Coca-Cola Hellenic Bottling Co

As usual, I was browsing the new lows list and noticed that Coca-Cola Hellenic (CCH) was hitting new lows every day.  Well, of course it's hitting new lows every day.  This is a Greek company.  But since it kept hitting new lows every single day, I decided to take a quick look as I really haven't looked very hard in Europe despite the meltdown going on over there.

First of All, Is it Cheap?
CCH is trading now at $15.30 or so compared to a high of close to $50 back in early 2008, so the stock is down close to 70% from it's high, and it's not even a bank stock.

But nominal price is not meaningful at all, of course.  So let's look at some comparisons.

Here's a quick look at CCH versus other Coke bottlers around the world (I exclude Japanese bottlers here as they seem to live in a different world altogether):

              ttm = trailing twelve months through September 2011

              Operating margin and ROE are also based on trailing twelve months.

              Data is from Yahoo Finance

From the above table, we see that CCH is indeed cheap especially based on next year's earnings estimate trading at 11.6x p/e versus 16.5x and 17.2x for Femsa and Amatil.  CCE is cheaper at 10.8x p/e, but CCE's markets are primarily mature markets in Western Europe (Belgium, France, Great Britain, Luxembourg, Monaco, Netherlands, Norway and Sweden) so their growth prospect is not that bright (it can still be a great investment here if they focus on returns on capital and returning cash to shareholders etc...).

Coca-Cola Amatil is the Australia/New Zealand bottler.  They have done well with very good margins, return on equity and decent growth but they are not particularly cheap.  Again, this is not to say that's a bad investment; we are just comparing things to CCH.  I haven't taken a close look at CCLAY.

Coca-Cola Femsa, of course, is the star of the the bottlers with decent margins and plenty of growth (sales have grown +15.5% in the last five years); a perennial favorite of fund managers around the world.

But if you look at CCH, even though their ROE and operating margin is a little depressed due to the current weakness in their European markets (they typically earn an operating margin closer to 10% and return on equity well into the double digits), it does seem to have good growth prospects compared to CCE.

CCE Was a Growth Stock

After the merger that created CCH (Hellenic Bottling and Coca-Cola Beverages) in 2000, CCH had a nice run of growth until the financial crisis hit.

Between 2001 and 2007, unit case volumes increased +9.3%/year, revenues grew 11%/year, EBIT grew +20%/year and EBITDA grew 13.6%/year.  Return on capital improved over time from 3.9% in 2001 to 12.2% in 2007.

Here are some charts that show nice growth and operational improvements between 2001 and 2007 (this is from the 2007 annual report):

It shows nice growth between 2001 and 2007.  Then the financial crisis hit and things flattened out.  On back of this growth, in early 2008, CCH stock traded close to $50/share.  EPS in calendar 2007 was US$1.90/share so that's a P/E of 26x.  Not cheap.    

Here are some snips from the 2010 annual report:

Things have flattened out since 2007-2008, but CCH has maintained their return on invested capital and margins at least through 2010.  This year, volumes are flat and earnings are down but that's no surprise given the crisis occuring in Europe now.

The question is if this slowdown and ongoing European crisis is a temporary thing or a permanent one.  If it's permanent and you think Europe and especially the smaller economies will go into a long depression, then CCH is obviously not a good idea.

But if you think over time that GDP per capita will continue to go up over time, this is an interesting play.

Let's take a look at some of the markets CCH is involved in:

This is actually a pretty impressive portfolio; only 34% of volume and 42% of revenues come from mature markets and the rest from emerging and developing markets.  Some of these markets are markets where people were falling over themselves trying to get equity exposure; emerging market funds etc... (remember "frontier market" funds?)   There seems to be plenty of potential for growing per capita GDP in many of these markets, and Coca-Cola consumption tends to rise as GDP per capita rises.

Here is a great graph illustrating that from CCH's 2010 annual report:

For those worried about specific country exposure (some don't want anything to do with Russia, Italy, Greece etc...), here is a breakdown of the largest sales by country:

Again, this is certainly an interesting portfolio compared to other bottlers in mature markets. Of course that also means there are a lot of risks here.

Here's a look at per capita carbonated soft drink (CSD) consumption per capita in CCH's ten largest markets compared to the EU (Eurpean Union) and U.S. averages:

Of course it would be silly to assume that the rest of the world would increase CSD consumption per capita to U.S. levels, but it wouldn't be unreasonable to assume that many of these markets might move closer to the EU average.  Of course, in mature markets where Coke has had a long presence and GDP per capita has been stable over time, I doubt CSD per capital figures would grow much, but for countries with low GDP per capita, I find it totally reasonable to assume CSD per capita figures will grow with GDP per capita.


So What's CCH Worth?

The above table shows the return on equity of CCH over the past decade; I just divided the net profit of the year by the shareholders equity at the beginning of the year.  I also calculated the EPS over the past decade in U.S. dollars.  I translated the Euro into U.S. dollars using the currency exchange rate at the end of each year.

So we see that this stock that traded near $50/share at 26x p/e is now trading at less than 10x what they earned in both 2009 and 2010, and 11.6x or so of what analysts expect them to earn in the year ended December 2012.  This seems to me a very reasonable valuation.

A lot of growth stocks come crashing down from a high p/e ratio to a ratio that would attract value investors (like me), but many of those come down due to limits on their growth due to market saturation (fast food restaurants etc...), technological obsoletion (new technology obsoleting products and services), end of fads (Heelys etc...) and sometimes things just come down due to temporary macro problems. 

CCH might fall in the category of this 'temporary' problem.  I don't think CCH fits into any of the other categories. Is there a secular change in this business, technological or otherwise?  I don't think so.  I don't know if CCH actually deserves to trade all the way up at 25x p/e either, but 10x might be a bit cheap for a company that seems to have so much growth potential going forward with a proven business model that works and has worked over many years.  Their business model is also supported by a globally dominant company that has an interest in seeing them succeed.  That's pretty important, especially when looking for exposure (for investors) in some of the smaller more obscure markets.

Free Cash Flow
Let's look at free cash flow.  CCH provided their own free cash flow calculation and forecast in the November presentation:

This cash flow doesn't deduct interest expense, so either we have to look at this versus enterprise value (EV), or deduct some sort of interest expense to compare it to the equity (stock) valuation.

First, let's look at this versus the enterprise value.

The stock is now trading at around 11.4 Euros/share and there is around 366 shares outstanding for a market capitalization of 4.2 billion Euros.  Non-current liabilities on the balance sheet as of September 2011 was 2.4 billion Euros for a total enterprise value of 6.6 billion (out of conservatism,  I won't deduct the cash on the balance sheet for now).

The above figures are rolling 3 year sums so we should divide by three to get rolling three year averages.

According to that, CCH is trading now at a 6.9% free cash yield versus EV using the past three years.
That basically means that if you spent 6.6 billion Euros to buy the entire company and pay down their debt, your cash-on-cash return on this investment would be 6.9% if CCH earned the same revenues/profits as they did in the past three years.   (Importantly, this differs from EV/EBITDA as it deducts taxes paid and capex; so the 6.9% would actually end up in your hands).

Using the CCH forecast for the 2010-2012 period, they expect cash flow to be 1.4 billion Euros over the three years frmo 2010 to 2012.  That comes to 467 million Euros per year and a free cash yield on EV of 7.1%. 

Let's look at this from an equity investor point of view.  I will just deduct 83 million Euros from the above free cash figures and compare that to the equity market valuation (or on a free cash per share basis).  83 million Euros is what financing cost was in 2010 and for the first nine months of this year, it seems to annualize to the same run rate.

So using 83 million, then the free cash flow for the past three years was 370 million Euros (1.36 billion divided by three minus 83 million).  With around 366 million shares outstanding, that comes to around 1.00 Euro per share.

To make it easy to compare to the ADR, let's call that U.S. $1.35/share.   At $15.30/share, CCH is trading at a free cash flow yield of 8.8%. 

Using guidance from the presentation and doing the same calculation gives you 384 million Euros or $1.42/share, or a free cash yield of 9.3% which is not bad at all given current bond yields out there.

The most interesting aspect of this, still, is the cheapness especially relative to the growth potential.

Obviously, Europe is not at all out of the woods and there will be a lot more volatility in the financial markets going forward and CCH has exposure to a lot of the 'wrong' places in the current environment, so it wouldn't be much of a surprise if this stock went down a lot more on the daily headlines.

But if you assume that CCH doesn't require a bubble to make good returns and grow (this is not a housing stock or a bank, for example, that benefited greatly from the bubbles), then it is reasonable to assume that they can resume their growth and make decent money going forward in a more normalized environment.

In any case, if you are looking for something in Europe from this crisis, some will make some money buying European bank stocks and other more levered played (if they are right). 

This one looks like a more conservative way to play that.

There is good reason to assume that CCH might be oversold due to their being a Greek company; Even if Greece defaults, it will not have an impact on CCH's credit rating; both S&P and Moody's have affirmed that as most of CCH's business is outside of Greece.

Plus, even if Greece does default and there is a blowup over there, solid companies with good businesses should come through fine, as many companies have done in the various blowups over the years in South America (oftentimes, blowups or times of near blowups have been the best times to buy into their stock markets!  You want to buy when everyone is running away).

There is a risk, however, in that most of their debt is denominated in Euros and U.S. dollars; if the Euro completely breaks up, the 'new' Euro may be the strong core countries and therefore it would be very expensive versus the rest of the currencies.  CCH does have a lot of sales in the European countries that are not big and strong (France and Germany).  However, many of the smaller countries CCH serves is not in the Euro so foreign currencies declines are already in the numbers.

A breakup of the Euro, for this reason would be hugely traumatic to Europe overall so is probably highly unlikely in the near future.  One mitigating factor is that if there is a breakup of the Euro, weaker currency economies will see high inflation so the loss from the foreign currency revenues would be partly made up by higher prices in those countries.
I don't own any at the moment and I will be looking at this more and I may buy some at some point.  Even if I don't buy some now, at the very least will go into my "watch very closely" list.

Alleghany - Transatlantic Merger

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

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

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

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

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

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

(You can read my original post on Y here)

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

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

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

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

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

Here is the combined ratio history of TRH since 1999:

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

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

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

Quality of Transatlantic's Insurance business?

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

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

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

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

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

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

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

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

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

Proforma Look at Combined Company

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Conclusion
So what do we have here?   It looks like a pretty darn good deal when you look at it the way I've looked at it above. You have:

• Y getting increased leverage from TRH's float (combined entity investment leverage of 3.0x versus Y's current 1.7x)
• TRH getting increased investment returns on it's float (from Y's own analysis, their equity investments increase returns by 2.9%/year, even in this horrible environment)
• Deal is accretive to Y's BPS; just closing the deal will add 7% to Y's BPS
• Both companies have decent underwriting histories according to their historical combined ratios
• A one-time bid for TRH by Berkshire Hathaway sort of serves as a due diligence by the best in the business on TRH; BRK would not bid for a subpar business even at a cheap price (plus Y would not buy a crappy business)
• Whatever risk and problems that might come with the insurance business, the fact that 'star' Joe Brandon will run the combined insurance operations sounds like a great deal for investors; this may be the biggest positive in the whole deal

Thinking about it this way makes the Y-TRH merger sound like a great idea and either Y or TRH great investments.

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

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

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

Y:      $288/share
TRH: $54.60/share

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

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

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

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

Fairfax Financial's Interesting Bet

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

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

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

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

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

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

Here is the history of their book value growth:

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

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

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



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

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

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

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

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

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

How are they as an insurance company?

Here is the long term performance of their insurance business:


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

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

So what's the big, interesting bet?

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

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

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

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

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

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

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

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

Anyway, enough of that.

Deflation!

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion?

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

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

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

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

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

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

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

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

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

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

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

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

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

The Problem with Sony

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

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

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

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

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

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

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

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

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

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

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

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

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

Unfortunately, that is highly unlikely.

Seth Klarman Buys Hewlett Packard?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tweedy Browne on Johnson & Johnson

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

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

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

Here is some of the text that goes with that:

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

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

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

Letter to Shareholders

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

Bill Miller Steps Down

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

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

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

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

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

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

Here are some more figures for the fund from Morningstar:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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