a bunch of big, blue chip names that popped into my head.  

This time, I wanted to be more objective and not do that.   So I figured why not look at the Dow Jones Industrial Average components?  It's not a great index as it's price weighted (which is ridiculous), but it has been highly correlated to the S&P 500 index over long periods of time anyway.

So I just googled Dow P/E ratio and up popped this page from the Wall Street Journal:

I almost fell out of my chair.  14x P/E for the Dow 30?!  No way.  I suspected this had to do with the price-weighting of the Dow (again, how ridiculous and arbitrary!) so I punched in some numbers on the spreadsheet and sure enough, if you just add up the prices of the component stocks and divide by the sum of the EPS, you get a P/E ratio of around 14x. 

But nobody is going to buy that as representative of a broad market index valuation. 

So I calculated the simple average of the P/E ratios of each component stock.  I used the last twelve months EPS of each component stock as listed in the recent Barron's.

Last Twelve Months, Current and Next Year P/E Ratios

Sure enough, if you calculate a simple average of each P/E ratio, it comes out to 18.5x; a bit on the high side and certainly not cheap.

Just out of curiousity, I typed in the current year analyst estimates for each component stock (from Yahoo Finance).  We all know analyst estimates can be wildy inaccurate.  But since we are already almost done with the current year, I figure the December 2013 year-end estimate can't be all that bad.

Using current year estimates, the P/E ratio of the Dow 30 (using a simple average) comes to 15.11x.  That's totally reasonable and I would consider that 'fair' for sure.   The Dow is not expensive at all.  Sure, 3Q and 4Q can come in lower than recent estimates but since 1Q and 2Q is already in the can, it can't change this figure too much unless we have a disastrous 3Q and 4Q.

The last column on the spreadsheet is certainly questionable.  It's the analyst estimate for December 2014 year earnings.  Earnings estimates for a year that hasn't started yet can be off by a lot depending on how the year develops. 

But that figure, for what it's worth, comes in at 13.74x earnings. 

Conclusion
I just took a quick look at the inside of an index to see where the overvaluation might be.  The macro charts seem to show expensive stocks and above trend earnings but for me the problem is that it just doesn't feel like it.  Other than a few pockets of mania, I just don't get the sense that people are rushing into stocks.   The economy too is slow growing so it doesn't feel like corporate earnings are above trend (I know they are, but it just doesn't feel like a corporate earnings bubble).  I know interest rates are low so that boosts corporate profits as it lowers interest expense, but it feels more like corporations are suffering from low rates as they are flush with liquidity.

Yes, the Fed pump priming (and others around the world) and fiscal deficit is highly stimulative, so earnings probably are higher than they would otherwise be.

So it's a little strange to me.  People seem to hate stocks (rushing into alternative assets), and yet valuations are a little bubbly.

Having done this exercise, I can see how the market can be considered fairly valued.  If you look down the list at each component stock, each one seems to me more or less reasonable.  Not cheap, but not expensive either, except for maybe Nike, Home Depot and Visa.

Is this a picture of mania in the stock market?  To me not at all.  Coca-Cola at 40-50x P/E was indicative of something, but I don't see that sort of thing in the above table.

Sure, maybe corporate earnings come down.  But if it comes down from current year estimate levels, the market may not be as wildy overvalued as some charts seem to indicate.

I just throw this out there as a thought, not an answer.
 

Tapering, Market Overvaluation etc...

For the record, I do agree with Stanley Druckenmiller who said the other day on Bloomberg TV (or CNBC) that the Fed blew it by not tapering.  It was in the market already that they would so it was a freebie.  

But anyway, the market has been obsessed with tapering lately.  The Fed is buying $85 billion per month in bonds; that's more than a trillion dollars a year!  If you told someone 10 or 20 years ago that this would be happening, they would guess that gold would be going parabolic.  But it's not.

We can't deny that if the Fed starts tapering that there will be an impact on the markets.  That would be silly.  Of course there will be an impact.

But the problem with these things is that we all know that.  I remember back in 2011 or so when QE1 ended; the Fed stopped buying $40 billion in bonds a month and the bond market was supposed to crash.  It didn't.  I think it rallied sharply (a trader bragged to me he had a huge short position on for this no-brainer, lay-up trade).

Sometimes, these no-brainers are not so easy.  Gold was a no-brainer too a couple of years ago when I started this blog.  But it hasn't really turned out too well for gold since then.  I admit it ain't over yet, though.  I have no idea what will happen to gold going forward.

So What Do We Do About Tapering?
For fundamentals-based, long term investors, should we worry about the Fed?  This reminds me of a CNBC clip a few years ago where someone chased after Buffett and asked him what he thinks the Fed would do that afternoon after the FOMC meeting.  Buffett laughed and said something to the effect that if he based his investment decisions on what he thought the Fed was going to do, he wouldn't have done so well.

Sure, tapering has artificially reduced interest rates.  I heard someone say that the Fed thinks the interest rate is 150 basis points lower than what it would be without QE3.

If interest rates pop up due to tapering, it will impact the financial markets and it will cause some volatility.  Well, so what?  The markets are always volatile.  Most of the time it's volatile for reasons that most people don't anticipate.  If you don't like volatility, you shouldn't be in the stock market.  So that's not a problem.

How about the longer term impact of higher interest rates?  Well, let's put it this way.  If you own a business (stock) that can do well in a 1.5% interest rate environment but would be in trouble in a 5% interest rate environment, then you simply don't own a good, robust business.  You shouldn't own it in the first place even with interest rates at 1.5% or 1.0%.  Likewise, if the stock is cheap only because interest rates are at 1.5% but wouldn't look so cheap with interest rates at 5.0%, then maybe it's not such a great stock.  Actually, if it's a good, growing business, it doesn't have to be cheap for it to be a good, solid stock to own.

If the business you own will survive a 5% interest rate environment, then who cares?  Yes, the market will be volatile.  Some people can't resist getting out and trying to get back in at a later date at lower prices. Most of the Financial Industrial Complex (or maybe I should call it the Financial / Media Complex) is geared to tickle those urges (and fears) to make people DO stuff.

Some people who got out of the market before the financial crisis were too scared to get in when the world was going to end.  And now they are too scared to get in because of tapering and other problems.  I remember last year it was the fiscal cliff.  It's so hard to resist the temptation to get out before the no-brainer drop to get back in at lower prices.

It just doesn't happen that way.  I'm sure we all know people who try to get in and out like that, but nobody does it well consistently.  If you look at the best track records in investing, that's just not the way it has been done.

Now, if you are Stanley Druckenmiller or some other really good macro trader, that's a different story.  There are guys like that who have done well trading the big swings in the market.  But they too rarely get out at the top and get back in at the bottom (Druckenmiller's performance is probably not so much from getting in and out of the stock market, but more from making huge, leveraged bets in the bond and foreign exchange markets (he said so himself!), and maybe some occasional big trades in the S&P 500 index; I doubt he calls the ups and downs of the stock markets consistently enough to be able to outperform the index just by doing that).

Debt Ceiling
This debt ceiling fear is the same.  So was Syria.  This is all just short term stuff that is good for macro traders, but is just irrelevant noise for the long term value investor.  As even Seth Klarman said, you just have to figure out what a business can earn in five or ten years on a normalized basis and see what it's worth, and if you can buy it for lower than that (or substantially lower), then it doesn't matter what the headlines say. 

So yes, despite what the pundits on TV say, I think it's OK to ignore all this stuff.  Pundits on CNBC will never tell you to turn off CNBC!

Valuation
The other big fear is valuation.  Commentator after commentator keeps saying that the market is overvalued, or substantially overvalued.  Shiller's cyclically adjusted P/E ratio is a very popular indicator now.  Here it is, direct from the Yale website:

Shiller's cyclically adjusted P/E ratio is an inflation adjusted P/E ratio.  One of the key things is that it's based on the earnings of the past 10 years.  This adjusts for the cyclicality in earnings; the past ten years would include good years and bad years and is more indicative of the normalized earnings power of the S&P 500.   This makes sense.

And this figure is currently 24.25x versus an average of 16.5x for the whole period.   That means that the stock market is currently 47% overvalued.

Yikes.  I say ignore this, ignore that. But this gets my attention (which is why I spent some time on it today; plus a post was long overdue here).

This indicator seems to be a great indicator.  The peaks are 1901, 1929, 1966 and 2000.  Most of these seem to be horrible years to be long term investors for sure.  The current level seems to be close to the 1966 peak, and we know that the Dow peaked out at 1000 or so and didn't convincingly break above that until the 1980s.

But let's not forget the Superinvestors of Graham and Doddsville.  I'll borrow a table from an old post back in 2011 (Stocks no Good? (Superinvestors):



So let's time-travel back to 1966 and talk to these guys and tell them that the market is overvalued.  We will tell them that they should just do something else and start their investment careers in 1979 or 1982 when the stock market will be really cheap and even idiots will put up big numbers.  Not!

And these figures only go up to 1982 and the bull market hasn't even started yet! 

This is what the Superinvestors essay (written by Buffett in 1984 or so) is about.  They just did their thing; value investing.

For the folks now telling people to get out of stocks because of high valuation, I would like to see their historical peers.  Has anyone done better than the superinvestors by getting in and out of the stock market?  Did anyone really sell out in 1966, buy back in in 1982, sell out in 2000 and get back in in 2009?  And even if they did would they have a better long term performance than the superinvestors?

Going back to what Buffett always says, if we think about owning stocks as owning a business rather than pieces of paper, none of this would be an issue.  High stock market valuations, corporate profit to GDP or any other indicator wouldn't really matter too much.

The question would be, do you like the businesses you own?  Are they well managed and priced reasonably?  If yes, then who cares what some macro indicator says.

But having said all that, most of us are not superinvestors, and many people own index funds.  So this valuation/chart may be directly relevant to them.  The S&P 500 index is the very business that they own.  And the question becomes, is it reasonably valued?

The first answer is that we have to remind ourselves that the long term performance of the stock market can only be realized by owning it throughout the whole period.  The market returned 10%/year over the long term, and that includes owning it before the great crash, 1966 etc... The long term stock market return is what you earned not by getting in and out based on valuation.

I used to read a lot of newsletters (when I didn't have to pay for them; my employers had subscriptions to them all), and many had great, convincing models.  When you read their stuff, it is compelling and convincing.  But the fact is that none of them ever really beat the market!

Study after study show that people lose money or not do well not because they buy stocks at the peak, but because they keep trying to get in and out (if you bought stocks in August 1987, you would still be doing pretty well today, and that includes Black Monday, 1989 mini-crash, Desert Storm, Drexel, S&L crisis, banking crisis of the early 1990s, 1994 bond crash, 1997 (LTCM/Asian contagion), and two bear markets in the 2000s which included a 100-year financial crisis and 9/11).

There's a great table going around that shows prospective returns in the stock market depending on the stock market p/e ratio at the time of purchase.  And it's a compelling table.  It makes perfect sense.  The cheaper you buy the index, the better your returns over time.  The higher the price you pay, the lower the prospective returns.

And yet, I have really yet to see anyone who has put up a great track record using that simple logic.  The table looks great.   But where are the Superinvestors of Convincing Tablesville?

What we are hearing from pundits is the same every time.   The market was very obviously bubbled up back in 2000 but I don't really know anyone who nailed the downside; they kept trying to call the top for so long in the late 1990s that by the time the bubble finally popped, very few people were still short.  Very few.  Even Stanley Druckenmiller didn't play that one well (and if the greatest trader of all time didn't get that right, who are we to think we can do it better?!).  I think it was similar in 2008/2009 too.  It wasn't as obvious as 2000, but once the problems started happening, it was pretty obvious that the market was going to get into some trouble.

But I think very few people actually were able to make money off the short, or even get in on the lows.

No matter how compelling charts and tables look, it's just not that easy to get in and out of markets, or to make money trading it.  Seriously.  I've been watching people (and trying myself sometimes!) try to do it for years and most of them are better off just ignoring it all and just owning an index fund or a basket of good businesses that they like.

A Closer Look at the Shiller P/E
Having said all that, and having told you to ignore it all, let's take a look at this Shiller P/E ratio.  I took the raw data from the Yale website to create this chart so we can see the Shiller P/E by itself.

The average for the whole period seems to be around 16.50x, and the current level is 24.25x.  Now, here's the thing that has nagged me about this for a while:

• What does this chart look like if you exclude the financials? The financial crisis really distorts this figure because of the huge losses in the industry in 2008/2009.
• The 24.25x p/e ratio is supposed to represent a cyclically adjusted p/e ratio.  This would be correct if we assume that the financial crisis of that magnitude is expected to occur every ten years!  I highly doubt that is the case.  I tend to believe (and not as an excuse for the CEOs that blew up) that it really was a once in a hundred year event.  If that is that case, then the cyclically adjusted p/e ratio would be too high (and normalized 10 year earnings understated).  Sure, some of that is offset by a huge credit bubble going into it;  a lot of money was made during the bubble years and the 10-year p/e includes that too.  But it seems like the crisis blew away a lot more than was excessively made in the bubble years of 2005-2007.  I have no evidence to support that; it's just my guess and it's not a major point of this post anyway (even though I thought it might be!).

So just for fun, I decided to take a look at the non-cyclically adjusted (but inflation adjusted) p/e ratio using the same raw data:

So you can see how the p/e ratio popped up to over 140 during the crisis.  I am not saying something like that won't happen again.  I just doubt it is something that will happen every 10 years. 

I redid the chart but capped the p/e at 50 so we can see the chart better.  This doesn't effect the average; the average was calculated using the raw p/e ratio.

I call this the CAPE 1, even though it's not cyclically adjusted.  The last twelve month p/e ratio is around 19.6x, so the market is certainly not cheap.  The average of this raw p/e ratio over time is around 15.8x.   So this seems to suggest that the market is 24% overvalued at the moment.  This assumes, of course, that current earnings levels are 'normal'.

I know there is an argument that earnings are above trend due to the high margins some data show and the fiscal deficit and QE3 are pumping up the economy (and therefore corporate earnings) over normally sustainable levels. So in that sense, maybe current earnings are peak earnings levels for this cycle.  In that case the market might be really overvalued.

The current 19.6x p/e looks like it overvalues the market a little bit.  I know that the tables tell you that owning stocks when p/e ratios are high gives you lower returns, but just eyeballing the above chart, it doesn't look to me like the current level is necessarily "get out now!!!!"-level either.

I did looked at this wondering what the Shiller P/E would look like in the future when the big losses from the crisis suddenly drops out.  It looks like it may go down a little bit, but maybe not as much as I thought as we are already at 20x p/e even if we maintain current earnings for the next ten years.

In any case, think of any investor you respect.  I'll just go back to Buffett (even though he's not a good example as he is such an outlier; he would overcome a lot of headwinds!).  The question becomes, would Buffett have been better off to lighten up on his holdings when the CAPE 1 is close to 20x p/e?  Despite what the tables tell you, would any decent equity investor have been able to improve performance by lightening up their holdings every time this chart showed a 20x p/e?  And then what level of this p/e would they have to wait for to get back in?  For that matter, look at the original Shiller p/e ratio (CAPE 10) and make the same argument.  Which decent value investor would have been better off by adjusting portfolio exposure according to this metric?

Tables and charts can tell elegant stories.  But to actually turn that into a good performance is another matter altogether.

Conclusion
None of this is to say that the markets won't go down.  It will go down.  There is no doubt about that at all.   The question is when, and by how much?  Anyone can call a crash or a bear market.  But not many will be able to exploit it.

I say ignore this and ignore that, but I only mean that in the investment sense.  If you are looking at something and see a stock that is trading at 1.1x book that should be trading at 1.5x book, go ahead and buy it!  Who cares what the market p/e ratio is.  That's what I mean.

And it's good to be aware of these things that people talk about and are worried about.  I don't advocate sticking your head in the sand.  I only advocate acting rationally and resisting the urge to do stupid things (like accumulating index puts in front of a possible debt ceiling debacle, shorting treasuries in front of tapering, or lightening up on stocks because of a possible problem in Syria etc...; the problem is that you may not be the only one doing so!).

So what to do?

• If you own individual stocks, review them and make sure you like them.  If you don't, or aren't sure, you'll feel horrible when it goes down 30% or 50%.  And you would sell out in fear.  If you really like it, you should be able to hold it through the storm and not blink.  As someone said about guiding the ship by the lights from a distant lighthouse and not the waves crashing against the boat, just make sure the business will be doing well in five or ten years (and hopefully doing a lot more business).  If so, sit tight.
• If you have stuff in your portfolio that is not high conviction, or even stuff you bought as a punt or on a tip, now is the time to clean house.  Dump that stuff.  You got lucky.  Now dump that stuff while the tide is lifting all boats.
• If your portfolio went down 50% tommorow and you would be upset, then that means you own too much stock.  Sell down to a level where you won't lose sleep if it went down 50% because it will at some point. OK, to say that it will happen in one day is a bit extreme.  This is Joel Greenblatt's idea; the mistake people made in the financial crisis is not that they didn't sell before the crisis, but that they owned too much stock and they freaked out and had to sell in the decline out of fear.  If you were comfortable with stock market volatility, you wouldn't have sold out and you would've been fine (unless of course you owned too much of the ones that went bust!).

etc...

This is the sort of thing I would advocate doing.  What I would NOT advocate doing is doing something to your portfolio just because Stanley Druckenmiller said that the markets will correct when the tapering begins, or because some charts are starting to look a little scary (Shiller p/e).

I know I haven't really made the case here that the market is cheap or fairly valued or anything like that.  It does seem overvalued either way you slice it.  I suppose on forward earnings the market looks fairly valued, but we all know about the accuracy of analyst estimates whether top-down or bottom-up.   

I was just playing with this stuff to see for myself what's going.

It's important to remember, though, that just because the market level is not cheap doesn't necessarily mean that you shouldn't own stocks!   It's nice to buy stocks when the market is really cheap for sure, but that has only happened very rarely in history.  Again, the 100 year performance in stocks includes holding through a 7x p/e and 30x p/e market!

If you only bought stocks when the whole market was cheap based on the Shiller p/e, you may have only bought in 1920, 1932 or 1982. If the market was at average valuation, you might hear the argument that the market doesn't bottom out until the valuation goes well below the average.  In fact, I did hear that argument after 1989, 1990/1991, 1994, 1997, 2002, 2009 etc... (that the market won't bottom until the p/e gets to 7x like it did in 1932 and 1982).

You wouldn't have bought any stock since the early 1990s since the Shiller p/e would have been above the historical average (well, I am just eye-balling the above chart; the average up until the early 1990s would not have been the same as the average shown above!).

etc...

You get my point. 

Third Point Reinsurance Ltd. (TPRE)

So Third Point Reinsurance Ltd. (TPRE) filed their S-1 recently.  This is basically part of a move by hedge funds to seek 'permanent capital', like Einhorn's Greenlight Re (GLRE).  

The insurance business is only ramping up now so there isn't much to chew on in terms of analysis.  Like GLRE, the key is going to be underwriting profits (or at least break-even) and investment returns.  If TPRE can generate float at a low cost and Third Point can generate some decent returns, this can be a great investment.

Third Point Investment Returns
Of course, the big question is how the insurance operation is going to turn out.  The investments will be managed on the same basis as the hedge fund and the historical returns are pretty good.  Third Point LLC has AUM of $13.2 billion (as of June 2013) and has returned 21.0%/year from June 1995 through December 2012.

The five and ten year returns (through December 2012) were:

Five year:    +9.7%/year
Ten year:   +17.7%/year

Third Point will own 8.5% of TPRE after the offering.  Kelso and Pine Bank will own 26.5% and 13.4% respectively.

Here's a cut and paste from the S-1 that shows the long term performance of Third Point Partners:

Management and incentive fees will be 2%/20%, a standard rate.  (GLRE pays 1.5%/20% to Einhorn).

Assuming the offering price is $13.50 (range of $12.50 - 14.50), the proforma book value after the offering comes to $12.41/share (excluding greenshoe). On a fully diluted basis, the BPS comes to $12.17/share (assuming no greenshoe and 7% underwriting spread).

So at $13.50/share, that comes to 1.1x fully diluted proforma BPS.  That sounds good to me.

Insurance Risk
There is the question of the insurance business.  These hedge funds that start up reinsurers typically go for the low volatility, low tail risk strategies by focusing on high frequency / low severity risks.  This is true with GLRE too, as they want to minimize insurance risk and take the risk on the investment side; to the extent that their portfolios are not low risk fixed income like most insurers/reinsurers, they would want less p/l volatility on the insurance side.

I can't say anything to comfort anyone with concerns in the insurance business of these entities (TPRE, GLRE etc.) other than to say that these hedge fund folks have made a career out of managing risk.  They may not understand the insurance business as well as people who are actually in the business, but I would imagine that they would know enough (and have the resources to figure out) to get the right people and understand the risk.  Things may not look good now for hedge funds with what's going on with JCP (and SHLD), but that may just indicate how tough bricks and mortar retailing is now more than anything about hedge funds.  

Of course, this is no guarantee of anything.  Even Loew's James Tisch has said in a recent interview that he thinks that some of these hedge funds that start reinsurance companies may be underestimating what the insurance business can lose in a really bad year.

Just because a reinsurer writes a bunch of short-tail, capped risks (like selling deep out of the money put spreads) doesn't mean that they can't blow up.  And if the insurance portfolio is managed to eliminate too much risk, there is a question of how much they can earn on such businesses.

So for me, these issues might put a constraint on how much exposure I would want in each of these entities; it is certainly not as rock solid as Berkshire Hathaway (but what is?), but that doesn't mean it can't have an attractive return/risk profile; just don't put 80% of your net worth in it.

For those interested in Third Point but don't care for float leverage, tax free BPS growth (and the insurance risk that comes with it), Third Point Offshore Investors is still trading at a slight discount to NAV in London (TPOU:LN).

Conclusion
At 1.1 or 1.2x BPS, I do think TPRE is an attractive opportunity.  I know that there is a big split in the opinions about hedge funds; some people love them, others hate them.  I don't have a problem with banks, investment banks or hedge funds (as long as they are doing things that I think I understand; I have no idea how SAC has made such high returns over the years, for example.  But Greenlight, Third Point and others seem to be doing things that I feel comfortable with;  value investing, event driven trades, value investing with a catalyst, distressed debt and other special situations etc.)

The S-1 does include an overview on the various strategies that Third Point does and it's certainly an interesting read, particularly for those curious about what some of these funds do.

This post is a little light, but I just wanted to get this out as I do think it's interesting.  If I have anything to add, I may post followups (and I probably will over time as it lists and more results come in).

Leucadia National Annual Meeting 2013

So I did make it to the Leucadia National (LUK) annual meeting this year.  As usual, these aren't comprehensive notes or anything like that. These are just some loose notes on certain things.   I didn't take detailed notes so some things might be a little off here and there, but I don't think I am off in the general ideas that were talked about.

First of all, both Steinberg and Cumming were there but since Cumming is no longer chairman, he sat in the audience and Steinberg made some introductory remarks and did the usual annual meeting stuff and then Richard Handler took over and ran the rest of the meeting.

This may be a first, but LUK had a slide show for this meeting.  You can see it here.  (Of course I did wonder for a second if Berkshire Hathaway will have a slide show in the post-Buffett era.)

Here is the first slide:

For the Berkheads that need to know, Berkshire Hathaway returned +15.7%/year from 1990 through 2012. But the JEF figures exclude dividends and the LUK figures exclude the special dividend back in 1999 (the HomeFed spinoff is also not included).

The meeting didn't seem as crowded as last year, but I can't say for sure.  The whole vibe of the meeting was a little different as it wasn't a Cumming and Steinberg show.

Anyway, Richard Handler did a really good job, I think, and people should feel comfortable that LUK is in good hands (even though it is now a very different entity so I totally understand people getting out now).  He talked a lot about the things he thinks are really important; act like owners, emphasis on risk management, diversification; avoid all-in bets, importance of balance sheet strength, capital structure etc.  He did say that protecting bondholders through the cycle is important for shareholders.

He said that what LUK has now is really good and he is excited about it; strong balance sheet / capital, good businesses.  This will be the basis of a lot of opportunity to create value over the next 5, 10, 15 years.

Culture
The culture at Jeffries (and LUK) is about honesty, high integrity, long-term greedy, acting like owners, non-bureaucratic, no arrogance (he said arrogance was the downfall of many companies), stay humble, do good things in good times and you'll get through the bad times.  He said that one thing he learned from Cumming / Steinberg is that even with their tremendous track record of success, they stayed humble and never got arrogant.   When you get arrogant, you start to think bad things can't happen to you.

Sees great opportunity in the investment bank / merchant banking model.  I forgot what this comment had to do with anything, but Handler said that Cumming and Steinberg rarely agreed on anything, but when they did things turned out really great.

Complicated Company
Handler said that LUK is a complicated company with a lot of moving parts but what they will focus on is how to build book value per share (BPS) over time.  He thinks they will create a lot of value.

President Brian Friedman briefly went through the various business lines mostly just saying that he sees upside in all of the areas and feels good about them.  The exception seemed to be Sangart where he said we will have to see how it develops.  Not in the list above is the Oregon LNG project which Friedman says has a lot of potential, but also a lot of work to do to get it realized (regulatory issues etc.).

He said LUK will focus on opportunities not available to the public, not run-of-the-mill things.

In early July, LUK bought Topwater Capital, a fund of funds business.  It's small, but there is a lot of potential to build it up over time.

National Beef
Founding partner and current CEO of National Beef, Tim Klein, also made a quick presentation of his business.

The key points are that National Beef is focused on going up the value chain to improve margins.  They are also processing / selling hide to improve margins.   U.S. is now a beef exporter and demand is expected to increase over time globally (increasing demand for protein).

They bought the rest of Kansas City Steaks as part of their plan to go up the value chain.  I think he said that Omaha Steaks does $400 million in revenues and Kansas City Steaks does only $20 million so there is a lot of potential.   There was no mention of (nor were there questions) any sort of discount to LUK shareholders. Klein said that the problem with lower cattle supplies due to the drought is ending as ranchers are starting to build up their herds again, but it may be two or three years before we start to see that coming back into the supply chain (I assume that means that it will take that long to see increasing volumes and improving margins).

Berkadia
LUK initially invested $217 million in Berkadia and as of July 2013 $191 million has already been paid out, and there is still "substantial value" going forward.

There is tremendous upside if interest rates go up, especially short term interest rates.

Scale matters in this business, so there is a lot of consolidation potential to come.

Garcadia
Garcadia is another roll-up type business where the industry is really fragmented.

Jefferies
Jefferies has been listed for a long time so I think many people are well aware of their business.  It has grown a bunch into a full service, global investment bank since 1990 when they were primarily a cash equities business with 140 employees and $7 million in net income. Handler mentioned a number of times that they don't engage in proprietary trading and are very client focused.

My comment:  Their ROE over the years is not as good as some of the majors, but that is probably due to JEF's not getting involved with proprietary trading, derivatives, internal hedge funds etc.  So it's possible that they are not as impacted going forward by many of these new regulations.  So on that basis, JEF can be interesting to people who do worry about that sort of thing at GS, JPM etc...  But that's just a thought.

OK, so these were some of the slides and comments from the various businesses where the CEOs were present.

Q&A
Here are some Q&A's, not word for word or anything like that

Rogue Traders
Someone mentioned that LUK shareholders never had to worry about rogue traders, but now with JEF, they do.  How can LUK shareholders feel comfortable with that risk?

Handler said that to prevent that sort of thing, they are focused on:

• culture
• transparent, listed securities that settle in a short time; they don't do long-dated, illiquid securities. 
• have systems in place to see positions, VAR etc...
• empower the risk committee

He said no business is 100% safe in any business, but if they stay focused on doing the right things, they can minimize the risk. 

Earnings Power of JEF in a Good Year?

Handler says that the world keeps changing so it would be misleading if he said what JEF can make in a good year.   He said they aim to make low-to-mid teens returns through the cycle (I assume that's ROE, which is consistent with JEF's past). 

Sangart Update? 

This question was tossed to Steinberg who simply said, "It's on life support".   Handler said that it's been written down so the there is upside, not downside (my comment: well, they can keep losing money in which case that would still be downside; just because a problem is not on the balance sheet doesn't mean it can't bleed us through the income statement). 

National Beef
My mind was wandering but I think there was a question regarding Walmart and National Beef.  I just remember some comments about that being a low margin business and the risks of having such a big part of the business with one customer.  I don't know if Klein made it sound like "good riddance", but Handler later stated that even if it's low margin they would have liked to keep the business.

Compensation Ratio at JEF
There was a question regarding the compensation ratio at JEF due to JEF going private.  What are the implications of that (private versus public company).  Handler said it has nothing to do with it.  But he says the comp ratio in the high 50s will come down as that was pushed up by a lot of hiring in the past three years (due to the opportunity).  The hiring has peaked so compensation expensed due to that will start to come down.  Also, as revenues rise, operating leverage should kick in bringing down the comp ratio.

Rising Interest Rates
Someone pointed out that JEF's competitors had a good quarter and JEF was not so great. Handler responded by saying that the volatility in the fixed income markets helps competitors' fixed income derivatives business.  In this environment, that business is like a license to print money.  JEF doesn't have that business, but then they didn't have it four years ago and it blew up some competitors back then.

Monetize or Hold LUK Investments?
They like the businesses they own; good businesses, scalable and throwing off cash.  There are benefits also to the various businesses in terms of idea generation (more eyes on the ground).  Can't say what LUK will look like in the future.  They will just be smart and avoid mistakes.

National Beef
Someone compared National Beef to Smithfield.  Smithfield is two times bigger (revenues and EBITDA)  than National Beef, but the Chinese are paying 4x as much.   Is National Beef worth more?  Klein said that the beef industry always tended to trade at lower multiples than pork.

Infrastructure Investments? 
Someone asked if LUK will get into infrastructure investing.  Friedman pointed out that the LNG business is an infrastructure investment.  But he pointed out that the usual 'infrastructure' investments like toll roads and things like that are for rate-of-return capital;  it is a fixed income alternative so there is a lot of capital chasing those deals.  Fixed income alternative / rate-of-return-type deals just isn't LUK's business.

How Does Handler / Friedman Allocate Time Between LUK and JEF?
Handler pointed out that the various businesses have their own CEOs (and on the JEF side, I guess division heads) and other operating managers that do their job well.  Handler said that it feels like he spends 60% / 60% between the two.  So I take that to mean he splits his time 50/50 between the two.

What is a "Dumb" Thing?
Someone asked, what exactly is a "dumb" thing?  Handler keeps talking about avoiding doing "dumb" things, but mistakes are obvious usually in hindsight.  So what exactly constitutes "dumb"?

Handler said he has been in the business a very long time and has seen very smart people do very stupid things.  He talked about how a great company levered up 35-to-1 and drove itself off a cliff.  Illiquid products that nobody can value has caused trouble.  Bad emails (referring to the Fabulous Fab trial going on at the time).  Avoid arrogance, thinking that you can't make a mistake.  Always have humility and excess capital.

Steinberg jumped in and said that in a nutshell, you don't want to have a margin call.  If you have a margin call, you're finished.  That's what LUK has been about.

Share Repurchases
Berkshire Hathaway has a 1.2x BPS repurchase policy.  What is Handler's view on buybacks?  Have they done any?

Handler said they bought some JEF stock back at the time of the merger.  Post merger, they have a 25 million share authority.   They will be opportunistic on share repurchases.

Does Book Value Approximate Intrinsic Value?
Handler said "that's your decision, not mine".

Which is More Important:  BPS Growth or Shareholder Return?
Handler said early on that they will focus on increasing BPS.  But Handler said shareholder return of course is the ultimate goal, but growing BPS will drive that shareholder return.

Who Makes Decision on Non-financial Acquisitions?
The questioner said something about how LUK built a team and Steinberg said that he never thought of it that way, but they have a great team.  On acquisitions, the board will make the decision.   The questioner probably wanted to know who is going to drive the process when an idea comes up; will it be Handler, Friedman, Steinberg?  I would guess they would all discuss it together so no one person is going to make the call.  They then present it to the board etc...

How Does Steinberg Manage His Time?
Someone asked about his new role, and how he will be spending his time; does he come to work every day? After talking about new office arrangements and some moves (Justin Wheeler moving to NYC etc...), he just said, "We're having fun".

Bank Deals
Someone asked about a small bank deal that JEF was involved in recently.  Is this a trend? Will they see more bank deals?  Friedman said that JEF had a good market share in that sector this week (or last week). This is not driven by Dodd-Frank, but more from capital requirements.  JEF has been waiting for a wave of deals here, but it hasn't really happened, but it will eventually.  The biggest barrier to the deal flow in this area is 'cultural'.  People don't want to give up their CEO-ship.


I don't know if that was the last question, but that's the last thing in my notebook.

Anyway, the meeting started promptly at around 10:00 a.m. and I think it ended at 11:45 am or so (I don't take notes on that sort of thing so I may be off).

I think Handler and Friedman were really good and reasonable and do seem to share the same sort of values as Cumming/Steinberg.   I personally don't have any problem with Handler/Friedman.  I do understand that many in the value investing community are just totally allergic to investment banks.  There is nothing I can really say to those folks.  If they don't like investment banks and bankers, well, then they should just avoid them.   That's totally fine.

But this is not the old LUK either.

13% and 15% Pretax Returns Now!

Banks/financials have been announcing earnings and they have been looking pretty good even though there is debate about the quality of some of the earnings (reserve releases etc.).  There is a lot to talk about but I just thought I'd make a quick update on Wells Fargo (WFC) and J.P. Morgan (JPM) as I have talked about them a lot here.

Buffett's 10x Pretax Earnings / 10% Pretax Yield Idea
I am just going to look at the simple Buffett metric; pretax return on investment.  I've mentioned this metric on another WFC post not too long ago.  Buffett has said in a recent annual meeting that he would like to pay 10x pretax earnings, Alice Schroeder (Buffett biographer) has said that that's all Buffett wants to do; make a 10% pretax return on his investment with little risk.  Munger also used WFC as a benchmark investment against which other potential investments would be compared a while ago; is the potential investment more attractive than WFC?  I think he said at the time that WFC is priced at a 10% pretax yield so if something doesn't measure up to that, why bother?

WFC Pretax Earnings
For the past four quarters, here is the pretax earnings trend for WFC:
   
                    Pretax           Preferred                Pretax
                    earnings         dividends               earnings (less preferred dvd)
2Q2013       8,471             247                       8,224
1Q2013       7,640             240                       7,400
4Q2012       7,221             233                       6,988
3Q2012       7,510             220                       7,290
                  30,842             940                     29,902

So on a trailing twelve month basis, WFC has earned $29.9 billion pretax (and after preferred dividends; I ignored minority interest as it is small).

WFC is now trading at around $44.00, so with 5.3 billion shares outstanding, that's a $233 billion market cap; WFC is trading now at a 12.8% pretax yield on a trailing twelve month basis.  12.8% pretax yield in a world of 2.5% interest rates is pretty attractive (of course, I would never price a stock to a 2.5% pretax yield, though!).

I don't think there is any doubt that Buffett still finds WFC attractive at these levels (he has been buying more all year).  Using his 10% pretax yield, or 10x pretax earnings valuation, he would probably be buying WFC (as long as he is allowed to) up to $56.   That's almost 30% higher than here.  And keep in mind, if I understand everything I've read about Buffett, $56/share for WFC is a price that he would be interested in buying the stock, not some notion of intrinsic value, fair value or anything like that.  It's a price that he would be willing to pay.

There are some issue with banks that people worry about, but we'll look at some of that later.

JPM Pretax Earnings
So let's take a look at another favorite on this blog.   JPM also announced pretty good earnings even though some argue that reserve releases make the number not so high quality.

First, let's just look at the numbers:

               Net to
               common                 Income      
               shareholders           tax             "Pretax income"
2Q13      6,101                     2,802          8,903
1Q13      6,131                     2,553          8,684
4Q12      5,322                     1,258          6,580
3Q12      5,346                     2,278          7,624
             22,900                     8,891        31,791

For pretax earnings here, I just took the net income to common shareholders and added back income taxes paid.  JPM is now trading at around $56, so with 3.8 billion shares outstanding that's a market cap of $213 billion.   That's a 14.9% pretax return, not bad at all.  We can see why Buffett likes JPM (assuming he still owns it.  I don't think anything has happened recently to suggest he doesn't own it; the whale loss didn't seem to bother him at all).

Using the above measure, Buffett would pay up to $84/share for JPM (10x pretax earnings); that's 50% higher than here.  Again, this is what Buffett would be willing to pay.

Yes, but... 
I know.  Many don't see current bank earnings as sustainable.  Reserve releases and a friendly Bernanke is really helping the banks (although we can argue that buying bonds is not helping banks as it flattens the curve (offset recently by a refinance boom that is tapering off)).

On the other hand, one can see the economy as still very subdued and not really recovered.  Housing is still running way below historical trends, and of course, the interest margin is arguably at an unnaturally low level that would eventually normalize.  Also, legal and other costs are elevated due to legacy problems from the financial crisis.

Anyway, let's take a look at what JPM says they can earn on a more 'normalized' basis from their investor day presentation earlier this year.

JPM has long said that under a more 'normal' environment (escalated credit and legal costs come down etc.), they can earn $24 billion in net income.  This is the slide from the investor day presentation that shows this:

This is assuming no change in the environment, but just a normalization of the recent big items.  Just for reference, the last twelve months net income for JPM came in at $24.4 billion.

And another slide showed there are growth initiatives that should allow JPM to earn more than $24 billion over time.  Dimon didn't say when earnings would get to $27.5 billion shown below, but said that the initiatives are close to being in place or will be in place soon so are not longer term targets, so he hinted that $27.5 billion can come soon too.  This is not some medium/long-term project/target.

Using the $27.5 billion ''normalized" figure including growth intiatives and $1.3 billion in benefit from a 100 basis point increase in interest rates, that would come to $39.3 billion pretax (assuming 30% tax rate), and deducting $1.5 billion for preferred dividends and "dividends and allocation of undistributed income to participating securities" leaves us with $37.8 billion.   With 3.8 billion shares outstanding and a $56 stock price, that implies an 17.8% pretax yield.  That's pretty interesting.

Again, not wearing rose-colored glasses, but borrowing Buffett's glasses, it looks like Buffett would be willing to buy JPM up to $99/share!  That's 77% higher than the current price of $56.   Another way to put it is that JPM is trading at 60% of what Buffett would pay for it.

The reason why I went back to these slides is to show that recent trends is within what JPM considers a normal range of earnings.  Even though JPM had great earnings due to reserve releases that can't go on forever, it shows that earnings can grow even without that as other areas 'normalize'. Banks may be benefiting in the short term by dramatically improving credit trends before other areas pick up, it doesn't mean that earnings are unsustainably above trend.   Of course, if other areas don't pick up, then recent trends may be unsustainable.

But, but...
Another big issue, of course, is the leverage ratio.  A lot of questions on conference calls is about leverage ratios.  This is obviously a factor.    Many seem to think that higher leverage ratios will mean that banks can't make money as they did before.  But I think this is not linear, necessarily.  There will be an impact for sure, but these will be priced into bank products.

For example, if a bank had 1% return on assets and had a leverage ratio of 5% and therefore earned 20% on capital and then suddenly the minimum ratio was bumped up to 7%.   This will obviously reduce the return on capital from 20% to 14%.  But what will happen over time is that banks will reprice their loans/products such that they make a reasonable return on capital.  In the above case, the banks would have to earn 1.4% return on assets to make a 20% return.   Loan prices would have to rise 40 basis points (actually, loans would be only a portion of total assets so other assets would also have to increase 40 bps).

This is just an example using random numbers to make a point so not realistic.  I may take a closer look once the dust settles on the rules.  I don't think loans/products will reprice immediately to maintain return on capital, and I don't know if they will be able to reprice to go back to the old returns.  But things will move in this direction.

A key point to remember is that this rule will apply to all big banks, so repricing should happen across the board.  It's just another increase in the cost of business that will eventually be passed on to the customer.  In that sense, this will have implications for monetary policy, of course, similar to raising the fed funds rate.

The problem, as Dimon pointed out, is if the U.S. has a more stringent leverage rule, it may put U.S. institutions at a disadvantage against other global banks.

Rising Interest Rates
The other issue is rising interest rates.  We can't really argue both ways.  We can't be upset with decreasing long term rates as it puts pressure on NIM, and then be worried about rising rates because that will kill the refinancing boom.

What do I think?  Well, I like WFC, JPM and other financials, but it's not conditional on interest rates.  For example, I don't say I like JPM with treasuries at 2.0% but hate it at 5.0%.  This really makes no sense to me.  I've been involved in the markets for a long time and I've seen all sorts of interest rate forecasts so the last thing I would do is invest based on a view on interest rates.

(At a firm I worked, I laughed at the resident economist who said that the Fed Funds rate will go down to 5%.  It was 8% at the time.  And then he said it will go to 3% and then I laughed even harder.  etc... You get my point.)

I like these well managed financials because, well, they are well managed. It's not because I think interest rates will stay here, go down to 2.0% or won't go above 3.0% or anything like that.  I have confidence that the management at good banks will do what is best in each respective scenario; I will let them worry about it. If I didn't think they could handle fluctuating interest rates, I wouldn't own them.  And they have been stress tested. Not by the Fed or a regulator, but by a serious financial crisis.

Off-Topic Tangent
OK, so the above thought on interest rates reminds me of a conversation I had recently.  I was talking to a guy who is really into value investing.  He is and has been studying value investing for a few years and it's his main passion/hobby (not his main job).  So I emailed him a whole bunch of stuff including book recommendations, told him to make sure to read Buffett's letter to shareholders, the article "Superinvestors of Graham and Doddsville" and the other usual stuff that we all read.

Then a few weeks later, during the market decline in June, I ran into him and he was very excited because he told me he sold out right before the sell-off  (I saw him the other day but didn't ask him if he bought back in...).

Well, he did tell me that he is a value investor and not a trader so I was a little surprised.  How can you do all the work and analyze companies, buy them and then just turn around and sell them just because the bond market goes down a little?  If you evaluate and like a business with treasuries at 2.0%, you should feel comfortable owning it with treasuries at 3% or 5%.  If not, then maybe it's not such a great business.  If you won't like a business if rates go up, then one simply shouldn't buy that business to begin with (because rates will go up, eventually).

This also reminds me of a cardinal rule of trading; if you buy something for one reason, don't sell it for another.  Of course, unless the other reason is a really good, valid reason to sell a stock (fraud uncovered, unfavorable management change, long term decline or permanent impairment of business etc.).

Anyway, time and again, I run into people who love and own this or that stock, but then they later tell me they sold because they feared a U.S. debt default, fiscal cliff, meltdown in Greece, bond market crash or some such thing.

Buffett wrote a comment (which Seth Klarman also said) in the "Superinvestors of Graham and Doddsville" article that this value investing idea is something people either get right away or not at all.   Time and again, people will do one thing (rational) and then out of fear or greed turn around and do something that makes no sense. He is so right.

If you do all the work, read the annual reports, 10-k's, 10-q's, understand and like the business and the valuation, then go ahead and buy the stock.  But please don't sell the stock just because everyone says that the bond market is going to crash and that stocks will follow it down!  If a company you are looking at is going to go bankrupt if a recession hits or if interest rates go up to 5%, then the right thing to do is to not buy that stock to begin with.  Don't buy it and try to sell out before the next recession or before rates start really going up because that sort of strategy doesn't work unless you are a really good macro trader (and those are rare!).

Yes, there are people who make a living doing macro trading.  But macro traders spend all of their time looking at macro trends and placing bets according to their own deep analysis of what they think is going on. It makes no sense for value investors who spend their time looking at businesses and financial statements to be a value investor one day and then a macro trader another (buy a stock on business fundamentals one day and then sell on another day for macro reasons).  When you really think about it, the sudden turning of value investors into macro traders is usually emotionally driven (fear), not by logic.

If you look at the great wealth created over time, most of it is created by people who buy and hold good assets; it is not created by dancing in and out of holdings (especially motivated by things that are simply unknowable).

But I know, I am preaching to the choir, but I can't resist as the above scenario happens to me all the time (and I'm sure many readers have the same experience).

Conclusion
I still like the financials.  My only reservation is that they are getting more popular.  But valuations are valuations and they are reasonable.  I looked at WFC and JPM from a slightly different viewpoint from what is common (usually looked at on a P/B or P/E basis) and find it interesting.

There are obviously a lot of risks here.  Interest rates can turnaround and head down and really continue to push NIM down and the economy can stay here or deteriorate making banking a horrible business.  Inflation can pop up and make rates go up in a bad way.  If rates go up due to a strengthening economy, that would obviously be good for banks regardless of what happens in the short term.  Over time a stronger economy would increase loan volumes and help other areas and rising rates would get NIM back up and increase profitability.

Yahoo - Alibaba Group

So I can't believe it's been more than a month since my last post.  This was not an intended leave or anything like that, time just flew by.  Preparing for the summer, going away and things like that.

Anyway, I do intend to keep posting here regularly.  Hopefully I don't have a gap of an entire month too often.

A lot of things are going on now and there are a lot of things to look at and talk about, but for now I just thought I'd look at Yahoo!, or more specifically, the Alibaba Group.

In the earnings release, there was a new slide that I didn't see before which includes the earnings of Alibaba Group.  These figures have always been disclosed in the 10-Q and 10-K's, but I don't remember seeing it in the earnings slides.

It would seem a little odd that something that has been known and disclosed for a long time suddenly gets noticed because it's on a colorful slide.

Anyway, let's take a look at it:

Let's just zoom up on the relevant table on the left:

So, we know that Alibaba Group is doing extremely well.  We all knew that, of course, but it's now even more known.  It's interesting that analysts are now rushing to up their value of Yahoo! based on an increased valuation for Alibaba Group.  I suppose the market/analysts are responding to what looks like some serious operating leverage kicking in (well, it kicked in last quarter too but people didn't seem to get this worked up about it).  Hopefully, that's real operating leverage (that is sustainable).

Anyway, so let's take a look at this thing.  I posted a couple of years ago how some thought that Alibaba Group was worth $32 billion, and last September YHOO sold some shares back to Alibaba Group validating valuations in the $30-40 billion range.

Since then, people have been talking about $100 billion for the valuation of Alibaba Group, and today I think some are saying it's worth $120 billion.

I really don't have any idea how these things are supposed to be valued, but I decided to take a closer look to see if I can get some sort of feel for it.

Alibaba Revenues and Earnings Trend
First of all, here is the trend of Alibaba Group's revenues, operating earnings and net profit (attributable to Alibaba Group):

So this is remarkable.  Revenues have been growing consistently around 70%/year and it has turned profitable since 2011.

Let's take a closer look at this on a quarterly basis:

This is pretty impressive for sure, and you can see why the market is responding to this.  Operating margin is up to over 50%.  We don't have details on Alibaba's financials, so it's hard to say where margins will be over time.  But if they keep growing revenues like they have been and keep margins in the 30%-50% area, this can be a huge market cap company for sure, no doubt about that.  With real earnings, this is no longer just a pipe dream, dot-com.

This is not so safe to do without knowing more details, but if you annualize the first quarter 2013 (ended March 2013) earnings figure that comes to $2.7 billion.  If you value Alibaba at $40 billion, a figure tossed around not too long ago, that would be less than 15x earnings annualized current earnings, which of course is ludicrous for a profitable business growing revenues at 70%+/year.

Taking this $2.7 billion figure, Alibaba would be worth $54 billion at 20x p/e.  20x would still be way too cheap.  OK, instead of looking at it like this, let's make a table out of this.

Alibaba Valuation: 
                     
                                     Value of                             Value per
P/E     Total Valuation    YHOO stake (@24%)      YHOO share
20x     $54 billion           $13 billion                         $13/share
30x     $81 billion           $19 billion                         $19/share
40x     $108 billion         $26 billion                         $26/share
50x     $135 billion         $32 billion                         $32/share
100x   $270 billion         $65 billion                         $65/share

The value is before any taxes that would have to be paid on a sale.   When Facebook came out, it came out at something like 100x earnings and 27x revenues.  At 100x p/e, Alibaba could be worth $270 billion, or $65 per Yahoo share, which is nonsense.

First of all, I am using a figure annualizing the 1Q net income figure which is not always a good idea.  But on the other hand, this doesn't take into account the 70% revenue growth through the rest of the year.  If they continue to grow revenues and maintain or improve margins, then annualizing the 1Q figure would be too low.  There may have been factors that pushed up margins in the 1Q that may not recur.

But anyway, even taking a valuation like 40-50x, which would seem reasonable (not that a value investor would pay that price!) for someone growing revenues so quickly, this would value Yahoo's stake (pretax) at $26-32/share.

YHOO has agreed to sell half of their existing stake in the IPO, so it seems the longer that takes, the more value YHOO can get.

This is really sloppy analysis, but if we push this out a year and assume revenues keep growing at 70% and margins stay up here at 50%, you can just push up the above valuation figures another 70%.  The potential is just insane.

China Crash
One problem that people seem worried about now is the China meltdown.  One thing to keep in mind is that during the financial crisis, companies like Google, Facebook, Amazon and others kept growing and did just fine; they are in growing businesses taking share away from the old economy so the biggest financial crisis / near depression was barely noticeable in their financial statements through the crisis.

In that sense, Alibaba Group exposure may not necessarily carry the same risk as other China-themed investments.

Conclusion
I really don't have any idea if Alibaba will keep growing at +70%/year, or whether 40-50% operating margins are sustainable.  And I didn't intend to fine-tune intrinsic value of YHOO; I just wanted to see what all the hullabaloo was about and in this case, there does seem to be something there.

I have no idea what the proper valuation for Alibaba is, but from the above table, I actually don't think a $100+ billion market cap is a stretch for Alibaba.

I do still own YHOO, primarily for the reason I stated in previous posts (sum-of-the-parts valuation), although I have lightened up as YHOO rallied a bunch.  But it's amazing how much value is being created here in Alibaba.

Do I have a view on Marissa Mayer?  Not really.  She does seem supersmart and well-liked.  It's really good that morale is up which is really important for companies.  But whether or not she can turn around YHOO is a tough question.  I have no idea.  I lean towards being optimistic and do think she has a chance, but it's a tough, fast-changing industry.  She certainly seems to be more qualified to run YHOO than other recent CEO's (who were not Silicon Valley 'geeks'.  Bartz was a tech industry executive, but from another era and didn't seem to have the hacker cred that seems so important)

Anyway, YHOO is certainly still very interesting and I will continue to watch this.  After looking at this data in this form, I almost wish YHOO wasn't in a rush to monetize some of these assets.  Imagine what Alibaba could be worth in a another couple of years.  But then again, who knows when things turn.

60% Yield! (CWGL: Crimson Wine Group)

So Barron's had an article about Crimson Wine Group (CWGL) last weekend.  It's a nice, small, ignored Leucadia (LUK) spinoff.  I talk about LUK so much that I feel like I have to say something about CWGL.   I looked at it like everyone else and just sort of shrugged; what am I supposed to do with a winery stock?  I don't have any particular view or opinion about the business other than my understanding that it's a tough business, prone to pests, weather, supply/demand problems etc.

But this article sort of got me thinking about it a little bit and there was an interesting article in the New York Times about wineries in general too, recently, so I thought I'd put them together to see what CWGL might be worth.

Oh, first of all, I have to explain my cheesy title.

60% Yield
OK, I think you can actually get something much higher than 60%, but here's the secret:  CWGL shareholders get a 20% discount on their wine purchases from them.  During the LUK years, this discount applied to both on-site tasting room purchases and wine purchased online and the Barron's article does say shareholders get a 20% discount on wine purchased on it's website.  I never tried, so I don't know if there are volume or frequency limits or anything like that.  Of course, they may stop you from buying bulk, but that's OK.  (During the Leucadia years, it was on an honor system; all you had to do was to say that you were a shareholder and you would've gotten the discount.  What's the return on that?)

If you bought 100 shares of CWGL, it would cost you $900 or so (of course you can buy less and really get a high yield).  Let's say you drink one bottle of wine per week and you like something in the $50 range (come on, I know you guys can afford it).  So that's $2,600 per year in wine purchases.  A 20% discount is worth around $520, so on your $900 cost stock that's a return of 58%!  If you have a taste for pricier wines or drink more, then your return would be even higher.  If you bought less than a round lot, your return would be higher too.

But anyway, I really don't know what the volume/frequency limits are so maybe this is baloney. And if this only applies to tasting room purchases, then only people out west can grab this yield.

Anyway, let's get to the other stuff.


Price-to-Book
One key point in the Barron's article is that CWGL trades at 1.1x price-to-book, but they recently sold some nonstrategic assets for 1.7x book.  These comparisons are a little tricky without knowing more; I wouldn't take one transaction and apply it to the whole, even though I would not be surprised if CWGL was worth more than book.  Comparisons to other listed vineyards may not be so meaningful either as one of the big purchases at CWGL happened as recently as 2011. Older vineyards may have lower cost basis.

But anyway, with Cumming and Steinberg, it would be hard to imagine that they would overpay for assets, even as a vanity play.  From that alone, book value may not be a bad place to start in valuing CWGL.  If they didn't overpay for assets and their accounting is conservative, then it's probably safe to say that CWGL is worth at least book.

$100 million in Sales by 2016
The other interesting thing in the Barron's article is that they quote (via Napa Valley Register) CEO Erle Martin as saying their goal is to double sales to $100 million by 2016.

By the way, I found a datapoint that showed that back in 2007 (yes, the peak), wineries M&A were done at an average of 4.4x EV/revenues.   That drifted down to 2.7x in 2010 and I don't have data after that.  With recent revenues in the $50 million range, that values CWGL currently at around $220 million versus the current EV of $195 million or so (@8.92/share stock price). 

If revenues get to $100 million by 2016, CWGL may be worth $440 million in three years.  But again, that's against the peak valuation (I think that's the peak) of 4.4x revenues.  It's not too prudent to use 'peak' values (or else, again, maybe investment banks would be worth 4x book!).  More on this later as it's not that simple.

Fetzer Vineyards was sold by Brown Forman in 2011 for what looks like 1.5x revenues, but Fetzer is a lot more down-market than CWGL so I don't know how meaningful that datapoint is (Brown-Forman kept the better vineyards in Sonoma etc.). 

New York Times Article
An article I read in the New York Times (April 26, 2013: Boutique Vintners Turn to Private Equity for Help) struck me as relevant to looking at CWGL.  I don't know how relevant it is as I don't have a high comfort level in evaluating vineyards.  But here are some of the details that I thought were interesting.   

The quoted expert on vineyards is Peter S. Kaufman of Bacchus Capital, which is a private equity fund founded by Sam Bronfman II (Seagram's founder's grandson;  Kaufman is a co-founder).  This private equity fund was set up specifically to buy wineries so I assume that's all they spend their time doing; looking at and thinking about vineyards.

So let's borrow their expertise here.

This is what Kaufman (and others) said:

•  Before the financial crisis wineries were selling for the equivalent of 12 to 15x trailing EBIDA (earnings before interest, depreciation and amortization (not EBITDA!)).   It was a level more than they could stomach. Valuations have now come down.
• Fundamentals for wineries are good for high quality producers with right distribution model.
• Wine consumption has been increasing steadily over the past couple of decades and remained robust during the recession (Wine Market Council).
• Baccus Capital thinks there is still plenty of growth, especially for premium wines.
• Bronfman said wineries that can improve their direct-to-consumer distribution through wine clubs and tasting rooms also have tremendous potential.
• Traditional channels (like restaurants and retailers) are still important, but can reduce margins by up to a third.
• Kaufman says a well-run, high-end winery should have gross margins of 60% and EBIDA margins in the 20-25% range.

Leucadia's Last Comments on Crimson
Just as a refresher, this is what Cumming / Steinberg had to say about Crimson in the 2011 Leucadia annual report (sadly, the last report written by this dynamic duo):

So it seems like CWGL is all set to increase volumes and make some profits.  I post this to highlight the fact that the history of losses at CWGL may be just that; history.  Maybe going forward, they grow profitably.


As a cautionary note, here's a snip from the 2010 LUK AR:

Even in good times, it's difficult to make money in wine... jeez...  At least they are good inflation hedges (didn't Steinberg tell LUK shareholders at the 2012 annual meeting that people who don't see high inflation should just sell their LUK shares?).  But at least it looks like volume is going to get ramped up as they said in the 2011 annual report.


Putting This Together
OK, so let's put all of this together.  The above comments by Bacchus Capital seem to describe Crimson Wine pretty well, doesn't it?  Premium wines, focus on improving direct-to-consumer channel (via wine clubs and tasting rooms) to get higher margins etc. 

When I read the article, I immediately thought, gee, that sounds exactly like CWGL.  And it's no surprise that Cumming / Steinberg focuses on an area of growth (premium wines) and focuses on profitability (direct-to-consumer channel).

So let's look at the above numbers and plug them into CWGL.  Kaufman said that good wineries have gross margins of 60% and EBIDA margins of 20-25%.  You know where I'm going with this; in good times (pre-crisis), wineries used to sell at 12-15x EBIDA margins.

Plus we know from the above that CWGL is shooting for $100 million in sales by 2016.  So we have all the pieces we need to get a value for this thing.

Of course, I am going to look at CWGL using the pre-crisis valuation, which might be high.  Maybe it was a bubble.  Or maybe right now we all have PCSD (Post-Crisis Stress Disorder) and can't imagine anything trading at pre-crisis levels anymore.  But a quick look at the stock market, art and other assets should prove otherwise.

But yes, I understand that this valuation may not be 'conservative' or even reasonable.  I'm just doing this to get a feeling for what's going on here.

First of all as a reality check, let's make sure that CWGL has some potential to make the above margins.  In the first quarter of 2013, CWGL had a gross margin of 46.8%, and they had 49% gross margins for the full year 2012.  So 60% looks within reach if CWGL is ramping up production and is going to realize benefits of scale. 

EBIDA margins were 25% in 2012 and 22% in the first quarter of 2013 (excluding other income which was gain on sale of an asset), so that's already within the 20-25% range of a good winery.

Putting this stuff together:

• CWGL goal is to get to $100 million in revenues by 2016.
• A good vineyard will have 60% gross margin, so let's say CWGL earns $60 million in gross margin
• A good vineyard has EBIDA margins of 20-25%, so EBIDA is in the range of $20 million - $25 million at CWGL in 2016.
• Pre-crisis valuations were 12-15x EBIDA, so CWGL might be worth (using the low multiple on low end of margin range etc.) $240 million to $375 million.

First of all, let's see what happens with these metrics using historical figures.

In 2012, CWGL had sales of around $50 million (close enough!).  We already saw that they had EBIDA margins of 25%, so that's $12.5 million in EBIDA. 12-15x that is $150 million to $188 million.

With 24.4 million shares outstanding and no debt (they had debt in 2012 but that was converted to equity by LUK so there is no debt now), that comes to $6.15 - 7.70/share.  There is around $20 million in cash on the balance sheet, so add that and you get $7.00 - $8.50 in value. 

OK, so sales are growing so you have to take that into account.   Sales grew 18% in the first quarter of 2013 and 24% for the full year 2012.  They are increasing capacity (more on that later), so let's assume they grow revenues at the same rate of 18% for the rest of the year.  I have no reason to believe this is realistic, but we know it's growing and I don't know that there is any guidance on revenues from CWGL itself.

With all else equal, a 25% EBIDA margin and 18% higher sales, CWGL would be worth by the end of the year $8.26 - $10.00/share (this assumes cash stays at $20 million; at 25% EBIDA margin and $6 million in expected capex this year, there should be enough cash to leave cash unchanged if not rise). 

So from the above figures, CWGL doesn't look too exciting.  I think if CWGL is already earning 22-25% EBIDA margins, it may actually be headed higher as sales grow and they get benefits of scale.  In that case, obviously, the valuation would be much higher.

$100 Million Sales by 2016
So let's look at this $100 million sales by 2016 for a second.  That's double what they did in 2012.  Using the same model as the above, we get $20 - 25 million in EBIDA and a fair value range of $240 million - $375 million.  That's a range of $9.80 - $15.40/share for CWGL without taking into account any cash. 

The problem here, of course, is that it will take some investments to get capacity up to 500,000 cases.  At the end of 2012, just adding up the wineries listed in the 10-K, I get current capacity of around 260,000 cases.   The 10-K lists two types of capacity; permitted capacity and fermentation and processing capacity.

Here is the breakdown:
                                                     Permitted           Fermentation and
                                                     capacity             processing capacity  
Pine Ridge Vineyards                 126,000               80,000
Archery  Summit                           21,000              15,000
Chamisal  Vineyards*                   42,000    ->  100,000 by 2013
Seghesio                                      170,000              120,000   ->  170,000 by 2013

(Chamisal doesn't have a separate "fermentation and processing capacity" listed in the 10-K, so I assume permitted and processing capacity are the same for this vineyard).  Double Canyon doesn't have any production facilities, but does sell wine produced elsewhere; I don't know how that fits into our scenario)

So it looks like at the end of 2012, capacity was around 257,000 cases.  Sales in 2012 were 260,000 cases.

They are spending $300,000 this year to increase Chamisal capacity to 100,000 cases from 42,000 and $2,000,000 to up the capacity at Seghesio by 50,000 cases.  These figures are just what they will spend in 2013 to complete the capacity increase so isn't the total cost of expansion.

The 2016 $100 million sales target assumes 500,000 cases of sales.  At the end of 2013, capacity seems like it will be 365,000 cases.   So there will need to be 135,000 cases more of capacity.  An increase this size may have to happen via an acquisition. 

CWGL paid $86 million for Seghesio in 2011 for 120,000 cases of capacity (as of 2012-end; I don't know what the capacity was as of May 2011 when it was acquired).

If $86 million is required to add another 120,000 cases of capacity via an acquisition, the above math obviously doesn't work out.   CWGL does have a $60 million credit line so this may be for acquisitions.

Let's say they did another acquisition just like Seghesio for $86 million and adding 120,000 or so in case capacity.  When they did Seghesio, it was funded more or less 50%/50% debt and equity.  So let's say they do so again.  Assuming they borrow $43 million and issue $43 million in stock (say, for $9.00/share), then in the above scenario, they would have 29.2 million shares outstanding and $43 million in debt, or let's say $23 million in net debt (if they keep $20 million or so cash on hand).

So if the EV fair value range is $240 million - $375 million, the equity value would be:

$240 million minus $23 million net debt divided by 29.2 million shares outstanding = $7.43/share on the low end (12x EBIDA based on 20% EBIDA margin) and $375 million minus $23 million divided by 29.2 million shares $12.05/share on the high end (25% margin and 15x EBIDA).

If EBIDA margins are already 25%, we can just use that and the 12-15x EBIDA range and we get a valuation range of $9.50 - $12.05/share for CWGL in 2016.  Not that super-exciting.

If it's true that CWGL is just getting up to scale and they can start to make more money, it's certainly possible that this 25% EBIDA margin is way on the low side.  It would actually have to be for this investment to be exciting.  At least from what we see in the above analysis.  

But in 2013, when they finish capacity expansion at their current vineyards, capacity will increase by 40%.  If sales grow to use that up with minimal incremental capex going forward, operating leverage can be significant.  I don't know the wine business so I can't tell you how much, but it does feel like it can be substantial.

Sales at Capacity
OK, so looking out to 2016 may require assumptions on how CWGL gets capacity up to 500,000 cases.  So why not just look at this from the point of view of where capacity would be during 2013?

We see from the above that after the 2013 capex, they will have total capacity of 365,000 cases;  40% higher than the 2012 year-end capacity.   These figures are just based on what I see in the 10-K.  Others may have different capacity figures and I may be missing something. 

So let's assume, instead of getting to 500,000 cases by 2016, that at some point within the next couple of years, sales gets up to 2013 capacity of 365,000 cases.   This way, there would be no new capex or acquisition assumptions required (other than maintanence and other non-expansion capex).

So from the $50 million sales from 2012, we will just add 40% because that is how much sales they can grow without an acquisition or expansion capex (other than what's planned for 2013). 

The new sales would be $70 million.  From here, let's just assume 25% EBIDA margin because as I said, they are already there and further sales gains should show some operating leverage and may even go higher.

With sales at $70 million and 25% EBIDA margin, that's $17.5 million, and 12 - 15x that is $210 million - $263 million.  Again, let's leave cash there at $20 million, so add that to the EV figures for a range of $230 million - $283 million. 

With 24.4 million shares outstanding, that's a range of $9.43 - $11.60. 

This may actually be on the low side since the new capacity expansion is at existing facilities, which means there should be some scale leverage at the facility level (and not just SGA leverage from increasing overall volume at the corporate level).  If gross margins move up to 60%, EBIDA margins may well get into the 30s, and if that's the case the above figures could move up by 20% or more.

But I actually don't know as I am not too familiar with this industry.

Other Valuation Guidepost
As usual, I just did a quick search of recent wineries deals and couldn't find much in the U.S.  One very visible one was the Constellation Brands purchase of Mondavi in 2004.

Citigroup used the following comparables for valuation:

Wine Companies:
  Chalone Wine Group
  Vincor International

Australia:
  Lion Nathan Ltd.
  Southcorp Ltd.
  Evans & Tate Ltd
  McGuigan Simeon Wines

Europe
  Baron de Ley SA.

They didn't provide mean, average, high and low as usual, but Citi said the valuation range using the above group for Mondavi would be 10-12x 2004 EV/EBITDA (as of May 2004).

For transaction analysis, they looked at 15 U.S. and 16 non-U.S. deals between 2000-2004, and the valuation range came to 12-14x EV/EBITDA.  Taking out the T would make a 12-14x EV/EBITDA higher than 12-14x EV/EBIDA.

Of course, this is 2004 so pre-crisis (but also pre-super-bubble of 2006-2007).  But unlike banks, which may very well have a reason to have valuations much lower than pre-crisis, it wouldn't be surprising to see winery valuations get back to more 'normal' levels.   Of course, whether this is 'normal' or not is arguable and I don't necessarily have a strong argument either way.

Other Comps
The other listed comparables are Vina Concha y Toro (VCO) and Treasury Wine (TSRYF).  Vina Concha seems to trade at an EV/EBITDA multiple of 16x and 23x p/e.    Subtracting 2012 taxes from ttm EBITDA (so not apples to apples, but close enough for a 'rough' estimate), it seems like VCO is trading at 20x EV/EBIDA (Yahoo Finance data). 

In a later post, I may take a closer look at VCO, TSRYF and whatever other comps from the above Citigroup list still exists.

But just from the fact that VCO is already trading at 20x EV/EBIDA (and they have much lower gross margins) seems to indicate that it might not be too far-fetched to assume that U.S. winery prices get back to 12-15 EV/EBIDA or even higher for profitable, high quality wineries (which would seem to suggest some upside for CWGL after all).

Conclusion
I didn't intend this post to be a really close, comprehensive look at CWGL (nor did I think it would be this long!).  I just wanted to do two things:

• point out the investment return (admittedly not scalable) one can get by being an owner of CWGL (20% discount; you can't eat outperformance, but you can drink this yield!) and also
• to put the expert thoughts on wineries by the folks at Bacchus Capital to use and put it together with what we know about CWGL to see what pops out.

In a later post, I may take a closer look at some of the comps and get a better feel for winery valuations from around the world.  I know wineries also tend to be valued per acre and other 'asset' measures, but I have nothing to contribute on that front.  You can google and get all sorts of per-acre valuations, but I have no idea what applies to CWGL so I would have no conviction on those kinds of valuations.

I tend to look at comps as important information, of course, but as an investor myself it's more important that I understand the economics of the business and see what the profits to shareholders are going to be.  Sure, it's fine if an industry trades at 20x EV/EBIDA or EV/EBITDA, and if something trades way below it, there can be profits to be had if valuations move up.

But I'm usually more comfortable with something simple, like, if I buy this what is my pretax return on investment?  When the two together fit well, that's great.  When it doesn't, then I am a bit more reserved.  

Also, CWGL is tiny at $50 million in sales.  So comparing them to other larger entities might not be that meaningful.  Again, I really don't know this industry.

Anyway, this post is way longer than I intended so I want to get this out. 

I may (not guaranteed!) post a followup to this after looking closer at the comps and some simple earnings model to get at a regular p/e ratio.

Although I have no real interest in this industry, I think it's worth the time to look at it because:

• It's a spinoff, and one from a company I really like (Leucadia)
• It's tiny so not worth the time for most institutions (which means we should look at it!)
• Run by two incredible managers with big ownership
• Industry is not viewed favorably (at least I don't think it is)

In any case, the key driver for this year and next is going to be the ramp up in volume due to the expansion of Chamisal and Seghesio and the leverage that will kick it at the facility level and the corporate level (leverage SGA).  It's possible that 25% EBIDA margin is way, way, too laughably low for CWGL (in which case it would be worth far more than the above analysis!).