Simply Summing up Sears: A Lesson in Intelligent Investing

Last week, I argued why Eddie Lampert's current strategy for investing Sears' capital was rational. This week, I'd like to write a little about why the future is bright as well.

With all the nonsense media hullabaloo over Sears' awful fiscal first quarter, I thought it might be nice to put the whole situation in context. While the media is talking about how Sears is "ugly," the company "might go bankrupt," and other ridiculous scenarios, my view is quite different.

Currently, Sears is having trouble with its stores. Indeed, they probably had the worst quarter of any major retailer out there. This is all true, and I think Eddie Lampert recognizes it to be so.

However, the panic over their cash balances, debt, and decreased cash flow couldn't be further from the mark. The company ended the quarter with $1.4 billion in cash. In context, their quarterly interest expense comes to $66 million, and the net loss was $56 million. The company is not circling the drain. The fact is, in a bad economy disadvantaged retailers suffer; I'm not sure what is shocking Sears onlookers so much. CEO Bruce Johnson even predicted the company would have higher EBITDA this year than the last. So far, Eddie has been nothing but honest with shareholders, and I see no reason why they would make this prediction unless they believed it to be true.

In essence, people are missing some simple points:

1. Eddie Lampert is heavily incentivized to make the Sears investment work. That doesn't mean that he is overly concerned with making Sears retail stores work, although I'm sure he'd love to, but that's not a prerequisite for a successful investment in Sears. ESL has over 60% of their assets invested in Sears, while Lampert has been making 25%+ annualized returns for his partners for 20 years now. Did he turn dum-dum in a year and a half? Do you really think that, from here on out, Lampert is going to permanently lose money on Sears? Me neither.

2. Of course, even the most incentivized owner couldn't make some investments work (think airlines). However, Sears has the assets to create cash flow and wealth. The big ones? Brands and Real Estate. Brands like Craftsman, Kenmore, and Diehard. Hundreds of owned real estate locations that companies like Target would love to take off their hands.

Think about how a successful restaurant franchiser works. How do they make money? Franchising fees due to their brand strength, and lease payments from owned real estate.

Sears can, for all intents and purposes, have their real estate unit operate like a REIT. They can either choose to lease out the real estate locations or sell them. Either way, they make money. In my view, the market has placed no value on this potential.

Regarding brands, the possibilities are endless. Wal-Mart, Home Depot, Lowe's, Autozone (Diehard), etc. These are not secondary brands, we're talking about high quality, easily recognized names embedded in American culture. Actually, I'll let Eddie tell you about brands:

"One of our most important resources is the great brands we own, in particular DieHard, Craftsman, Kenmore, and Lands’ End. All four of these brands have significant equity with customers and provide tremendous opportunity for value creation. To illustrate, let me discuss one of them, DieHard, in more detail. Based on brand recognition studies, DieHard leads in customer recognition among car battery brands by a wide margin, but it lags dramatically in market share. Why? We believe it is due to fewer points of distribution. As a proprietary brand, DieHard is only available in 900 Sears Auto Centers and 1,400 Kmart stores. Yet it is competing with other batteries that are available in thousands of locations across the country. Further, a car battery purchase is a duress purchase event, in which the customer is looking for the nearest, most convenient solution. Unfortunately, it is not always us, but there is an opportunity for us to rethink our brand distribution strategy to create value. "

Obviously, Eddie is talking about taking Diehard and placing it in other stores: Autozone, Advance Auto Parts, Wal-Mart...these are places that'd love to have a brand like Diehard. Think about similar situations that could arise with Kenmore and Craftsman in appliances and tools.

Problem is, the analysts and journalists can't see further than their noses right now. 12 months is about as far out as they can imagine. Retail is in trouble! Sears lost money last quarter! Lampert is failing! Thus, the market prices Sears at $11.5B.

On the other hand, when I look at Sears, a few years out, I see a company that is operating a REIT, selling tremendous volume of branded merchandise, operating marginal retail stores, and running a profitable online retail operation, all being run by highly incentivized capital allocating machine. The possibilities are endless.

What I don't see is the same company that's been struggling for over a decade. I don't see the status quo that lead to Sears decline, the very situation that the media is so heavily focused on. Do I think this view is entirely irrational? No. Actually, it is the current reality. Sears retail stores are struggling. Their cash balance is down year over year.

However, these struggles are not being placed in the proper mental framework. As a long term investor with a probabilistic mindset, I see tremendous opportunity in the Sears story. I see an opportunity to take advantage of the auction pricing mechanism of the stock market to pick up a business at prices with very little downside and tremendous, although uncertain, upside.

The story is quickly summed up by Mohnish Pabrai, who to my pleasure, recently disclosed a position in Sears (from the Chicago Tribune)

"Hedge fund investor Mohnish Pabrai has been watching Lampert since he worked his magic at Kmart and until recently viewed Sears shares as too expensive. But last fall—a time when the shares began their decline to below $100—his Irvine, Calif.-based Pabrai Investment Funds began buying and as of March 31 held 517,607 shares, according to Securities and Exchange Commission filings.

"There are two ways to look at Sears," Pabrai said. "One is as a retailer. The second is as a collection of assets being managed by the greatest capital allocator. And I view it as the latter."

Remember this: Short-sightedness can be blinding. Those who saw Berkshire Hathaway as a textile maker were trumped by those who saw it as a collection of assets being managed by a brilliant capitalist.


Disclosure: I own shares of Sears.

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The Next Buffetts? Maybe. Also, 3 Simple Rules from a Canadian Investor

With much thanks to one of my favorite blogs, Controlled Greed, I found a terrific article written by the Canadian magazine Moneysense.

The article is called The Next Buffetts, and it profiles 4 investors whom are thought by many to be "Buffett-like." While this is a recurring article topic, (remember The Buffetteers?) I find each one to be enlightening in that I often discover an investor previously unknown to me.

Who is that diamond in the rough this time?

That'd be Mr. Timothy McElvaine. Mr. McElvaine runs the McElvaine Investment Trust, a Canadian trust, similar to a partnership, with free range to invest in anything, anywhere, at any time. According to the website, McElvaine has returned an amazing 20.4% (before incentive allocation) since 1996, vs. 9.6% for the TSX/S&P blended index.

What's more, Mr. McElvaine has now underperformed the index for four running years. It toys with my investing ambitions to think that he has underperformed for nearly half a decade , yet he still has beaten the market by over 10% on an annualized basis! What that means is, before he began underperforming, he had a margin of superiority over the market of nearly 20% annually over a 7 year period. Truly astounding numbers.

The most impressive fact I left out: In the 11 year life of the trust, he has not had one down year. Sound familiar? I believe was it Warren Buffett who, during his partnership days, beat the market by a fat margin for 13 years without a down year. If you think (as I do) that Mr. McElvaine will resume his outperforming ways in the coming years, it's feasible that by the 13 year mark, he'll be up on the indicies by 12-13% annually, or more, without a losing year.

Let me pick my jaw up off the floor before I continue...


With these unbelievable numbers, I had to check out his website to look for partner letters, and luckily enough, they were there.

Suffice to say, the letters were everything I'd hoped. He outlines his major investment tenets, provides humorous analogies for the market and life, and even tells us about a few specific investments he's made in the past. Reading them, I was reminded of the first time I read those magical Buffett Partnership letters. While it's impossible to compare any investor to Warren Buffett, McElvaine's writing forced me to make the analogy in my head.

My advice to you? Read the letters, soak them up, and then read 'em again. Any investor, young or old, could benefit from applying the principles laid out in Mr. McElvaine's thinking. The simplicity of merely finding a handful of business selling for way less than they are worth inoculates the reader.

Mr. McElvaine lays out three basic investing tenets in every letter, and they are thus:

"As I get older in this business, I value certainty more and more. Let me clarify what I mean. I am not referring to a prediction of what is going to happen to the stock price. I am referring to certainty over the items I focus on. As discussed in the past, these are:

1. What I think the company is worth

This is always a guess at a broad range. It does not depend solely on assets on hand.

2. How volatile I think this rough estimate of worth is

This is a stress test of item 1. I think about the story of the three little pigs. The
grass house and the stick house, from the perspective of a pig hoping for longevity,
are much more “volatile” structures than the brick house.

3. Do I think management and the board are working for or against us."

In essence, Mr. McElvaine is saying that the best approach is buying businesses with stable value, for much less than that value, with a management that won't destroy it in the meantime.

You could do worse than to follow his advice.

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The Festival of Stocks May 26, 2008

Welcome Everyone to the May 26, 2008 Festival of Stocks!

We had a lot of great submissions this week to the Festival, so pay attention and read up! They should provide you with much reading material for the week ahead.

For Past posts on the Carnival, or a description of how it works, please go here.


Some of my favorites from this week's crop of insight:


AlexG over at Contrarian Value Investing with a look at Francis Chou and the idea that value investing may have down periods, but it always comes back. A great insight from a legendary investor: Value Investing Always Bounces Back



FIRE Getters over at FIRE Finance show us how a small individual investor turned a pittance into a fortune with some simple investing tenets: How to Turn $5000 into $22 million? Lessons From One Successful Individual Investor



Silicon Valley Blogger shows us some great reasons why investing for the long term gives you an advantage over others: 7 Compelling Reasons Why Long Term Investing Is Better Than Short Term Trading.

I was a big fan of a post by Enoch Ko at The Wealth Accumulator this week regarding Phil Fisher. Enoch argues that Phil discovered Range Bound Investing long before Vitaliy Katsenelson brought it up in his book. Congrats to Phil and Vitaliy for their insights: Phil Fisher on range-bound investing

Steve Alexander over at MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy reviewed Jeremy Siegel's book. This is the synopsis of his review: "The Future for Investors is a 2 part book investigating what the future will hold for stock investors, and what investing strategies are likely to be successful. The lessons of the past outlined in this book help explain why the Magic Formula strategy works:" Book Review: The Future for Investors by Jeremy Siegel



Some specific Investment recommendations:


Larry Russell presents The Top 25 Low Cost Best US Money Market Funds posted at THE SKILLED INVESTOR Blog.

Bullish Dividends presents Dividend Stock Analysis: Russel Metals Inc. (TSE: RUS) posted at Traders Corner: "Weekly Dividend Stock Analysis. This weeks stock is Russel Metals Inc. (TSE: RUS)"

Dan at Everydayfinance presents How a Bank in Colombia could be the Sleeper Stock of 2008 posted at Everyday Finance: Everyday Finance highlights a surprisingly attractive play on the improved picture for Colombia.

Dividend Growth Investor presents Kinder Morgan Energy Partners (KMP) Dividend Analysis posted at Create Rising Passive Income From Dividend Paying Stocks.

Turley Muller presents Authentidate (ADAT) Remains Undervalued posted at Financial Alchemist.

kozen presents Why you should go short in Oil - I do! posted at Market Thoughts for Profitable Investment.

GBlogger presents Get More Exposure to China, According to “Random Walk” Author and Professor Malkiel posted at CAN I GET RICH ON A SALARY.

Here are some posts on general investing and investing strategy:

Emore Ogho presents Stock Market Update posted at Emog: "Overview of the Nigerian Stock Market"

Aussie Investor presents Stock Analysis - Debt To Equity Ratio posted at Stock Market Investing For Beginners: "When investing in the stock market, do you look at debt. Do you know how much risk you're taking on through the borrowings of the stocks you own? This article discusses the debt to equity ratio. What it is, how to calculate it and how to apply it to your stock market investments."



Dividends4Life presents The Power of 5/15 in Dividend Investing posted at Dividends 4 Life: "Dividend investing takes advantage of certain undeniable math principles."

Steve Faber presents - Investing in Oil vs. Investing in Energy for the Future – Do Alternative Energy Funds Track Crude Prices? posted at DebtBlog.

Babak presents Conditions Of New Bull Market: 20% Or More Drop posted at Trader's Narrative: "Third in the series exploring the conditions that precede a new bull market: a drop of 20% or more in the Dow Jones."


Brice Hogan presents Use Investors Business Daily posted at Financialzip.com.


Leon Gettler presents Banks want to change accounting rules posted at Sox First: "Here is a warning for bank investors. Banks and securities firms are hiding $35 billion of writedowns. Instead of putting this stuff on their income statements, where it will hit the bottom line, they are leaving it on their balance sheets"

And Lastly, a few posts on personal finance:

Matthew Paulson presents Save For Later or Pay it Off Now? posted at American Consumer News.

Debt Freedom Fighter presents Getting a Credit Card in College: Does it Make Sense? posted at Discover Debt Freedom!.

Dorian Wales presents The Relation between Age and Portfolio Risk – Counter Intuitive Results posted at The Personal Financier: "Should young investors really hold riskier portfolios?"

That concludes this edition. Submit your blog article to the next edition of festival of stocks using our carnival submission form. Past posts and future hosts can be found on our blog carnival index page.

Technorati tags:

festival of stocks, blog carnival.

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Einhorn speaks at Tomorrow's Children's Fund Conference

I read David Einhorn's speech at the TCF charity conference, and once again, I'm impressed.

In the first part of the speech, Einhorn goes through some thoughts on Allied Capital, recapping the trouble he's felt since 2002. In one swift analogy, Einhorn crushes the Allied naysayers:

"When I speak of investors I am including hedge fund managers. An author on
Investopedia defined hedge funds as “lightly regulated, private investment funds that use unconventional investment strategies and tax shelters in an attempt to make extraordinary returns in any market…these factors have given them a secretive and shady aura in the financial community.” Forbes has called us “The Sleaziest Show on Earth.” Basically, according to some in the media, elected officials, government regulators and individuals, hedge funds are really gambling operations amounting to ticking time bombs with secret plans to destroy the galaxy. Good thing they don’t say what they really think. In truth, hedge fund managers at their core are simply investors.

The SEC seems much more interested in whether investors share analysis, particularly critical analysis, of public filings rather than whether management teams made accurate public filings in the first place. The SEC seems more interested in whether investors discuss investments among themselves on private phone calls than in whether management teams make truthful statements on public conference calls. The SEC seems more likely to bring a case against an individual investor over a small crime than it is to prosecute a large corporation that fudges its numbers for years on end and pays out management bonuses in the millions based upon inflated accomplishments.

Imagine what would happen if a whistle-blower made a detailed public presentation
showing a hedge fund cooked its books. Under no circumstance would the immediate
focus start by investigating the accuser. How long would it take for the SEC to arrive and how tirelessly would the media investigate and cover the story? What would the chance be that the SEC would take five years to find exactly the type of record keeping violations that were alleged in the first instance and, then, inflict no meaningful penalty on the offender? How likely is it that the SEC would permit additional sales of equity in that hedge fund to new investors? How likely is it that our most prestigious investment banks would line-up to introduce that hedge fund to new capital?

Imagine if a hedge fund operated a unit that defrauded the SBA federal lending program out of millions of dollars – engaging in what the SBA inspector general would call “the largest fraud in SBA history.” How long would that hedge fund be in business?

Imagine if a hedge fund hired a private investigator to impersonate the spouse of a CEO and obtained his home and business telephone records. Imagine if after making loud, public denials, the hedge fund admitted to obtaining the records, but did not explain or apologize, or even return the stolen records, when requested. How long would it be before someone was arrested?

Of course, I don’t know of a hedge fund that has done these things. Everybody now knows that Allied Capital has. The Allied situation persists only because of lax regulatory enforcement and Wall Street’s continued willingness to sell new shares to unsophisticated retail customers."

The speech then moves to his newest target: Lehman Brothers (LEH), the august investment bank that once was a large part of American Express, until its spinoff in 1994 (profiled in You Can be a Stock Market Genius).

Einhorn's thesis is that Lehman, who many talking heads have praised to this point for avoiding the death blows of billion dollar write-downs, is not being honest with its shareholders.

There's a pretty simple, indicting, underpinning of the Lehman short: on $6.5B in CDO exposure they showed in Q1, they took a grand total of $200mm in write downs. That comes to a meager 3%. In a credit environment where CDO's are being sold for .20 on the dollar in some cases, is it honest accounting to show a 3% loss? Are Lehman's CDO's so well built that they are holding up in this environment like no others have?

The short answer is "of course not." Q2 probably won't be very pretty for Lehman the company, and with the cat now out of the bag, the same goes for Lehman the stock. When the write-downs inevitably come, not only will angry shareholders probably sell, new questions will be raised. What else do they have that they are not telling us? Will they need to raise capital?

Secondly, Lehman seems to show some signs of "Allied Capital Syndrome," the mis-valuation of illiquid assets. It wrote down its "Level 3" assets, those with no ready market, a mere 3% again. Einhorn says comically:

"In the real world, illiquid assets carry a discount. In the current melee the opposite seems true: illiquid assets are more valuable because it is easier to convince the accountants that they have not declined in value compared to liquid assets where there is more transparent pricing data."

If you're a Lehman shareholder, I'd advise you not to stick around and find out the results of this potential disaster.


Disclosure: No position.

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Einhorn Interview on TheStreet.com

Here's a cool interview with David Einhorn by TheStreet.com on Allied Capital (ALD) and its devious ways... one I thought you guys might enjoy viewing. To this point, nothing about the man has struck me as fake or deceptive, and it's a shame that honest, analytical individuals like Mr. Einhorn are vilified in the general media.

More recently, the publicity of the book has gotten Mr. Einhorn some positive reviews as people delve into the story. It's nigh impossible to read the book and conclude that Mr. Einhorn is the greedy, profiteering short-seller that Allied Capital has led the public to believe since 2002.

Don't be deceived by the recent positive press he's gotten, however; up until this year, Einhorn had gotten nothing but flak from the media, ALD shareholders, regulators, and the company itself. Their main argument: Einhorn was lying to manipulate ALD's stock and push it down for personal profit.

I only highlight this story on CoC because I truly believe that people with integrity should be respected by the public. Instead of giving a logical refutation of his analysis, naysayers have chosen to attack the weak link: motive. Ignoring the anti-semitism that is part of this story (in this writers opinion), it pains me to listen to ad hominem attacks from people with limited knowledge of the situation (read: ALD and Einhorn, MBI and Ackman).

If you've read the book, you know exactly what I'm talking about. Because Einhorn had the motive to manipulate ALD's stock, well by golly he must have been doing it! Shareholders actually believed this line, because all the while ALD has kept paying their regular "dividend," a tax distribution fueled by capital raising that is akin to a modern day Ponzi scheme. In the meantime, the real issues of portfolio mis-valuation and corporate corruption have yet to be addressed in any substantive way. Nothing holds up in the court of public opinion quite like motive.

To this day, Allied maintains:

"Allied Capital finds it ironic that Mr. Einhorn claims to be speaking on behalf of shareholders' interests, when he continues to work against those interests and may profit from declines in the company's stock price,"

What's actually ironic is that Allied Capital claims to be speaking on behalf of shareholders when they have been profiting though salaries and bonuses for years while shareholders are defrauded and wronged. What's ironic is that Allied Capital has the gall to personally attack Mr. Einhorn while not too long ago they condoned the theft of his personal phone records, a practice called pretexting.

Eventually, I believe Einhorn will be vindicated, and shareholders will suffer. As it stands, he won't make a dime of off Allied's demise (all the profits of the ALD short will go to charity), so there goes motive, folks.

Charles Ponzi was able to profit for 3 years of off postal and mail fraud. How long will Allied Capital last?


Disclsoure: No position.

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LG focuses on ROIC

I put up a new Reflection this evening on the use of ROIC metrics to improve and value an organization. Go over to Reflections on Value Investing and enjoy.

Here's an excerpt:

Warren Buffett has made it clear that Return on Capital is one of the most useful metrics in evaluating the strength of a given company.

In an interview with the WSJ, LG CEO Yong Nam talks about how an organizational shift to ROIC thinking has improved the organization.

WSJ: What is the biggest change you've made in the operation of the company?

Mr. Nam: We changed the criteria for employee and management performance to return on invested capital rather than revenue growth. We have tried to make every individual in the organization sensitive to shareholder value. We introduced performance metrics as well as a signal-lighting system -- green, yellow, red -- so that everyone understands where they stand. We are also providing necessary financial information to them so they can make their own decisions.

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Primus Investor Presentation Out

Just a quick note for you guys today: Primus (PRS) presented at a Lehman Brothers Investor Conference this morning and they have posted the webcast from the event, along with their supplemental Powerpoint (32 slides), on their Investor Relations Page.

If my last post on the company interested you at all, I'd highly recommend you read the presentation and/or listen to the webcast. The presentation is full of some wonderful graphics and management's own thoughts on the company.

One slide alerted me to a fact that I didn't even consider in my valuation: if you adjust that $9.58 in BV for unearned premiums, the potential value of the company goes up above $18.

Regarding Unearned premiums, Primus is basically saying that they have written contracts in effect that will provide them with about $9/share in future premiums (or "fees" as I called them in my previous post). Once Primus provides credit protection for the given time period, they are allowed to recognize the corresponding fee revenue.

Here's how the journal entry would work there, for you accountants. A liability carried that will be taken down with a debit as the revenue is earned with a credit.

So, as Primus earns the revenue (provides protection for time period "x"), they will record this entry:

DR: Unearned Premiums xxx , CR: Premium Revenue xxx

The unearned premium account decreases with a debit, thus book value increases, and Primus recognizes the revenue in the income statement with a credit.

Thus, the economic book value of $9.58/share is probably understated relative to the future. It's more likely somewhere in between $9.58 and $18.50, without any growth in written business.

Slide 4 of the presentation has the numbers on unearned premium and book value.


Besides all that good stuff, the presentation is absolutely worth a good look; you can get a better feel for the company and hopefully more comfortable with the numbers.


View the presentation here.

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Buffett Opens Europe in Frankfurt, Switzerland

On Monday, Buffett held court at a press conference in Frankfurt, Germany to begin his trip through Europe. He commented on buying great businesses, European acquisitions, and the real purpose of his trip. As always, he was in good humor and dropped many investing gems.

Watch the Video Here

On Tuesday, Buffett's news conference moved to Switzerland, where he discussed further his thoughts on investing in Europe and whether or not businesses will sell to Berkshire in the future. The three part video clip is below.

Watch the Videos Here

Originally posted by myself on Reflections on Value Investing

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Another Attack on Eddie

I read an article called "Sears majesty to hedge-fund dust" at the behest of a reader on the gurufocus message boards, and I have to say it is one of the most uninformed and incomplete articles I've ever read. There are so many misguided and shallow statements that it's hard to know where you'd even start to refute the allegations. Before you read my refutation, please read the article for context. Please read my refutation through before commenting.

I’ll start with a quote from the article, and continue on down from there:

“But as all readers of this site well know, things sure changed in 2007. Many of the hedge fund strategies that paid off like slot machine jackpots in the previous two years, such as huge heavily leveraged bets on subprime mortgage paper, came up lemons last year.”

Leveraged bets on subprime mortgage paper? What on God’s green earth does subprime mortgage paper have to do with ESL Investments? While this reporter basks in the failure of many hedge funds last year that were doing things extremely far removed from what ESL does, I question if he actually looked at any other ESL investments outside of Sears and Citigroup. If he did, then it’s a classic red herring argument fallacy; he is using irrelevant information that doesn’t have anything to do with the argument at hand.

“In reality, what has been happening with both Kmart and Sears during the Lampert era was that the operating expenses for both entities have been cut to the bone, in order to free up the billions that Lampert would use for hedge fund speculation at ESL.”

Hedge fund speculation? This statement had to be the most egregious of the bunch. Lampert was “freeing up billions” to reduce Sears’ debt, make over a billion in capital expenditures, and buy back shares for Sears at advantageous prices. I’d hardly dub that “hedge fund speculation.” Here’s what Eddie spent the money on last year alone:

"Finally, our cash flow generation remained strong as we generated $1.6 billion of operating cash flow in 2007, which exceeds the $1.4 billion generated last year. We ended the year with $1.6 billion in cash, as we deployed $4.3 billion in 2007 as follows:
• $2.9 billion for share repurchases;
• $600 million for net reductions of debt;
• $580 million for capital expenditure reinvestments in our business; and
• $220 million contributed to our legacy pension obligations."

Here’s another gem from the article:

"Somewhere along the line, America got the idea that the buck generated from financial services, from manipulating money, from passing it from hand to hand, was equivalent, or even superior to (after all, you come home with a lot better smelling clothes after a day on the trading floor compared to a day at the steel mill) the same buck made actually making and sustaining something - such as the great brand Sears once was. "

Just another terrific statement: The great brand of Sears is being destroyed by evil profiteers like Eddie Lampert. This kind of populist grandstanding really grinds my gears, because you can’t just pretend like profit-motivated capitalism doesn’t exist. While I agree that financial engineering doesn’t create anything, that’s simply not what Eddie is doing, as we just saw from the cash uses. From reading this article, you’d think that Lampert came in with Michael Milken’s junk bonds and pulled off a hostile LBO on Sears so he could sell off all of its assets to pay down the debt. Capitalism is change, and Sears is no longer the respected retail brand it once was. Get over it.

ROI

The real tragedy is that people still don't get what Mr. Lampert's strategy is, what he's actually doing over there at Sears. The economic concept called return on investment. Why is it such a crime that he chooses to invest dollars where he'll find a compensatory return? Reducing debt, buying back shares, reducing pension fund obligations; those are the surest returns right now, as Lampert has pointed out time and again.

This reporter insists that Lampert is "bleeding Sears dry." What he’s actually doing? He's putting the most money where the highest returns are. Right now, those returns are simply not in the brick and mortar retail business. Might they be in the future? Sure. They're working on it. As a side note: There is a computer system Sears uses that tracks every little piece of information, inventory piece, and dollar in Sears’ stores. Gee, guess who is the number one user? Lampert. Imagine Eddie waking up one day:

"Oh, geez, if I just stopped bleeding Sears dry for hedge fund speculation, all that money could revive the brand! Then our same store sales would go back up! It's just that easy!"

People need to wake up and read what he's writing and hear what he's saying instead of pushing their own shallow views upon the situation. The once-powerful Sears brand was on the decline when Eddie got there, and he'll try his mightiest to reverse that but there has to be a return on dollars invested. A corporation is run on the behalf of shareholders; not management, customers, or the employees, as the reporter seems to imply. While neglecting those last three will not benefit your shareholders, I promise you that much, the shareholders are the ones with capital at risk, and thus where the focus of the corporation lies.

In the meantime, how’s he doing for his shareholders? In 2003 the stock price was $14. The current price is $95. That’s a return of 47% annualized over the holding period. Even if you didn’t get in until mid 2004 with the stock in the 70’s, you still would have made 2.5x your money by the beginning of 2007, and could have sold for a mint. So I’d say he’s done pretty good for the shareholders, regardless of what current critics say.

For Eddie Lampert to choose to withhold dollars for their highest return is his choice as by far the largest shareholder, and additionally, Chairman of the Board. It’s his (and his partners') capital at work. Why don’t we ask these people who write so critically to put up their capital and turn the Sears boat around? We'll see what they're writing then. Until then, I leave you with some common sense from Eddie on investing in stores vs. investing elsewhere:

“Let’s look at a hypothetical example. Imagine that we invested $200 million to remodel or improve 100 stores, or $2 million per store. If the store profitability after that investment is exactly the same as before, then the $200 million investment generates 0% in return. By simply keeping our money in cash, we could have earned anywhere from 3-5% over the past several years, which is better than the 0% return in this case.

The related question then becomes: why can’t you find ways to invest in your stores that generate an acceptable return? That’s exactly the problem we have been working to solve and we will continue to work until we solve it. Until then, we will seek to be responsible with our shareholders’ capital and to make decisions based on the results of the portfolio of tests that we have in process at any point in time."

Disclosure: I own shares of SHLD.

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Primus Guaranty: Prime Value

Since all of my readers know how successful my past forays into financial institutions have been, I’d like to introduce you to another today, a company called Primus Guaranty (PRS). Primus’ main line of business is selling credit default swaps (CDS) to institutions needing to hedge their corporate bond portfolios, and their market value is about $215mm. They call themselves a CPDC, or credit derivative product company.

“…thus our derivative positions will sometimes cause large swings in reported earnings, even through Charlie (Munger) and I believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter and we hope you won’t either….we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run.”

-Warren Buffett

The Business

When I look at Primus Financial, I see an insurance company, for all intents and purposes. We'll take Citigroup as an example. Citi owns billions of dollars in corporate bonds, all placed nicely on their balance sheet collecting interest payments year after year. However, were any of these bonds to default, Citi would be on the hook with potentially worthless bonds, or if not worthless, severely impaired.

This is where Primus comes in. For a quarterly premium, Primus will say to Citi, “We’ll take that risk off your hands. Pay us 70 basis points (0.7%) of the principal value every year and we’ll pay you the full value of your bonds in case they default, and you can hand over the bonds."

Now, obviously this fee will vary from company to company (or Reference Entity, as Primus refers to single companies). If you are selling protection on Berkshire Hathaway, the fee is tiny, maybe 30 bps on a normalized basis. If you are selling protection on Circuit City, the fee is probably much higher, maybe 130 basis points (I’m using hypothetical numbers). Thus, Primus is offering insurance on the default of institutions.

Not only do they offer insurance on single companies, they also do business selling swaps on tranches, or a large swaths of corporate bonds. So for a fee, again, Primus might insure the risk that a $10mm pool of GE, BRK, MSFT, AAPL, and RIMM experiences a credit event. Generally, a “credit event” is bankruptcy, default, or restructuring. Most importantly, Primus holds these contracts to maturity; they are not trying to profit off of trading gains and losses.

The Swaps

To give you a little insight into their swap portfolio, the weighted average S&P rating of the companies in their portfolio is an A, with 97% of the total being investment grade or higher. Their total swap portfolio is $24.3B in notional amount, $19.5B being single names, and $4.7B being tranches, with a very small amount of CDS on Asset Backed Securities.

The great thing about the business is that Primus, with its “hold to maturity” approach on these contracts, is never required to put up collateral with their counterparties, no matter how much value the contracts lose. As such, Primus’ swap selling subsidiary is rated AAA (Aaa) by the rating agencies, and is a counterparty of the highest quality. Scaling up to a ‘AAA’ rating isn’t easy, thus providing Primus with stability and a nice competitive advantage.

The Other Stuff

Primus is no one trick pony, folks. While the vast majority of their capital is tied up in the swap business, they also are beginning to build an asset management business as well. At March 31, they currently have $1.6B in assets under management. They manage a few CDO’s, and a few CLO’s as well. But Jeff, CDO's are toxic waste! Well, that doesn’t matter for Primus; they are merely managing the CDO’s not investing in them, and they receive management fees for doing so. The total capital they’ve put into the CLO’s themselves? About $14mm.

This is still a small part of the business but according to management, it is one they are trying to build. We’ll see where it goes, but for now in the 1Q management fees only accounted for $1.1mm of revenue.

The Manager

The fella’ who runs the joint is Chairman and CEO Tom Jasper. If there is a respectable person out there running a business in swap selling, it is Tom Jasper. Mr. Jasper is one of the legends of the swap business; he helped create and run the ISDA: the International Swaps and Derivative Association. Mr. Jasper is also an inductee to the Risk magazine hall of fame. I like it when my managers are in the Risk Hall of Fame, like Mr. Jasper, rather than at home eating potato chips, like Merrill Lynch’s former CEO Stan O’Neal.

Another attestation is from Tom Brown who runs a hedge fund called Second Curve Capital and the terrific website, Bankstocks.com. I mentioned Tom in my article about First Marblehead. Tom wrote up an article refuting Primus’ critics a few months back, and gives some great information on the company, I highly recommend reading it. In the article, Mr. Brown says of Tom Jasper:

“I’ve met many, many CEOs over the past 30 or so years, and would rank Tom Jasper among the very top, especially as regards his integrity, business prudence, and conservatism.”

One more thing I liked about Jasper was that even though he began to creep into selling CDS on asset backed securities, which went bad, he did it very, very slowly. The peak notional value on CDS of ABS was only $80mm, peanuts compared to their corporate stuff. Unfortunately, half of those were downgraded below investment grade, and the company was hit with a “credit event” at the end of last year, which hurt their economic earnings. But they are out of that business completely with just a bruise to show for it.


The Irony

The funny thing about Primus, and the way the market looks at it, is that as their GAAP numbers get worse, their business is probably getting better. How the GAAP numbers work is such: Primus must “mark to market” their unrealized gains and losses on swap contracts. Thus, as credit spreads widen (read: recently) their swaps lose value at market, thus making their GAAP earnings and book value horrendous. As an example, they lost $14.85 a share in the first quarter according to their income statement, but I’d argue the business is better than ever.

From the end of last year, to the beginning of this year, spreads widened so deeply that even on AAA rated entities like GE, Primus was writing business at unbelievable spreads! If they were getting 35 bps for insuring GE in August 2007, by January they were getting 70 bps instead. Has GE gotten that much worse? ‘Course not.

The company has a habit of increasing the credit swap business as spreads widen, as they have in the past 6 months, and decreasing activity as spreads come back down. Check out this chart to see what I’m talking about. As the CDX index went up (thus indicating widening spreads), their CDS volume followed suit. Seems pretty smart, eh?

So I mean it when I say, as the GAAP numbers get worse, the real numbers are probably improving. That creates a buying opportunity for those willing to look at the economics of Primus’ business.


The Valuation

Ok, so you know the business, you know the manager, you know why business is good right now. What is Primus worth?

The answer is: I can’t give you an exact value. I can, however, show you how cheap it currently is, and you can decide for yourself. The first you thing you have to do, however, is look at the real numbers that show the business’ value, rather than the GAAP numbers which mean Squanto.

In their annual and quarterly reports, Primus gives a reconciliation of GAAP to what they call “economic” earnings. In doing so, they add back the unrealized gains and losses, and add back realized gains on swaps sold before maturity. They then amortize those gains over the remaining life of the contract, so those gains get added back eventually. The main thing here is that mark to market losses, which are meaningless, get added back.

Looking at the numbers this way, Primus earned $1.20 a share last year on a normalized basis (excluding the one-time CDS of ABS credit event), and $.49 a share in the first quarter. The current stock price is about $4.75. That’s about 4x last year’s earnings, 2.5x earnings if you do a run rate on their 1Q earnings: Cheap.

Another way to look at is through economic book value. This, again, adds back those pesky marks. Their Economic Book value is about $9.58 a share.

So we have a company in its sweet spot, with a fantastic manager, selling at 3-4x earnings and half book value. I like what I see.

The Risks

I can’t give you all the roses without a little blood, however. The company has risks in that if their corporate Reference Entities experience default or bankruptcy, the company is on the hook. The company has about $800mm in capital supporting the $24.3B in swaps. Thus, the company has to be careful in its risk management. This is the main focus of the company, luckily for us, and with Tom Jasper’s history I am confident that they are keeping a close eye on the companies and tranches they’ve sold swaps on. Not in their 4 year public history have they experienced a credit event on a corporate bond.

If a company does begin to deteriorate, I believe Primus would begin cutting their losses early by selling the swaps at a loss, rather than experiencing defaults and having to pay out. This practice would hurt earnings near team, but keep them from having to make massive payouts. In this case, you have to like the portfolio being 97% investment grade bonds; bonds that rarely default.

In an added note, Primus doesn’t take too much counterparty risk because it in all essence they are the major counterparty. If one of Primus’ customers were to go under (unlikely, since Primus deals with major global financial institutions), Primus would merely stop receiving premiums. Again, this might hurt earnings but Primus itself would be fine.

Conclusion

Primus is a company that I like; very simple for a financial institution, and I feel that I understand the balance sheet and economics of the company. There’s no off balance sheet entities, CDO investments ready to go bad, or black box financial statements I don’t comprehend. Mostly, Primus just is just getting cash for insuring bonds against default, and that’s it. Best of all, they get paid in cash. I like cash.

You can download my spreadsheet of Primus' numbers here.


If Primus interests you, I recommend you get together all of their filings and read up on the business and get to know the numbers yourself, rather than take my word for it. I could easily be wrong, or have missed something, so get comfortable with everything on your own.

Disclosure: I am long Primus Guaranty.

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Buffett Reflects on Great Business: Rising Prices Equal Rising Profits.

Buffett has reflected many times on the workings of a great businesses. In looking at the transcripts of his speeches to students, this theme and many other recurred. I put my first post up at Reflections on Value Investing today with some Buffett quotes and two terrific transcripts of his talks to MBA students at Notre Dame and the University of Florida.

Go over to Reflections and enjoy.

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What do Buffett, Pabrai, and Jim Rogers Have in Common? They Look For the Obvious

It sounds crazy that Warren Buffett and Jim Rogers might have something in common besides intellect and wealth. Buffett has owned the Washington Post for 35 years, Coca-Cola for 18 years. Jim Rogers owns exotic commodities and currencies, usually leveraged up to the hilt, and was once partners with the most famous speculator in the world, George Soros.

However, I’ve now read enough about Rogers where I see some terrific parallels between his approach and that of Mr. Buffett.

What’s the major parallel? They are looking for simple, painfully obvious investments. Buffett has said it over and over: a great investment should be apparent very quickly.

When you feel like you are shooting fish in a barrel, your thesis is going to be simpler and more understandable, and thus more likely to work out. The obvious ones are the best ones.

Often times when I say such things, people respond by saying “But if it’s too simple, you might be missing something!” Ah, but this is flawed thinking, and skews the idea of making investments simple: you still have to do all your homework, but the final thesis should be a few sentences. It always kills me when I hear these investment ideas; so convoluted and over analyzed that there is no possible way all of the moving parts I hear can be satisfied. It’s just not simple enough.

The great investors know their holdings like the roads leading to their house: eyes wide shut. Eddie Lampert has described his process as “Zen-like” focus, and his scuttlebutt research is legendary. Buffett can fawn on for hours about the history of Coca-Cola, or the Washington Post. David Einhorn probably knows more about Allied Capital than the people who run the place.

But their great investments are simple, obvious, and deeply discounted from their true value. Heck, Buffett’s Post investment was selling for $80mm when its liquidation value was north of $400mm! How many tabs do you need in your spreadsheet to figure out that you’ll make a ton of money there?

Instead of telling you myself, I’ll let you read some things Buffett and his disciple Mohnish Pabrai have said:

Q: In your letters you speak frequently of the importance of not over-complicating things. What are your secrets to keeping your life simple?

Buffett: When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in. Big money is made by obvious things. If using a discount rate of 8% vs. 10% is going to make or break an investment idea, it's probably not a good idea.

At a Berkshire Annual Meeting, someone comments on discounted cash flow modeling:

Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one."

"It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close."

In a talk with Wharton Students in 2003, Buffett reflects on the “obvious investment” approach:

"I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out."

Mohnish Pabrai responded in a similar way when asked about his successful investments.

Question: Would you say that in your experience, your best investments have been derived from some obscure "hidden" asset value you find in an investment or from some traditional valuation measures?

Mohnish Pabrai: The best investments are total no-brainers that can be explained in a short paragraph or two. They are obvious investments. The more words and spreadsheet cells it takes to layout the case for an investment, the worse it’s likely to do. Frontline was obvious. Stewart Enterprises was obvious. Level 3 was obvious. Pinnacle Airlines was very obvious. More recently, Ipsco was very obvious and that was nearly a 300% return in less than 2 years.

Knowing this, I was re-reading some passages from a book I enjoy: Market Wizards, Interviews with Top Traders, one of the interviews being investing legend Jim Rogers. Rogers and George Soros were partners in the 70’s, and after a rough breakup Rogers has been managing his own money since. He’s been compounding at incredible rates for 40 years, north of 30% by some accounts.

While he has a different range of investments than most investors, he’ll just as likely invest in Malaysian Palm oil as General Motors, he has a laser like focus on finding investments that simply can’t lose; ones where the economics are too right to be wrong.

Mr. Rogers’ quotes on investing in Market Wizards are investing gems:

It sounds like you have a great deal of conviction when you put on a trade.

Yes, I do; otherwise I don’t bother doing it. One of the best rules anybody can learn about investing is to do nothing, absolutely nothing unless there is something to do.

Do you always wait for a situation to line up in your favor?

I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime. Even people who lose money in the market say, “I just lost my money now I have to do something to make it back.” No, you don’t.” You should sit there until you find something.

Going from ground zero in Sep. 1970, where did you start picking up tradingwise to build up to your ultimate trading success?

My early losses taught me a lot. Since then – I don’t like to say this kind of thing- I have made very few mistakes. I learned quickly not to do anything unless you know what you are doing. I learned that it is better to do nothing and wait until you get a concept so right, and a price so right, that even if you are wrong, it is not going to hurt you.

And lastly:

If you were counseling the average investor, what would you tell him?

Don’t do anything until you know what you are doing. If you make 50% two years in a row then lose 50% in the third year, you would be worse off than if you just put your money in a money market fund. Wait for something to come along that you know is right. Then take your profit, put it back in the money market fund, and just wait again. You will come out way ahead of everybody else.

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Fooling Some of the People All of the Time

I finished David Einhorn’s investing “novel” Fooling Some of the People All of the Time this afternoon, and I have nothing but praise. I mentioned here that I’d write up a quick review, so I’d like to do just that.

The Story

In the early chapters, Einhorn does a great job introducing us to himself and the beginnings of his firm, Greenlight Capital. He talks of his early years working as a hedge fund analyst, the launch of Greenlight with a colleague, as well as some of their successful early investments. I have to say that I really enjoyed this part of the book, and if I had one complaint about the story, it's that Einhorn mostly leaves behind the descriptions of Greenlight’s progress and investment performance once he launches into the story of Allied Capital, because it makes for terrific reading.

Once Einhorn gets us through the early years of Greenlight, he introduces the Allied Capital saga; it’s at this point that a story of greed, fear tactics, and misperception begins. Not only was the story engaging on its own merit, Einhorn and Greenlight were absolutely put through the ringer for the past 6 years, but the book was full of lessons in investing, accounting, and human misbehavior.

If you aren’t familiar with Allied (ALD), they are structured as a business development company (BDC). Generally they make mezzanine loans, senior to equity but subordinated to long-term debt, to small businesses private and public. Greenlight originally identified Allied as a short based on their shoddy valuation processes: often a company they invested in became nearly worthless but they carried their loans at full value because they claimed the company might recover in the future. They found over time that not only did Allied mis-value its investments, thus violating GAAP treatment of fair-value accounting, but a major portfolio company called Business Loan Express had engaged in SBA loan fraud for years.

What I found really interesting was the amount of time and effort the Greenlight team put into the investment, which never represented more than 8% of their portfolio to this day. From originally building an entire database of the company’s loans and investments, to digging into obscure regulatory filings, to talking with anyone who would give them the time of day, Greenlight put new meaning to the words “due diligence” in my mind. I’m reminded of the Bloomberg article about how Bill Ackman was charged $109,000 for photocopying and printing documents related to MBIA research.

Speaking of Ackman, the Greenlight story is all the more interesting in the context of Ackman’s recent battles with MBIA and Ambac. While Einhorn was bringing Allied’s shoddy accounting and poor regulatory oversight to light, Ackman was doing the same with the bond insurers. Unfortunately for Mr. Einhorn, Ackman’s investment has worked out great while Einhorn is still about even.

Poor Regulators Galore

Einhorn brought all of these fraudulent transactions, poor valuations, and shoddy accounting practices to several different regulators over a 6 year period, yet the company remains perfectly viable even today! It’s scary to think that SEC and SBA regulators could do so little with so much evidence in front of their faces. In fact, not only did these regulators not punish Allied with more than a slap on the hand, they investigated Greenlight on market manipulation!

Einhorn points out that in our culture, short sellers are often portrayed as villains; market manipulators out to bring down good people for profit. In reality, short sellers often do just as much in depth analysis as long only investors, sometimes more so, and are not manipulating the market any more than a long investor who presents his favorite stock idea with fervor. Going short doesn’t push a stock down any more than going long pushes a stock upwards. Why can’t short sellers accentuate their theses just as passionately as long investors?

The real story of the book, though, is the gutless regulatory system and the absolutely clueless Wall St. analysts who cover Allied. The regulators have backed down time and time again, incentivizing Allied to continue its horrendous accounting practices, and incentivizing their subsidiary BLX to continue its fraudulent loan practices. The Wall St. analysts haven't been willing to do the necessary work to uncover the fraud behind management's comments, and I believe the shareholders will eventually suffer.

OK, but what about those investing lessons?

From purely an investing standpoint, there was much to be learned from the book. Not only does he outline Greenlight's approach to value investing, Einhorn takes us step by step through Allied’s misleading accounting practices, and I learned an amazing amount about proper accounting and how to detect when accounting practices are poor.

The key here for investors is that one must read SEC filings and management discussions with a very skeptical eye on differences between the true economics of the business and the numbers presented. Not only does this give you a much better sense of the business itself, it can help you spot fraudulent accounting or bad business practices while they occur. Reading the book, one gets a sense the Einhorn and his team aren’t merely investors, but forensic accountants looking to spot gaps and inconsistencies that can be used to gain insight that the market is missing; long or short.

Conclusion

I’d highly recommend any investor or business person pick up Fooling Some of the People All of the Time and read it cover to cover. Like any great investment idea, this story is a real no brainer. Einhorn uncovered some bad, bad things, and the people doing them were willing to spare no cost preventing the truth from surfacing. He stuck with it for years, and now the whole story is out there for anyone interested.

I hope the shareholders and regulators of Allied Capital eventually do the right thing; but until then, we can only revel in the power of incentive-caused bias and its ability to sway people down some dark, dusty roads.


See Einhorn’s site dedicated to the story
See Einhorn’s speech “Private Profits and Socialized Risk”
Buy the book

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Jaclyn, Inc.: Success

Update May 23: Cash Received, JLN transaction officially closed.


I just wanted to give everyone a quick update on the Jaclyn transaction. My shares were taken from me this morning, and "submitted for cashout" to JLN. According to my broker, they are merely waiting on a cash out date, which should be sometime in the next few weeks.

I bought in at $7.82 / share, and I should receive 10.21/share in due course. That's a gain of 31%, in about 50 days of holding (assuming I get the cash in two weeks). That comes out to a whopping annualized gain of 226%.

I wish these came along more often, but alas they do not. Most of the time, these arbitrage spreads will be much narrower, and their prospects much more uncertain. Jaclyn was a rare case of a very big spread, a short holding period, and a high probability of success. It could only be taken advantage of by very, very, small holders of stock as well.

Quoting Yogi:

"When you come a fork in the road, take it."

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Joining Reflections

I just wanted to update everyone quickly on a great new situation for me. I've been invited by the current contributors of Reflections on Value Investing, a terrific site that features "Reflections," stories of interest to the value investing community, with excerpts and a link to each interesting item. The site was started by Shai Dardashti, who runs Dardashti Capital Management, and has some wonderful other contributors.

I'm flattered to be invited to join them, as they are all much smarter and more experienced than I am!

So, I'll be posting my "Reflections" both here as well as over there, so you guys can keep track. Most of my writings will still be exclusive to Circle of Competence, but a few will go over to Reflections as well. I'd highly recommend you all add the site to your RSS feed and read all the amazing links the folks over there post.


On another note, I'm almost done with Fooling Some of the People All of the Time, and it is quite a story. I'll give the full scoop soon.

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First Marblehead Update

First Marblehead released their earnings for their FY 08 3Q (their fiscal years run summer to summer) on Thursday. As I expected, the numbers were not pretty, but I actually saw some things I like in there, and their balance sheet remains viable. Read my original take on First Marblehead here.

Here's the Deal

First, the actual earnings: the company lost $229mm on a GAAP basis, compared to a $71mm profit last year in the same quarter. Like I said, ugly. The TERI bankruptcy forced them to write down the value of their residuals to the tune of $315mm on a pre-tax basis. Service receivables (the residuals) on their balance sheet declined from $809mm to $467mm YoY, putting their book value at March 31, 2007 at around $700mm.

If you remember from my last article, the Goldman Sachs equity capital infusion is limited to 25% of FMD's book value, so based on these numbers the investment is going to cap at $173mm. According to management, there is approx. $162mm in unrestricted cash on the balance sheet and the Goldman investment, when completed, should bring that number up to $300mm.

With those cash numbers in mind, management said on the earnings call that with their newly announced cost reductions should put operating costs at an annual run-rate of $100mm. Great, right? Well, before we get excited, remember that those are just operating expenses – this number does not include loan origination costs at their bank subsidiary, as I mentioned in the last article. In order for them to continue originating student loans, FMD will really need to find a new warehouse line. Their existing one is about tapped, and the Goldman line that was promised is no longer available.

Looking at the bare-bones economics, FMD should have some sort of future revenue stream available to it; student loan originations are insane for them right now:

“Overall loan facilitation volume for the quarter was $1.25 billion up 23% over last year. The volume was significant given the underwriting changes. On a year-to-date basis volume was $4.7 billion up 37% over prior year.”

The question remains: how will FMD continue to fund these loans in a way that is economically beneficial? Right now, it is obvious that their funding costs are too high to allow them to make any real money originating and holding the student loans at their subsidiary bank. That is, the “spread” between their funding costs on the loans and the coupon the loans pay isn’t so hot as of now. This is a common problem with student lenders in this environment; but luckily for Sallie Mae the government seems to be coming around to a solution for originators of federally backed loans. No help for FMD; they only originate and sell private loans with no government backing, so no matter what the government does or doesn’t do, FMD is in a mighty pickle.

FMD (and other lenders) used to be able to get around this funding problem; once their warehousing lines got full they could package up the loans and sell ‘em off to Wall Street for a hefty profit. Problem is, lots of that “profit” was merely accounting profit; the present value of expected future streams of cash that FMD hadn’t yet received. They were victims to assumption bias, and the level of cash earnings was much less than reported earnings.

Now, we can sit and debate their assumptions on prepayment rates, defaults, and the like but it’ll do us no good: obviously FMD made some wrong assumptions. With all of the write downs in the past few quarters, and the bankruptcy by TERI, there is no doubt that the assumptions they originally made were off. Whether it was because they didn’t expect this credit disruption, or they just flat out were too optimistic, FMD overbooked earnings in previous years. Wish I had seen it then.

What to do?

So, what’s still there? The company has $500mm in loans held for sale, $467mm in residuals, and $291mm in cash on the balance sheet. Book value is $700mm. With a market cap around $350mm at this time, price to book is a mere 0.5. While cheap on a quantitative basis, that number can be misleading: FMD will never show a higher market value unless they begin to generate serious cash earnings.

Management talked a lot on the earnings call about the future, but most of it was hopeful and theoretical. They “want” to generate cash flow near term. They "plan" to be profitable long term. They are “selling” new structures to their remaining partners (major ones are RBS and Chase) in hopes of a securitization in the future. All these things sound great; but in the end the proof will be in the pudding and there’s no chocolatey goodness yet, folks.

The company has enough cash to function for another year or so, it looks like, so I continue to hold my investment. I’ve come to terms with the fact that even if the company begins to recover in the next year or so, and the stock rises, I’ll still be deeply underwater. If I had a personal balance sheet, I’d be marking down my FMD “asset” due to permanent capital impairment. With that said, I still believe future intrinsic value is higher than the current market value, and management has some options to create value. At $3.50-$4.00/ share you basically are getting a cheap call on future improvement. If you could wrap your head around the economics of the business, an investment at these prices wouldn’t be the worst idea in the world, although there is probably more certain payoffs out there right now.

Other Stuff

In other news, I began reading the Einhorn book I mentioned here. So far it is fantastic; everything I expected and more. I’ll be sure to get a review up in the next week.

I’m also planning to write up another financial company that I currently own, a name I have much, much more confidence in than FMD or any of my past forays into the financial arena. This is a company that sells credit default swaps on corporate bonds, and holds them to maturity. I’ll explain why that line of business is in its sweet spot right now, and the company that can (and has been) taking advantage of it. To top it off, the stock is cheaper than dirt. Stay tuned.

Lastly, Berkshire weekend was last week, and there are some fantastic transcripts of both the meeting and the Wesco meeting (held by Charlie Munger) up at Reflections on Value Investing, so check 'em out.


Disclosure: I hold a position in FMD

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Of Toads and Princes: The Yahoo! Deal Falls Apart

I’d like to focus CoC mainly on intelligent investing topics- stock analysis, mental models, margin of safety and the like. That’s what we here at CoC love most. With that said, I can’t resist a comment on this Yahoo!-Microsoft nonsense.

My first reaction when hearing about this potential transaction was…huh? Take a terrific business, one of the best on the planet in Microsoft, and spend $40 billion on the competitively-disadvantaged Yahoo!?

Tell me this: if I’m a Microsoft shareholder, holding this absolutely wonderful business selling at a discount to its true worth (in my humble opinion), would I rather see the company take its $40 billion cash hoard and buy back a huge chunk of stock, or would I like to see them buy Yahoo!, a company that seemingly has no discernable competitive strategy or advantage? Think of it this way: you could spend $40 billion on a wonderful business selling at a good price (MSFT), or spend $40 billion on a very expensive business that is thoroughly dominated in its main market (YHOO)?

To me, this is a no-brainer: buy back stock. Count me a skeptic that a mega-merger such as this would work out. Does AOL Time Warner come to mind for anyone? Citigroup? Boston Scientific? I’m a show-me guy, and M+A success on this scale has not proven successful in the past. Show me the history of companies spending $40 billion or more to buy a business at 60-80x earnings. It's not pretty.

Get in this house right now Steven!

Why does Steve Ballmer think this time is different? Not only that, but rumors of an advertising deal between Yahoo! and Google have been floating around for months. Would you want to buy a business that is almost about to partner with the very company you are trying to compete against?

I’m often reminded, in these situations, by Warren Buffett’s likening of major corporate purchases to fairy tales:

“In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We've observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses -- even after their corporate backyards are knee-deep in unresponsive toads.”

From a capital allocation standpoint, I can’t see buying Yahoo! at 60x earnings being smarter than buying Microsoft at 16x earnings, regardless of how fast you think Yahoo is growing revenues. I just don’t see it. If you really are worried about Google, trying to be a hero by buying Yahoo! just won’t do it, I’m sorry. Google dominates Yahoo! in every conceivable category, and I can’t see Microsoft making any difference there.

To me, Microsoft trying to “catch up” with Google in search by buying Yahoo! is like Pepsi trying to catch up with Coke in soda by buying RC Cola. It ain’t gonna cut it.

Those Yahoos over there at Yahoo!

From Yahoo!’s side, I see some behavior that is equally asinine. The deal ultimately fell through because Yahoo! thought it was worth $40 a share. $40?? Yahoo! earned an average of less than .50/ share in the past two years, meaning they are valuing themselves at 80x earnings. Google sells for an already inflated 40x earnings, and their business dominates search.

Imagine this: Coke sells for 20x earnings, in its current business state. Now, you are Joe Private Equity looking to buy Pepsi’s cola business, leaving them with Frito-Lay. Would you pay 30-40x the cola division’s earnings for that business, which is less profitable and less dominant than Coke?

Yeah, me neither.

Which is to say, Yahoo! did a massive disservice to its shareholders by pushing for such a ridiculous price. Not only did Microsoft almost blow $40 million, but Yahoo! was dumb enough not to let them. If (YHOO) drops back down to where it was before the bid, I could see a shareholder lawsuit in the cards.

The narcissists at Yahoo! should be ashamed, and the shareholders of Microsoft should rejoice that this deal has fallen through. If you hold Yahoo! stock, I’d advise you to call up your partner Mr. Yang and read him some portions of Security Analysis; he could use a refresher on business valuation. Yahoo! is not worth $40/share Jerry.

Even so, despite Mr. Ballmer’s claims, even Microsoft’s corporate kiss wouldn't be able to turn this toad into a prince.


Disclosure: No position in any securities mentioned.

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