Value Discipline

The Developing Compensation Philosophy of the Treasury Department

2009-06-11T12:50:00.001-04:00

Here is a link to Gene Sperling's opening statement: http://www.treas.gov/press/releases/tg166.htm#_ftnref3

There are some very interesting quotes that help to frame Treasury's philosophy re systematic risk and executive compensation in this statement.

Compensation structures that permitted key executives and other financial actors to avoid the potential long-term downsides of their actions discouraged a focus on determining long-term risk and underlying economic value, while reducing the number of financial market participants with an incentive to be a "canary in the coal mine."

The testimony describes one investment bank which acknowledged the skew in its incentive structures:

Simply measuring bonuses against gross revenue after personnel costs with "no formal account taken of the quality or sustainability of those earnings."

It is clear that Treasury intends to broaden itself beyond its initial focus on financial services:

But what is important for our economy at large is the topic of this hearing: understanding how compensation practices contributed to this financial crisis and what steps we can take to ensure they do not cause excessive risk-taking in the future. And while the financial sector has been at the center of this issues, we believe that compensation practices must be better aligned with long-term value and prudent risk management at all firms, and not just for the financial services industry.

Here are the principles that were outlined in the "way forward":

Compensation plans should properly measure and reward performance.
- In other words, performance metrics should not just be based on stock prices but also relative performance and adherence to risk measurement. "Don't confuse brains for a bull market."

Compensation should be structured in line with the time horizon of the risks.
- The testimony discussed the trade-off of large short term gains that presented a "tail-risk" of large losses. Hence, the notion of stock compensation that is required to be retained for a long period of time, even beyond retirement, is being introduced. Also suggested that bonuses could be "at risk" and withdrawn if a poor year follows a good year.
Here is an abstract regarding executive pensions and their role in long term compensation.

Compensation practices should be aligned with sound risk management.
- The testimony refers to The Financial Stability Forum's Principles for Sound Compensation Practices. The authority and independence of risk managers is "all the more important in times of excessive optimism when consistent -though unsustainable -asset appreciation can temporarily make the reckless look wise and the prudent look risk-averse." The context of risk management is broadened to include all employees, not just executives, that may be incentivized for excessive and imprudent risks.

We should reexamine whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders.
-The testimony describes that golden parachutes were in place at over 80 percent of the largest firms as of 2006.

We should promote transparency and accountability in setting compensation.
-According to one Congressional Investigation, the median CEO salary of Fortune 250 companies in 2006 that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use consultants with such conflicts of interest.
House Committee Report on Executive Pay Also see blog for additional discussion.
Also please see Ferri and Maber abstract which describes the change that "say on pay" has made in making CEO compensation in the UK more responsive to negative results.
Also please see the CFA Institute survey's response to "say on pay"
Also please see "Shareholder Say on Pay:Ten Points of Confusion"

Executive Compensation-Government is Not Going Away

2009-06-11T09:34:00.002-04:00

Corporate governance is a topic that many of us tend to ignore, leaving it to the institutions or corporate raiders that are looking to influence the strategic direction, the capital allocation, the corporate structures or the compensation structures of business.

Yet, the way business is run should matter to us all. We need the goods and services it produces, or the employment it provides. As shareholders, whether directly or through our 401-Ks or pension plans, the long term wealth that corporations create is important for our old age dignity and in fact, the national prosperity. Hence, the governance of corporations affects us all whether customer, employee, citizen or shareholder. The effectiveness of corporate governance is indeed a factor in determining whether companies survive and prosper or stumble and fail.

Some years ago, Jonathan Charkham noted in his book, Keeping Good Company :

“It is difficult to escape the conclusion that government has a role here as it is the only power in any land which can strike a balance between the conflicting wishes of competing interests. Furthermore, the framework within which these interests compete is one of government’s own making. Everywhere the corporation is a creature of statue not nature, designed to encourage the continuity of power that the sophistication of modern economies require. It is not government’s role to double-guess individual commercial decisions-but to ensure as best it can, that the structure it creates for companies contains checks and balances that are effective in resolving the tensions between differing legitimate claims.”

One does not undermine one’s dedication to capitalism by believing that companies are more than just engines to maximize return on capital. After all, one could repeal child labor laws, ignore plant safety, ignore anti-trust and thereby maximize profitability, but at what cost to society?

Playing for very high stakes has been an ongoing theme in American capitalism probably since Alfred Sloan of GM declared that “The business of business is business.” Excessive and sometimes fraudulent risks, competition, and the increasing size and complexity of organizations: these three factors have been at the heart of every corporate breakdown and crash and burn. The call for greater regulation and greater scrutiny has followed every scandal, for example, the salad oil scandal of the mid-1960’s resulted in more stringent commodity trading regulation after nearly taking down American Express and causing significant loan losses in the banking system.

So it is little wonder that the Obama administration has begun to scrutinize certain aspects of corporate governance, in particular, an effort to rein in executive compensation. Though far from setting executive pay ceilings at all corporations, the new compensation czar – lawyer and mediator Kenneth Feinberg – will have broad discretion to set the pay for roughly 175 top executives at seven of the country's largest companies, which received billions in government loans. He will set the salaries and bonuses of some of the top financiers and industrialists in the United States including Fritz Henderson (GM), Vikram Pandit (Citigroup), and Ken Lewis (B 0f A).

The Obama administration argues that poorly designed compensation packages encouraged some Wall Street executives to take on excess risk in the mortgage market and elsewhere, which in turn helped trigger the financial crisis and a global recession. As Barney Frank, chairman of the House Committee on Financial Services observed (bolded words are my emphasis):

“It is not the role of government to set policy regarding the amounts that are paid in compensation to top executives, nor to deal with the question of how that compensation is allocated among salary, bonuses, retirement packages, etc. But as Secretary Geithner’s remarks recognized, there are two very important points that we should address.”

“First, shareholders must be empowered to have a major role in the process of setting overall compensation. While it is not the government’s role to say that a certain amount is too much, it is very much the right of the people who own the company to speak out if they think excessive compensation is being proposed. The system of say-on-pay that was piloted in England is a reasonable way to do this, and I was proud that the House adopted the bill that came from the Financial Services Committee to institute this in 2007. Unfortunately, the bill did not go forward in the Senate, but I am optimistic that with the support of the President, we will be able to enact this important principle into law. Recent evidence in England shows that when shareholders are in fact troubled by excessive compensation, say-on-pay is an effective tool for them.”

“I also agree with Secretary Geithner’s annunciation of the principles that should guide the structure of compensation – not the amount. But I differ with his view that this can be accomplished by strengthening the independence of compensation committees. Given the inherently close relationship that exists between CEOs and other top executives on the one hand, and boards of directors on the other, it is very unlikely that you will ever get the degree of independence that will allow the boards of directors to be left completely on their own to set compensation. That is part of the reason for say-on-pay. But it is also the reason why legislation should be adopted that instructs the Securities and Exchange Commission to set principles which prevent boards from providing compensation systems that lead to excessive risk taking.”

Many proxy statements this year contained “say on pay” shareholder proposals, almost all of which were opposed by managements. I am strongly in favor of such proposals which now appear to become the law of the land. Though these proposals are not enforceable per se, they do provide moral suasion and have had influence in European countries that have adopted the practice for example, Royal Dutch Shell. See also the recent impact in some UK retailers.

Proxy statements frequently contain a report from the compensation committee which generally outlines the company’s philosophy of compensation, what it uses as its peer group for a model of compensation, and what sorts of behavior are being rewarded both short and long term. In general, the compensation committee charter suggests that compensation should align managers’ interests with those of shareholders. An excellent template for what should be part of the compensation committee’s report was recently produced by the California State Teachers Retirement System. Among the points that CSTRS suggests is some specificity regarding the role of risk in incentive compensation:

“The role of risk in the context of the executive compensation program, which should include both a defensive perspective (how the committee ensures potential compensation does not incentivize excessive risk), and an offensive perspective (how the program is designed to incentivize appropriate risk and aligns the interests of management with those of long-term owners)”

Our summer intern, Drew Levine, recently completed a study of proxies that we have voted at our firm and run some statistics on components of executive compensation trends versus share price performance. If shareholder and management interests are truly aligned, one would expect some degree of correlation between comp and share performance. Sadly, that has not been the case. Here are some of Drew’s observations:

After conducting analysis of executive compensation data, it is safe to say that there is little to no correlation between stock price performance and compensation. The data compiled is from a tumultuous time in the stock market where nearly all of the companies we voted on stocks were down. One would think that because the company's stock performed so poorly the executives pay would subsequently suffer, but that was certainly not the case in some instances. The strongest correlation in the data was the percentage increase or decrease in bonus compensation in relation to stock price performance. However that measure of correlation was still extremely low at .21 for the CEO and .16 for the CFO. It's shocking to see that there really is no correlation between pay and performance because one would think that would be the most basic and truest basis for compensation. What I found most surprising was the average salary and total compensation growth from 2006-2008. It is amazing to see that although the majority of these companies were struggling with the economic downturn, the average salary growth for the CEO in 2008 was 74.9% and their total compensation growth for 2008 was 25.7%. What this indicates is that executives are increasingly taking more base pay with the knowledge that because their company's stock won't perform well, they will not get the oversized bonuses that they were used to receiving just a few years ago. Although, when looking through the data, it was relieving to see that in most of the companies the executives did not receive bonuses for 2007 and 2008.

In 2007 and 2008, we surveyed 79 and 92 CEO's respectively, and 55 and 81 CFO's respectively. This was due to new hires and fires at the executive positions. From year end 2006 to year end 2007, the average stock price of the company's surveyed was up 26.7%. From year end 2007 to year end 2008, the average stock price was down 40%. The average salary for the CEO in 2007 and 2008 was just over $1,000,000 and the average salary for the CFO during the same time frame was around $600,000. The average bonus for the CEO and CFO in 2007 was over $1,000,000 each with that number decreasing to about $450,000 for the CEO and $300,000 for the CFO in 2008.

For the 2009 proxies we voted, we emphasized voting for "best practices" such as shareholder's votes on executive compensation (say-on-pay) and shareholder's ability to call special meetings. Many people forget that the shareholders are the real owners of the company and that management is working for us. For that reason we find it important to vote every proxy for companies which our clients hold shares and not just throw them away like many shareholders do.

Looking at total compensation for the CEOs rather than just bonuses, the correlation to share price performance is non-existent at -0.03. Apparently, CFO total comp has a somewhat stronger link to share price performance at a still rather weak 0.19. Here is a spreadsheet of our compensation study and the statistical correlations that we observed.

Last year, the CATO Institute published a paper on Executive Pay Regulation versus Market Competition by Ira Kay and Steven van Putten which argues that: “The misperceptions that drive regulatory efforts are grounded in the idea that the market for executives is not competitive and that pay levels do not reflect supply and demand for talent” (pg. 1). Kay and Van Putten argue that the “myth of managerial power”, executives control over the board which sets their compensation, leads to greater regulation because lawmakers believe that the market is rigged as they put it. The authors present evidence to the contrary that says that the market is actually competitive and that the appropriate level of executive compensation tracks performance.

This may well have been the case but we face a new reality. We had better become accustomed to the idea of big government as regulations to restore financial order come into force. Jeff Immelt, in a recent address to the International Economic Forum in Montreal stated it most succinctly, “The government has moved in next door and it ain’t leaving. You could fight it if you want but society wants change. And government is not going away.”

A Report from Today's Citigroup Meeting re Governance

2009-04-21T17:20:00.002-04:00

Corporate governance has always been an important part of value investing. Obviously, most of us hate waste when precious company resources are squandered to build executive dreams rather than shareholder capital. Misallocation of capital and failure to optimize returns on capital have led me at times to conduct activist campaigns with some managements. This can lead to stormy verbal exchanges, but occasionally, has led to real change in management strategy, abandonment of some projects, and greater focus.

Though managements can ignore shareholders for a period of time, the annual meeting of shareholders allows investors an opportunity to vent, to express opinions, and to make suggestions.

Today, I attended the Citigroup annual meeting, as you can imagine, a very raucous affair.

I thought readers may find it helpful to see a question that I posed to Richard (Dick) Parsons, the chairman of Citi. Much of the board of Citigroup has been in place for many years, and though management has started to slowly bring in some new board members (with actual banking experience) some of the "deadwood" remains.

Mr Chairman, my question relates to the effectiveness and qualifications of our Audit and Risk Management Committee.

On page 35 of our proxy, we have the Report of our Audit Committee which indicates that the Committees meetings facilitate communication among members of the Committee, management, independent risk managers, internal auditors, and Citi's independent auditors.

On page B-3, Annex B of the proxy, the Committee is charged to review and discuss with management, at least annually:

"Developments and issues with respect to reserves" and "Off balance sheet structures and their effect on Citigroups consolidated financial statements." as well as

"Effectiveness of the bank's advanced systems for the calculation of risk-based capital requirements"

Under the section regarding the "Oversight of Risk Management", the audit committee is charged with responsibility to review with management the categories of risk the company faces including financial, operational, reputational risk AND

Review the risk policies and procedures adopted by management.

No one can deny that risk management at Citi has been an abysmal failure. It seems that the mission of this company was a Star Trek mission..."To boldly go where no man has gone before."

This company lived under an illusion of prosperity...an illusion that has been endorsed by the lack of oversight and ability of the Audit Committee to fulfill its responsibilities.
Over the last five years, the Chairman of our Audit Committee was Mike Armstrong, who at the same time served on the Executive Committee. That same committee was chaired by none other than Bob Rubin whose hypocrisy and denial of the risks that have taken this company down, all shareholders are suffering for.

I am at a loss to understand how someone who was on an Executive Committee, supposedly steering this lumbering ship, could maintain independent judgment by chairing the Audit Committee. Obviously, someone here, most likely the Nominating Committee agrees since:

Mr. Armstrong, who has been a director since 1989 is no longer part of the Audit Committee, as of this year, continues his "service" to our Company on the Nomination as well as the Compensation Committee. Much as this company has suffered under an illusion of prosperity, it appears to continue to suffer under an illusion of competence.

During Mr. Armstrong's tenure as the Audit Committee chairman, the incalculable loss in shareholder value due to his failure, and the Committee's failure to properly manage risk has led to some of the spirited discussion that you are experiencing today. I applaud Mr. Armstrong's removal but wonder about how much more damage is feasible after his 20 years on this board.

I see we have now appointed John Deutch to chair the Audit and Risk Committee.

John has been part of the board for two tenures, initially between 1987 and 1993 and currently since 1996. John is a brilliant scientist who has served this nation with distinction as an Undersecretary in the Department of Energy as well as the Director of Central Intelligence. It seems that one of the things most lacking at Citi is central intelligence.

John apparently did a BA in History and Economics back in 1961, presumably he may have studied some accounting back then, perhaps Accounting 100, though unlikely to have studied anything about risk management or auditing.

John has served on the Audit Committee of our Company since 1997 and hence, likely drank the Kool-Aid as to the Illusion of Prosperity.

John has served on other boards, mostly as a member of the nominating committee or technology committee but I see that he has served on the Finance Committee of Cummins Engine.

The last time that Citi had a Finance Committee, it was chaired by Jamie Dimon in the mid-90's...I hear he's done pretty well since.

John's only other service on an audit committee was at CMS Energy where while under his tenure, where:
-the Company had to restate its financials for its energy trading business a la Enron
-it had inflated its revenues by $5.3 Billion
-had to engage in major asset sales in order to survive, selling off most of its foreign operations in India, Brazil, Australia...unusual for a funny little utility in Midland Michigan
-and presided over the CMS stock falling to an 18 year low and down some 90% peak to trough.

I suppose that in some ways, John may be imminently qualified to add value given his experience, nevertheless, it does seem odd to offer an audit committee post to someone who presided over disaster in his only prior "at bat."

It is surprising to look at the current board, outside the new additions, and see so many characters,who though they may have a lot of management experience and executive expereince, seem to lack accounting or audit or even finance credentials. As Buffett has said, there are many banks but few bankers. It appears that none of our existing audit committee members have any prior financial services experience!

I note that the audit and risk management committee has many members who, like Mr Deutch and MrArmstrong presided over this seemingly out of control disaster.

Andrew Liveris since 2005 on Audit

Ann Mulcahy since 2007 on Audit

Dr Judith Rodin since 2004 on both Executive and Audit Committees

Shareholders can no longer countenance the shameful incompetence of our Audit and risk committees financial expertise where it is clear that there is none.

Rather than your vote, they deserve a dressing down that would knock years off their lives. We have been victims of their steely eyed stare into nothingness.

Mr Chairman, is it not time that the same standard applies to our board as has been applied to some former members of management...the standard that sent our Chief Risk Officer in 2007 to the dugout to contemplate the meaning of "sub-prime"...the same standard that sent Chuck Prince into a glorious retirement at huge expense to shareholders...out presumably for dance lessons.

Mr. Chairman, I respectfully submit that it IS time for meaningful change in our Audit and Risk Management Committee.

...................................................................

Most of us investors tend to vote with our feet and simply sell the stock. I urge you to read the proxy statements and if there is something egregious that you see, to let the board know and to let it be known in a public forum. Stupidity needs to be aired out and benign neglect needs to be addressed.

Change, though glacial and slow can be achieved. I am more than happy to use this blog as a forum to bring some of these matters to readers attention.

Disclaimer: I, my family and clients may have a position in certain securities mentioned in this post.

NCR versus Diebold

2009-04-19T22:29:00.004-04:00

Courtesy of Seeking Alpha, I have been privileged to have been introduced to an exciting new research product called Gridstone Research. Gridstone is a new research platform that combines financial data, operational data, and unstructured textual information about a company into a structured useful form.

As I become more proficient with its use and application, I will be incorporating Gridstone into my financial models.

For now, a very basic look at NCR versus DBD's profitability over the last several years.

http://tinyurl.com/d2kjv8

Disclaimer: I, my clients and family may have a current position in securities mentioned in this blog post.

Techonomics and the ATM

2009-04-19T22:27:00.001-04:00

“By prevailing over all obstacles and distractions, one may unfailingly arrive at his chosen goal or destination.”- Christopher Columbus

Needless to say, it has been an incredibly tumultuous environment. The economic outlook, despite a few specks of light in a dark sky remains quite bleak. Despite this, I have been encouraged by valuations, by the tape action, and by the prevailing sentiment that continues to express doubt in the strength of this rally.

For today’s thoughts, I would like to focus on the tech sector. Tech stocks, in my view, are beginning to discount a recovery and unlike the tech bubble of the turn of the century, generally constitute reasonable business models. Many of these companies have substantially improved their manufacturing footprint to lower cost geographies. Many enjoy recurring revenue models. Many enjoy strong reputations and decent customer loyalty. However, in a climate of falling capital expenditures by their customers and the experience of building inventories, and falling prices for commodity products, the industry has generally been swift in its response by cutting employment and focusing on cost control.

Real tech spending fell at almost a 24% annualized rate in the fourth quarter (according to Ned Davis Research), the biggest drop since 1990 and in fact, much larger than the 18.6% drop in Q2 of 2001, when the tech bubble burst. As a percentage of GDP, tech spending fell to just 3.6% of GDP down 0.3% Q4/Q3 and down from a peak about two years ago of just over 5%. The quarter over quarter drop in tech spending to GDP exceeded the drop in the 1973-75 and 1981-82 recessions.

The industry responded by cutting production and employment. Capacity utilization in the industry went from just over 80% to 59.9%, a record low.

It is important to keep in mind that many of these trends are quite long in the tooth, in many cases having portended the industry recession. We may well be near the end of the downtrend in this industry. For example, new info tech orders declined for 28 months post tech bubble…currently, we are in the 34th month of decline in this metric. The semiconductor book-to-bill ratio declined for only 13 months post tech bubble…now, we are in the 31st month!

Earnings expectations have weakened substantially. The 2009 median expected growth rate has dropped to about -10% from expectations in early 2008 of about +20%. Though growth expectations post tech bubble bottomed at -26% in September of 2001, this coincided with the bottom in these stocks. From a valuation standpoint, price-to-book and price-to-sales ratios are below the 2002 troughs. The current price-to-book ratio is at 2.5 times as compared to the September 2001 trough of 3.3 times. The price-to-sales ratio is currently at 1.5 times as compared to the prior 2.1 times.

Here is a screen (courtesy of Cash Flow Analytics ) of high tech companies with revenues greater than $100 million that have produced free cash flow though the last twelve months.

http://tinyurl.com/c6zj3s

As you can see from the screen, there are many cheap stocks from which to select, in many cases with excellent balance sheets.

One subsector within technology that I believe has been ignored is the ATM sector. As one can imagine, at a time when banks are more concerned about retaining capital to ensure their solvency in a deteriorating credit environment, there should be little propensity to spend on ATMs. Investors remain concerned that increasing bank failures, potential nationalization, and general credit concerns will severely impact the operating performance of the ATM manufacturers. Yet, some of this concern may well be overblown. During the S&L crisis of the 1980s when almost 1500 banks failed, the ATM manufacturers experienced rising sales as new banks emerged and surviving banks increased their focus on efficiency and innovation to reduce their costs.

The global market is dominated by Diebold (DBD)and NCR (NCR). Demand for self-service solutions has been steady from the large national banks that have rolled out deposit automation and bulk checking products. Roughly two thirds of ATM demand is replacement driven. Replacements are driven by regulatory and technological changes as well as aging of the equipment which has a useful life of six to eight years.

In a recent broker conference, NCR’s CEO Bill Nuti described the recurring nature of his business:

“ I think we also have a fairly stable revenue stream inside the Company. When you look at our revenue stream, approximately 40% of it is services, annuity-based services maintenance, which has contracts that stem from a year to five years in length, and a fairly stable revenue stream.”

“Another 10% of our revenue is in consumables. That tends to be fairly stable. This would be purchasing of paper rolls for point of sale or two-sided thermal paper technologies and printers. Another 20% or so comes in the year vis-a -vis backlog. Backlog coming into the year that we expected to turn in the year.”

“So, you've got about 70% of the revenue stream that's relatively reliable, strong revenue stream. The rest, of course, comes from success within the year.”

“ I think large banks in the US will continue to roll out deposit automation at a fairly aggressive rate in 2009. We have a very good position in that particular segment of the banking market.”

One of the important technological developments in the ATM industry has been the direct deposit taking ATM where the money is deposited immediately as opposed to an envelope-taking ATM.

Nutti describes the advantages of this technology:

“A return on investment has been nothing short of outstanding for the banks that deploy deposit technology. In fact, today, the reason why in this environment you're seeing banks roll out deposit technology as aggressively, is because they're being, basically, the departments of the banks that are rolling this technology out are being told by the leadership of retail banking, we need to get X tens of millions of deposits out of the branch and automated onto a machine because of the cost savings.”

“So, the cost savings are phenomenal for a bank to take someone who was once depositing checks in a branch vis-a -vis a teller now onto a machine. And so you're seeing tremendous cost savings.”

“I've got one customer who recently was requested to move more rapidly with deposit automation because they need 60 million checks that were normally deposited in branches to now be deposited vis-a-vis deposit-taking ATMs. So, that's one customer. And you can imagine, you could put any number, any dollar savings you want against the 60 million checks and come up with a pretty good ROI given the cost difference.”

The difference is discernible to customers as well, spending only seconds rather than waiting inline in a branch for a teller. The bank would far rather employ a person as a salesperson, selling additional higher margin services and establishing customer relationships rather than depositing checks in a drawer.

For NCR,there is also exposure to the airline industry and its self-serving kiosks. NCR is the number one provider of these devices to the airlines with an 80% share. According to the company, to check in by waiting in a queue at the airport costs about $3.15 per transaction. Checking in by kiosk runs $0.14! That is a tremendous cost savings.

The company anticipates that it will generate free cash flow in 2009 despite needing $200-$250 million to fund its pension plans. Currently, the company has $403 million in cash and investments per share (roughly $2.50 per share) net of debt.

The company launched over 50 new products in 2008, the highest number in more than a dozen years, including the launch of the industry's newest and most innovative ATM family, NCR SelfServ.

In the retail industry wit introduced a next-generation self check-out solution, 5.0, and other point of sale solutions that have captured significant market share.NCR is gaining significant traction in expanding its self-service strategy into new industries including the entertainment industry that promise to open up future avenues of growth for NCR.

For Diebold, some 50% of its revenues are service oriented, consisting of annual maintenance, servicing and monitoring contracts. In North America alone, the company has over 120,000 annual contracts to service the installed ATM base with a renewal rate of well over 90%. The company has generated about $250 million- $300 million in EBITDA annually whereas capex has run around $40 million. A concern is that DBD has been the subject of an accounting investigation by the SEC relating to revenue recognition practices. From a corporate governance standpoint, last March United Technologies (UTX) offered to buy DBD for $40 per share which the company rejected as inadequate. Recently, the company allowed a poison pill provision to expire. Back in 2005, the board dismissed most of its senior management because of poor internal controls and controversy about its election systems division which represents about 5% of sales.

The company has made significant strides in cost reduction since the 2005 disaster. As per its most recent conference call:

“More than just squeeze cost out of the old process, they identified best practices that were new to Diebold and implemented them successfully. As a result of the success of this initiative in 2008, we expanded the effort to eliminate an additional $100 million of cost out of the Company by the end of 2011. Key to the next 100 million, we expanded our relationship with Minlo, our logistics partner in the supply chain area. They assisted us in reducing our finished goods warehousing footprint from 89 company operated facilities down to three Menlo operated logistics centers. One center located in Greensboro, North Carolina is a flexible delayed product configuration facility serving market in North America and Latin America. This helps us improve lead times to customers while reducing costs.”

“We also improved manufacturing footprint. We have 85% of our production in low-cost geographies. By increasing production in low-cost geographies, we are also manufacturing our ATM products closer to our key customers in growth regions in Asia and eastern Europe. In addition, we consolidated security manufacturing facility in Ohio, with existing facility in North Carolina. To further streamline our operations, we expanded our vendor managed inventory system. We continue to leverage our relationship with Ariba implementing best practices and direct indirect procurement processes.”

NCR trades at merely 2.6 times trailing EV/EBITDA reflecting $1.5 Billion in equity market cap, $333 million in debt and over $700 million in cash or an enterprise value of $1.1 Billion.

DBD trades at 7.6 times EV/EBITDA with $1.5 Billion in equity market cap as well, but $620 million in debt and $360 million in cash or an enterprise value of $1.7 Billion.

Here is a look at the quarterly progressions of working capital management, capital intensity, and ROIC for these companies:

http://tinyurl.com/cm7vc2

In conclusion, I believe that there are many opportunities within the tech sector that are worth further exploration and investigation. By prevailing over the many distractions, focusing on value, and relying on recurring revenue models, investors can earn significant long term returns with some patience. I believe that the ATM industry in particular represents an unappreciated sub-sector in tech.

Happy New Year!

2008-12-31T15:53:00.004-05:00

What can be said in New Year rhymes,
That's not been said a thousand times?
The new years come, the old years go,
We know we dream, we dream we know.
We rise up laughing with the light,
We lie down weeping with the night.
We hug the world until it stings,
We curse it then and sigh for wings.
We live, we love, we woo, we wed,
We wreathe our prides, we sheet our dead.
We laugh, we weep, we hope, we fear,
And that's the burden of a year. - Ella Wheeler Wilcox

What a tough and rugged year it has been for all of us in capital markets! Who could have imagined the volatility, the fear, the panic that we, our friends, clients and employees felt at times. To our friends at Lehman, the Bear, and many others in investment banking, losses are particularly deep as victims of the financial tsunami that washed through the financial system.

We think of all of you as the old year passes and the hopes for a new year are in our hearts. We thank you for your readership, your support, and your thoughts! We are looking forward to a regular dialog through this blog and through some new and exciting alternative channels that we are developing. We appreciate the ongoing support of friends like Henry To of marketthoughts.com and David Korn of The Retirement Advisor. Special thanks to Geoff Gannon who has one of the most insightful blogs in investing. I look forward to hearing more about Geoff's ongoing publishing projects. I would be remiss in not mentioning David (Dah Hui Lau) who is determined to dedicate his life to value investing as well as a fellow Ontarioan Nurse B who continues to Triage his Way to Financial Success.

Finally, the ongoing help of The Wall Street Transcript as well as Cash Flow Analytics have helped mold and shape many of our thoughts and theories. Our friends at Seeking Alpha have also provided great support in terms of distribution of ideas as well as access to conferences.

Best of the New Year!

Rick

Finally, an Irish toast:

In the New Year, may your right hand always be stretched out in friendship, never in want.

Fair Value, Mark-To-Market and Financial Reporting-Another Revision?

2008-12-29T17:05:00.003-05:00

Less than a week to go for 2008, and the Financial Accounting Standards Board (FASB) has a proposal which it has thrown into the arena to address the problem of fair value.

Mark to market accounting has stirred up a very ugly debate between its adversaries and its proponents. Mark Sunshine, in a Seeking Alpha post some months ago noted that: " Mark to market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse." Other prominent naysayers as far as the current accounting rules for mark-to-market include Steve Forbes and noted fund manager, Ron Muhlenkamp.Here is a recent interview where they discuss mark-to-market accounting.Forbes does not mince his words:

"Henry Paulson is the worst treasury secretary in living memory. But even though he's miserably mishandled this financial crisis there's still time for him to turn things around. He can--somewhat--repair his reputation. He simply needs to back away from the disastrous policies and practices that have defined his tenure."

"His first mistake was to support the weak-dollar policy that sparked and fed the crisis. Then he continued to enforce mark-to-market accounting rules. Mark to market destroyed bank balance sheets. Now insurance firms are faltering under its weight. But there's still time for common sense...And while mark to market is fine for publicly traded stocks, it makes no sense when you don't have a market, as with packages of subprime loans. And it also makes no sense for long-term insurance reserves. Paulson and the SEC can suspend this inane rule in a heartbeat, yet they refuse. Adhering to one position without regard to consequences and expecting a different result is the definition of insanity. It's time for Paulson to follow the path of reason."

Proponents of mark-to-market generally perceive greater transparency with its usage. For example, here is a part of a letter to FASB by Rebecca McEnally of the Investors Technical Advisory Committee (IATC):

"The ITAC believes that it is especially critical that fair value information be available to capital providers and other users of financial statements in periods of market turmoil accompanied by liquidity crunches such as we're now experiencing. In the absence of timely fair value information, uncertainty increases, further exacerbating market instability and causing investors to withhold investable funds or demand a hefty uncertainty premium. A cornerstone of the restoration of investor confidence must be to provide the information investors need to make risk-based decisions."

"Regulators recognize that fair value measurement is an essential tool in their oversight and monitoring of the risk management practices and risk profiles of financial institutions, and ensuring that the institutions' capital provisions are adequate to support the risks embedded in the financial instruments and other assets the institutions hold and the financing used to support those assets. Given this widely-recognized critical importance of providing relevant, high-quality financial information to the markets, the ITAC has been dismayed to learn that a few managers of major financial institutions, along with representatives of industry organizations representing some financial institutions, are now calling for a suspension of fair value reporting for financial instruments. They argue, in effect, for a return to the old financial reporting model for financial instruments in effect decades ago with its out- of-date historical cost reporting and lack of transparency, particularly for embedded financial risks."

The proponents credit the transparency they believe that mark-to-market has brought to capital markets with the market's improved understanding of the risks and consequent selling off of many financial services stocks.

"Recently, some have attempted to shift the blame for the current crisis from the poor business and investment decision-making, including the flawed underwriting, securitization, risk management, and disclosure practices in which they engaged, to fair value financial reporting, a "shoot the messenger" argument. This reasoning is both perplexing and misleading. In fact, the current requirement to report financial instruments at fair values was instrumental in the uncovering of the deep and widespread problems in the markets. The long-term solution to the problems relies heavily on the retention of the requirement to provide fair value information to investors and regulators: the higher the quality of fair value information that is provided, the faster will be the necessary market adjustments to the problems."

"What those making the argument fail to recognize is that these are not abnormal features of the measurements, per se, but rather characteristics of the normal functioning of markets as investors reassess risks and rewards and liquidity disappears for poor quality securities and investments with little transparency. Some downward price revisions will inevitably result in the triggering of covenants that the original purchasers of securities or lenders demanded as a condition of investing in the securities and agreeing to the terms upon which the capital was provided to issuers. Again, these triggers are a normal part of the contracting process and designed to protect the investors, including lenders. The fact that the triggers were activated is not an indictment of the measurement system but rather is a direct function of the poor or deteriorating quality of the investments. Arguing that by not recognizing the poor or deteriorating quality of the investments we will somehow solve the problem is not only inappropriate but is a variant of the "shoot the messenger" argument: Pull the covers over the problems and maybe they will just go away."

I certainly recognize that under most normal circumstances, there is great transparency in fair value as opposed to other methodologies. However, it is also very clear to me that a myopic and complete focus on fair value can in effect be liquidation or bankruptcy value in times of severe systemic stress. I would agree with Forbes that the triggering of covenants that has resulted from large and probably unnecessary write-downs has caused more panic than elucidation as far as asset values. As he said very colorfully:

"Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline."

A compromise of sorts appears to be coming. The FASB would like firms to include in their financial statements a table which provides a comparison of three different reporting measurements:

The reported carrying value
Fair Value
Incurred Loss Amount

These changes would allow managements to highlight future cash flows of securities that will be held to maturity and are available for sale. Though the near term "fair value" or "market value" in a very constrained and illiquid market may look dreadful, the majority of many of these assets will likely pay off over their long term maturity. Hence, the "incurred loss" category when it demonstrates that few losses have actually been incurred may create some substantiation of long term value that is more realistic in my opinion than what we have now.

This proposal labelled proposal FAS 107-a, if approved, would go into immediate effect for reporting periods after December 15th, 2008! That puts more than a little uncertainty into forecasts of fourth quarter financial services profit forecasts. But at least the uncertainty may be somewhat positively skewed in favor of less write-down in the recognition of "fair value."

Part of the backbone of accounting is what's known as the conceptual framework which describes the function and purpose of accounting. As the FASB and the global body, the IASC consider a new conceptual framework, they propose (italics are mine):

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. Capital providers are the primary users of financial reporting. To accomplish the objective, financial reports should communicate information about an entity’s economic resources, claims to those resources, and the transactions and other events and circumstances that change them. The degree to which that financial information is useful will depend on its qualitative characteristics.

Financial reporting information is a faithful representation if it depicts the substance of an economic phenomenon completely, neutrally, and without material error. It must also be relevant.

In my view, the substance of financial reporting should focus on the long term substance of the transaction rather than the strains of the current capital market. Perhaps the new proposal begins to address the situation. Perhaps what is sacrificed in terms of timeliness and verifiability is offset by improvements in comparability and relevance.

Unfortunately, forecasting results will become even more difficult as accounting rules may be modified at the worst possible time, the year-end for most companies. But, if implemented, these rules may provide a bit of sunshine and upside at long last to a sector that has been wrapped in uncertainty and fear if not deprived of common sense for some time.

Happy Holidays!

2008-12-24T17:20:00.002-05:00

A simple and sincere message to all. Here's wishing you the best of holidays in this blessed season.

Wishing all of you a Happy Hanukkah, a Merry Christmas, and peace!

Looking forward to 2009, a Happy, Healthy and Prosperous Year for all!

Rick

Stocking Stuffers

2008-12-21T18:51:00.002-05:00

It has been a remarkable year. It has been year that many of us would just as soon forget. The cascading effects of deleveraging have been rampant across all markets.

The financial turmoil of 2007-08-09? has deeply affected households as well as businesses in most parts of the world. The reduction in the target Fed Funds rate since September of 2007 has been dramatic going from 5.25% (it really was this high!) at the beginning of this period to its current range of 0 to 0.25%. As any borrower knows, reductions in Fed Funds do not result in immediate parallel movements in interest rates that you and I pay, nevertheless, interest rates are likely lower than they otherwise would have been.

After peaking at a multi-decade high of +9.8% in July, the US producer price index (PPI), inflation rate has completely collapsed to +0.4% in November.

Little wonder that investors are huddling for warmth, are seeking "guarantees," and are about as risk-averse as I have ever witnessed. I warn my analysts about turning into "life insurance company treasurers" seeking relative shelter rather than seeking capital appreciation. Strangely, for long term real returns what appears to be safest in the capital markets at the moment may well be the most dangerous investment you can make,treasury bonds.

In this weekend's Barron's (subscription required) Rob Arnott, the former editor of the Financial Analyst's Journal provides some very thoughtful discussion in this interview by Lawrence Strauss.

As he describes,

"What we saw in September and October was a take-no-prisoners market in which everything outside of Treasuries was savaged. Finally, in November, we saw the beginnings of a rationalization where some markets did begin to recover-but some markets had been hit beyond any rational valuation of the risks associated with those assets."

Arnott goes on to describe very aptly, the behavioral tendency of most investors to continue to bank on "winners" rather than looking for bargains.

So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors.

He describes the current environment as "the richest environment of low-hanging fruit I've seen in my career."

A further key point...

"This is not a time to be hunkering down in the safety and comfort of the Treasury curve." "There are tremendous opportunities right now."

This being the holiday season, I suspect that Mr. Market has provided us some gifts for the taking if we choose to partake. I will be putting together a number of screens of bargain or quality ideas that I think may contribute to a happy new year. As well, I will be providing a review of many of these names in the coming days and weeks.

I will start with a list of Stocking Stuffers, as you will see, not necessarily very high quality businesses with strong competitive advantages. This list was constructed using Reuters and the following assumptions:

Price under $10 per share...i.e. Stocking Stuffers
Operating margins on a Trailing Twelve Month (TTM) basis better than that of the respective industry and showing improvement versus last year or two years ago.
Company must be generating free cash flow in the most recent TTM period
PE multiple must be within 20% of the lowest PE in the last five years
Enterprise Value/EBITDA must be less than six times.

Here's a look at several reporting formats for this screen:

Stocking Stuffers-Operating Margins, PE's, FCF

Stocking Stuffers-ROI, ROE

Stocking Stuffers- Debt Leverage

Here is another screen but rather than considering operating margin improvement, this screen looks for the following attributes:

Price under $10 per share but above $1.
Stock price below book value per share
Cash exceeds debt
Interest coverage more than two times
Net earnings must be positive for the most recent twelve months.

Remember that frequently, book value can be a misleading metric for value investors. Companies which chronically earn below average returns on capital or equity may well have assets whose valuation needs to be written-down. Impairment of these overvalued assets can lead to too low a price to book ratio. It is also important to note that companies that have a history of buying back stock at prices above book value will drive down Book Value and hence increase P/BV. Consequently, excellent companies that have generated excess cash and treated shareholders well by returning capital through buybacks will be missed by P/BV screens.

Book Value Bargains?

The Barrons interview makes it clear that Arnott favors investment grade corporate bonds at this stage. Spreads against treasuries have widened to immense gaps, for investment grade about 6% over treasuries, for below investment grade, perhaps 15-20%. As Arnott suggests, even if defaults reach historic proportions, it would take several years of defaults to lose a 20% spread in the competition against treasuries.

As Arnott concludes, and I agree, the less you hold in Treasuries, the better you are likely to perform in 2009. Riskier assets are priced to provide some significant returns for the coming years.

We'll have a deeper look at a few of the names within these screens over the coming days and weeks.

The Commodity Investment World Conference-Some Observations on Commodities as a Diversifier

2008-12-07T21:32:00.004-05:00

For two days last week, it was my privilege to attend the Commodity Investment World conference through the courtesy of Seeking Alpha. A broad spectrum of commodities markets, their economics and approaches to these markets were discussed.

Commodities conferences historically have been the denizens of inflation hawks. Theories of Malthusian catastrophes as population and consumption growth outpace agricultural production have always suggested dwindling supplies with the development of shortages and hence,higher prices for commodities.

Beyond the Club of Rome disaster scenarios, come monetary arguments for inflation. If currencies have value because of scarcity, central banks around the world have spent the last several months creating fiat money by decree-simply put, when money becomes too plentiful, it loses its value. Even Ben Franklin observed some 230 years ago:

"The currency, as we manage it, is a wonderful machine. It performs its office when we issue it: it pays and clothes troops and provides victuals and ammunition, and when we are obliged to issue a quantity excessive, it pays itself off by depreciation."

Many commodities historically have functioned to offset the depreciation in the currency that Franklin described and have been storehouses of value and hence, inflation hedges.

This conference was much more realistic in its tone. Commodities, which generally serve portfolios as tremendous diversifiers because of their low or negative correlations to equities have unfortunately demonstrated near perfect positive correlation with equities recently. The English translation of this statistical notion is straightforward...stocks have been declining- and so have all commodities.

So why bother even thinking about commodities in what appears to be a deflationary environment? Two reasons:

As Marc Faber of GloomBoomDoom fame has cited, when the investment community is fascinated by a major theme (deflation), outstanding opportunities arise elsewhere. "The greater the mania in one sector of a market or in one stock market, the more likely that neglected asset classes elsewhere offer huge appreciation potential." I believe that commodities, as several panelists at the conference indicated, may bottom within a few quarters.
The sources of return for commodities relate not only to issues of supply and demand and economic fundamentals but also to the possible returns from long/short active management as well as what are termed, "roll yield" and "collateral yield."

Roll yields occur when the price of a commodity is higher for shorter delivery dates. The investor earns a positive roll yield by buying, waiting for the price to appreciate as the delivery date approaches, then selling and using the proceeds to reinvest at a cheaper price at a longer term future delivery date. Collateral yield is the return earned by margin held against a futures position (generally T-bills.) The significance of roll returns should not be ignored...for the 15 years between 1989-2004, crude oil returns averaged about 20% per annum of which 6% per annum consisted of pure spot price returns and 9% consisted of roll returns.

Under more normal circumstances, if any of us can remember what normal is anymore, commodities can be a terrific portfolio diversifier. Why?

Commodities tend to correlate positively with inflation whereas stocks and bonds tend to negatively correlate with inflation. In an article that Warren Buffett authored in Fortune in 1977, he explained the deterioration of securities under inflationary conditions.
Commodity prices and stock and bond prices react differently under different phases of the business cycle. As business cools, treasury bonds tend to rally, whereas stocks and commodities tend to skid. As business expands, stocks and commodities tend to be pro-cyclical whereas bonds will decline.
Commodity prices tend to be more affected by short-term expectations whereas stocks and bond prices tend to be more affected by long-term expectations...not necessarily true at the moment, but at least a "normal" expectation.

Hence, commodities can be very potent portfolio risk diversifiers.

Here are a few links which you may find useful:
The Benefits of Commodity Investment

Alpha, Beta, and Commodities: Can A commodities Investment be Both a High Risk-Adjusted Return Source and a Portfolio Hedge?

Perhaps, one of the most interesting presentations at the conference was Dan Sternoff of Medley Global Advisors whose primary research focus is China. Though much of the commodity boom prior to July related to a silly notion that Chinese and Asian economies had decoupled from North America, the slowing of the Chinese economy has become quite evident.

Disturbingly, the deceleration is more rapid than even the Chinese government had anticipated no doubt precipitating China's biggest interest-rate cut in 11 years with the 108 basis point cut in one-year lending rates. However, according to Sternoff, the slowdown so far has been domestically led and not yet linked to the global cycle, more a consequence of China's slowing property sector affecting industries such as cement, steel, cars, appliances, and furniture.

Residential construction represents a significant 12% of Chinese GDP. Though not a real estate bust per se, (there are no Mortgage backed securities or other forms of securitization and housing is purchased with 25-30% down payments) property prices are down probably 5-10% nationwide with higher end apartments in larger cities down markedly more. Real estate transaction volume has fallen off a cliff.

Though Sternof expects Chinese GDP growth of about 7-8% next year, the composition of Chinese GDP growth is shifting away from resource intensive activities. He expects that state owned enterprises may well become acquisitive overseas as global valuations provide opportunities.

Other presenters had rather bleak views of Europe suggesting that most European authorities did not have a pro-active view of stimulus programs and that no governments had the skills of a Larry Summers or Paul Volcker in handling crises. Their conclusion in short, it is wrong to think that despite the steepness of the price waterfall, it is wrong to think that commodities have bottomed.

Roger Kubarych of UniCredit and a former associate of Henry Kaufman suggested that a reasonable fiscal stimulus plan of perhaps $400 Billion for the new Obama regime could include 4 segments:

Low to middle income tax benefits
A business investment tax credit or R&D tax credit
A program to stop foreclosures or a plan to help states and municipal governments buy foreclosed properties
An infrastructure building plan

It seems that many commodity traders are perplexed by the rather tight correlation of commodities to one another, not just their price movement relative to securities. It is unusual for industrial commodities such as base metals or energy which are clearly sensitive to economic activity to correlate this well with agricultural products that generally have little sensitivity to the economy.

As well, most commodities tend to bottom at their marginal cost of production, yet many instances were cited where producers, starved for working capital in the credit crunch, are willing to produce under their full cost of production merely to access cash flow.

Another interesting presentation addressed timber as an uncorrelated commodity asset whose value creation is largely attributable to biological growth rather than inflation. Basically, value increases as tree diameter grows and if current prices for small diameter trees don't work for you, a tree will grow about 7% every year, so greater value should accrue over time.

A very broad spectrum of commodity topics was considered. My only complaint about the conference relates to no-shows-there were numerous no-shows among presenters who were scheduled to appear for some topic panels. Despite this annoyance, in my view, the conference was worth attending.

Historically, portfolio construction meant a split between stocks, bonds and cash. I believe that going forward, commodities will also be an important component for portfolio construction.

Opportunities exist for not only portfolio hedging because of their usual uncorrelated returns, but also for active management strategies that take advantage of unusual backwardation. Like capital markets, commodity markets are in disarray and bathed in horrible sentiment. Though highly volatile in physical or futures formats, structured products and commodity ETFs may offer individual investors better opportunities to participate. It is too important a market with too many unique characteristics to ignore.

Analysts in the Confessional

2008-12-02T15:11:00.001-05:00

So why the lag in taking earnings estimates down? NBER yesterday declared the existence of recession, yet analysts continue to be reluctant to fess up and mark down their numbers.

In an interesting article in Australia's Business Spectator this morning, two analysts confess why it is so hard to reduce their forecasts.

The confession was written by two Goldman Sachs JB Were analysts, Sam Ferraro and Matthew Rose, who, after meeting their buy side counterparts, detected some frustration. So even though their strategist was forecasting a decline in earnings of 15%, their own forecasts still pointed to higher earnings.

Here are the reasons they cite:

The analysts haven't seen anything like this before--hence, they tend to underestimate the effects of systematic or top-down developments.
Their researched companies and managements haven't seen anything like this before- A survey of analysts reveals that 25 per cent of companies that used to provide profit guidance no longer do (and guidance is all-important – see the next point, below). CEOs, they say, are chosen for their “left brain skills: optimism, ambition, hard work, focus and decisiveness. Patience and an appreciation of history are not considered virtues for these individuals"
Analysts seek to curry favor with management in order to preserve their information networks- Remember, that for most brokerage firms, the investment banking client is the "real" client...the individual client represents far less revenue, and hence, upsetting him/her is less onerous and career-threatening than upsetting the major client.
Analysts need to manage their "reputational risks" so they engage in herding behavior. There is comfort in numbers. The costs of being out in left field with a big call gone wrong far outweigh the benefits of getting the big call right.

As I said in my previous post, earnings estimates at this stage of the game may well be ignored by most participants,"I also believe that in a well-established and hopefully, late stage bear market, analysts are completely ignored and stocks will rally in the face of declining earnings estimates."

As portfolio managers, we do our own forecasts and tend to use Wall Street for idea generation rather than forecasts or recommendations. We have long recognized that many estimates are candy-coated to stroke the egos of the "real" clients rather than serve our needs. Similarly, there is a reluctance of research analysts to say "sell" or to couch it by calling a company a "hold" so as not to offend the investment banking client.

As in every part of investing, self-reliance and judgment are an important part of success.

Staying in the Game

2008-12-01T16:46:00.001-05:00

My sincere apologies to readers I have disappointed in my absence over the last several months. As our business has grown, time has certainly been at a premium and unfortunately, we have neglected our responsibilities to this blog. We hope to mend our ways with more regular postings of commentary regarding markets, economies, analyst upgrades and downgrades, as well as independent analysis of interesting companies.

Some of you may be aware of our regular monthly commentary to Marketthoughts, Henry To's excellent subscription service. Henry, who is currently working on his MBA at the UCLA Anderson School is a CFA charterholder as well as an actuary. Henry's thought provoking analysis and commentary is insightful and ruminative. His productivity in his subscription service despite his full time efforts as an MBA student is a real inspration to me. I hope to aspire to his level of publishing productivity! In Ocotober, I first published this commentary in Marketthoughts. I think most of this remains quite applicable:

Baffled? Frustrated? Worn out? Most of us have to answer yes to these questions. After over thirty years of investment management, I still try to stand up to my own sinking feelings and act professionally and as unemotionally as possible. A value discipline forces you to take notice, to battle your emotions, and to recognize value with at least a small order. Courage is in exceptionally short supply especially among newer clients who have never seen this before. But even when I visit some of the brokers who sell our products, many of whom have years in this business equal to or greater than mine, there is terror in their eyes and no activity in their books. It is never easy to battle feelings of inadequacy and powerlessness which overcome you in bear markets.

It's been over a year since housing issues triggered problems in mortgage markets which triggered problems in credit markets which triggered problems in the shadow banking system which triggered a bust in the commodity cycle, etc, etc, etc. The sequence of events reads much like the "begat" verses which describe generations in the Old Testament.

We have been through some twenty years of credit expansion...like most "topping" experiences, as we neared the peak, more and more credit was needed to produce less and less real economic growth. The credit experience of the last twenty years parallels most other addictions where greater amounts of the abused substance are needed to achieve the desired result. Not unlike substance abuse, too much will indeed kill you.

The widespread deflation of asset values, whether stock prices, housing prices, or commodity prices has exposed the excesses of borrowing and destroyed the creditworthiness of the debt that was secured by the price inflation of the underlying assets.

All business cycles are driven by some excess "thing" that needs to be corrected. Many bear markets of the past have been triggered by credit tightening...not this time. Others, such as the internet bubble burst were triggered by excessive valuation of a sector...not this time. Others, such as the 1974 bear were triggered by fears of earnings collapse in the face of a seemingly uncontrollable macro variable, at that time oil prices...to some degree, this had been an aggravating factor again.

Abrupt changes in the availability of credit lead to abrupt changes in liquidity and hence, asset prices. This turns into a self-fulfilling prophecy...fears that asset prices may fall, lead to falling if not cratering asset prices.

The downward spiral of the current crisis parallels the emerging markets crisis of 1997 and 1998 where Thailand, the Philippines, Indonesia, and Malaysia faced currency attacks that undermined investor confidence in foreign denominated debt. Asia lost access to foreign credit, currencies plummeted and creditors lost confidence that they would get their dough back, all rushing for the exits at the same time. The decisions of the credit markets ensured that the crisis deepened.

The global economic response this time is much more heartening with bank recapitalization, broadened limits on deposit insurance, guarantees of bank debt, coordinated interest rate cuts, and major increases in liquidity. I suspect that much more can be done in terms of encouraging increased lending into the rea leconomy from the newly recapitalized coffers of the "favored few" banks. In addition, in this deflationary time, interest cuts have only begun.

The somewhat haphazard and piecemeal initial response to the crisis, especially in Europe has done little to boost confidence. However, following the UK's massive bank recap plan, the world began to coordinate it activity.

I am encouraged by some signs of life in the commercial paper market and by recent moves in LIBOR (finally.) As well, perhaps whimsically, there is now a TED spread gadget to be monitored on your iGoogle homepage. In my view, more of a sign of the late innings of a crisis than the beginning. We have also survived the Lehman CDS episode with nary a whimper.

The very high probability of a long and deep recession has prompted considerable fear recently. Though quite clearly, cyclical stocks
have reacted quite negatively to this prospect, most analysts have yet to revise their estimates downward for next year. Of course, this is causing some trepidation that more disappointment will follow. Here's a look at S&P consensus estimates according to Bloomberg and Bank of America stats.

Of all estimates that are higher in 09 versus 09:

Consensus estimates for 406 (82%) in the S&P are higher for 09 over 08. The overall average increase is +19% with a median of +11%.

45 of 500 (9%) are up +30-200% averaging +64%
34 of 500 (7%) are up +20-29% averaging 23%
156 of 500 (31%) are +10-19% averaging +13%
120 of 500 (24%) are up +5-9% averaging +7%
48 0f 500 (10%) are up +0-4% averaging +2%

In my view, most investors/ speculators/ traders in this market are completely oblivious to Wall Street estimates in this environment. People are trading from the gut rather than from consensus estimates. I believe Roy Neuberger ( of Neuberger and Berman fame) once spoke of analysts quite disparagingly, " In a bull market, who needs 'em, in a bear market, they'll kill ya.) I also believe that in a well-established and hopefully, late stage bear market, analysts are completely ignored and stocks will rally in the face of declining earnings estimates.

Recently one street strategist described a complacency that given stocks are down 30%+ that earnings misses are reflected in the valuations. According to him,"Magnitude of surprises on the downside can still surprise the market despite significant downward moves in the stock price prior to earnings release." As an example, Alcoa which had already been down 54% YTD dropped another 12% on its recent negative earnings surprise, and then fell another 27% after the earnings date. similar fates awaited shareholders of EAT, RT, IR, MWV, PEP, DPZ, JNY, SVU, NVLS, EBAY and others.

I have attempted my own analysis of negative earnings surprises. According to Zacks data between September 1st and October 23rd, there have been 190 companies that reported a negative earnings surprise of 10% or more.I chose the first 50 names of their screen for further analysis. Companies selected were not necessarily part of an index and had market caps ranging from $30 million to $72 Billion.

The average earnings surprise was -129%, obviously a horrific miss! The reaction on the earnings miss was as high as -37% though it averaged about -7.2%, even in these hardened times, a significant reaction.

However, after the earnings miss, the performance from that date to October 23rd was hardly supportive of the strategist's conclusion. In 25 cases, the stock outperformed the broad Russell 3000 index. In the other 25 cases, the stock underperformed the Russell. Here is a spreadsheet link outlining the findings.

Wall Street frequently puts far greater emphasis on its ability to forecast earnings as a stock picking methodology than is warranted. Though I have enormous respect for the work that analysts do, having served as a research director for a sell side firm, there are tremendous lags in information flow that can result in very limited usefulness. As well, GAAP allows tremendous scope for a management to make choices or assumptions that are not captured in a single point E.P.S. number. My advice, look for confirmatory evidence of conservatism and focus on cash flow rather than earnings.

Some final thoughts for this month. The market abounds in very cheap stocks. Free cash flow yields exceeding 10% are relatively easy to find. This particular metric is always a standard that I find produces the first inkling of a decent business value. Naturally, all screening depends on observation of historical data, and it is dangerous to simply extrapolate the past into the hereafter. Look to return on invested capital for evidence of superior profitabiity relative to its peers. Explore the basis of this competitive advantage.

When credit is difficult to obtain, companies with free cash flow generation can obviously survive. Low capital expenditure needs, low working capital needs keep both commercial bankers and investment bankers from knocking at the door, or at least management need not answer their futile calls. The ability to self-fund is golden in these times. Great businesses have histories of free cash flow generation for some years, not merely flash in the pan occurrences.

The adage of investigating before you invest is more important than ever. pronouncements by strategists using selective data points may sound impressive but check the reliability of the data...it may not always be complete. Though the Buffetts of this world may find a price to swing the bat with fierce determination when that fat pitch arrives, most of us do not have the intelllectual capital or emotional wherewithall to do so with confidence. Nibble and graze...diversify rather than feast. You will be able to concnetrate your positions later as evidence mounts that you have chosen well. Cash may seem like the greatest refuge but when a market abounds with bargains, it represents the sirens' lure.

In an environment where daily returns resemble traditinal monthly or even annual returns, volatility creates tremendous fear. Show some greed when the world seems to be falling apart. If your portfolio contains questionable stocks, use this opportunity to buy high quality names that you can grow wealth with through time.

Ignore Cramer and other prophets of myopic fortune or doom. These are times to think big and have long horizons.

It is exceedingly tough out there and easy to be discouraged. Be careful but stay in the game!

The Success Effect

2008-11-30T18:54:00.001-05:00

Business and investing is all about people. Great ideas are not just about numbers, and are not just about metrics. Developing an insight into how a business is run is easily translated into what creates a business' competitive advantage. Those sorts of insights are best garnered by interviewing and observation of managements, their competitors, and their customers.

Prior to the onset of Sarbanes-Oxley and Regulation FD, most analysts spent considerable time in interviewing of CEOs and CFOs of companies under their coverage. Unfortunately, in today's world where selective disclosure fears abound, far less time is spent in training analysts how to interview, and what sort of questions can be asked.

The "Success Effect" is written by the business reporter for the Cincinnati Enquirer,John Eckberg. Eckberg kept his tapes from various interviews he has conducted as a reporter. These interviews offer unusual and unique insight into the minds of this collage of successful, entrepreneurial and motivated people.

The book is an easy read based on Eckberg's easy, conversational style. His interview candidates have ranged from true business scions such as Donald Trump, Larry Bossidy and Lou Gerstner to much lesser known business people such as Dennis Spiegel whose career evolved from the age of 13 when he began taking tickets at the gate of an amusement park to founding the largest amusement park design and operations firm.

The interviews never drag...I think the longest interview of the 47 presented spans ten pages. This staccato style makes this an ideal night table book, where each chapter represents a rapid observation of what that person holds true, what has influenced his/her life, as well as lessons in leading a successful life.

Eckberg also compiles some additional personal information for each interviewee... each chapter contains a little vignette of "Books on The Nightstand," and "CD's In The Changer."

One of the more interesting interviews is of Doug Newburg, the Director of Performance Education at the University of Virginia School of Medicine. He believes that top performers share a trait of "resonance"- a sustained energy flow, an ever-present buzz that is linked to performance and engagement. As he observes, "Real competition is the competition between your vision and your skills-not between you and other people." Essentially, the more engaged you are, the more you enjoy what you are doing, and the better you perform. People who make it, hate to lose. The people who don't make it are afraid of losing.

At the end of each interview, Eckberg summarizes the findings with a two or three line "carryout," a summary of lessons learned. Here is an example from the Oscar Robertson interview:

"For group success, help the worst guy on a team achieve. Talented staff take care of themselves. Let customers know you and your company. Familiarity brings revenues because business in a cyber-age is still about relationships. Opportunities are all around you all the time."

There are many role models here from all walks of life. There are valuable lessons in what it takes to lead, to prosper, to establish a brand or niche, and to succeed.

This is an enjoyable read, a great stocking stuffer for yourself, your partner, your friends. I highly recommend!

Ben Graham meets the Exchange Trade Note part II

2008-08-18T15:46:00.004-04:00

As discussed in the previous post, Nuveen has created an interesting Benjamin Graham based index. Here is a look at the Graham Small Cap Index constituents for the Benjamin Graham Small Cap Value ELEMENTS portfolio:

A O Smith Corp
Administaff Inc
Adtran Inc
Alon USA Energy Inc
American Eagle Outfitters Inc
American Financial Group Inc
Amkor Technology Inc
Applied Industrial Technologies Inc
Arkansas Best
Aspen Insurance Holdings
Axis Capital Holdings
bebe stores inc
Biovail Corp
Black & Decker Corp
Brinker International
Brown Shoe Co Inc
Carlisle Cos
Carpenter Technology Corp
Cash America International
CF Industries Holdings Inc
CSG Systems International
Darden Restaurants Inc
Endurance Specialty Holdings
Ethan Allen Interiors Inc
Flowers Foods
Frontier Oil Corp
GFI Group
Graco Inc
Granite Construction
Group 1 Automotive
Guess? Inc
Harte-Hanks
Hasbro Inc
HCC Insurance Holdings
Heartland Express Inc
Heartland Payment Systems Inc
Heidrick & Struggles International Inc
Helmerich & Payne
Herbalife Corp
HNI Corp
Holly Corp
Hubbell Inc
IPC Holdings
J B Hunt Transport Services
Jones Lang LaSalle Inc
Kaiser Aluminum Corp
Landstar System Inc
Lennox International Inc
Manitowoc Co
Manpower Inc
Max Capital Group
Men's Wearhouse
Meredith Corp
Methanex Corp
Micrel Inc
Montpelier Re Holdings
NutriSystem Inc
Odyssey Re Holdings
OfficeMax Inc
Oshkosh Corp
Packaging Corp of America
PartnerRe Ltd
Patterson-UTI Energy Inc
Perini Corp
PETsMart Inc
Phillips-Van Heusen Corp
Platinum Underwriters Holdings
Polaris Industries
Pool Corp
Precision Drilling Trust
RadioShack Corp
Reliance Steel & Aluminum
Renaissance Re
RLI Corp
Robert Half International Inc
Ross Stores Inc
Rowan Cos
Sanderson Farms Inc
SEI Investments Co
Sierra Pacific Resources
Skywest Inc
Sotheby's
St. Mary Land & Exploration
StanCorp Financial Group
Technitrol Inc
Temple-Inland Inc
Tempur-Pedic International Inc
Terra Industries Inc
Tidewater Inc
Titanium Metals Corp
Toro Co
Total System Services Inc
Trinity Industries Inc
Watsco Inc
Werner Enterprises
Williams-Sonoma Inc
Wolverine World Wide Inc
XL Capital Ltd
Zenith National Insurance Corp

Disclaimer:I, my family, or clients hold current positions in American Eagle Outfitters, Applied Industrial Technologies, Endurance Specialty Holdings, Graco, Harte-Hanks, HNI Corp., Hubbell, Manitowoc,Micrel,RLI, Ross Stores, and XL Capital.

Ben Graham meets the Exchange Traded Note

2008-08-18T14:58:00.005-04:00

Exchange traded notes (ETN) are a fairly new investment product that share some characteristics of exchange-traded funds, or ETFs. They are simply direct debt obligations issued by a bank or investment firm rather than an interest in a pool of securities that define an ETF.

A bank simply issues a note and promises to pay the holder whatever the total return of an index is over the maturity of the note, less a management fee. The bank may or may not use the cash to invest in the index...it matters not, what an investor should care about is the return on the note which is the return of the index less fees. So long as the bank is solvent, investors will get the returns that they are promised.

An ETF has essentially no credit risk from a fund collapsing...an ETF investor is entitled to his/her share of the collective unit assets. There is always some tracking error risk in that the return may differ slightly from the underlying index.

ETN holders have no tracking error risk but do need to concern themselves with the credit risk of the offeror.

With that intro, proviso, and warning, let's talk about the Ben Graham aspect of ETNs.

Deutsche Bank, a AA-/AA1 bank has issued as of early August, a new ETN whose return is linked to the performance of one of several Benjamin Graham Indices. These securities are senior unsecured obligations of Deutsche. To be clear, these securities are NOT principal protected. The sponsor of the ETN is Nuveen Investments. The indices have been constructed by a Nuveen subsidiary, Hyde Park as part of their ELEMENTs series of product.

"The Index tracks the value of a portfolio of 50 large-cap U.S. stocks that are selected according to the Benjamin Graham Methodology.The Methodology seeks to identify businesses with strong, liquid balance sheets that trade at a discount to their implied intrinsic value, implementing the investment principles of Benjamin Graham through a quantitative, objective process utilizing modern portfolio theory and statistical analysis. The Methodology consists of four steps: (i) Universe Screening, (ii) Stock Selection, (iii) Semi-Annual Re-allocation, and (iv) Annual Reconstitution."

Interesting to see the juxtaposition of modern portfolio theory with Graham Methodology!

Certainly, the essential elements of Graham's theories are in place: The seven major factors are:

1. Earnings Quality – a quantitative analysis that seeks to measure a company’s reported earnings as
compared to an assessment of its true economic earnings.

2. Valuation – an examination of the ratios of a company’s share price to certain financial metrics, including historical earnings and book value.

3. Forward P/E – a ratio of price to consensus estimates of future earnings. Such estimates will be based
on data obtained from one or more vendors who provide consensus earnings estimates.

4. Dividend Yield – the ratio of a stock’s dividend to its share price.

5. Profitability – an evaluation based on measurements of a company’s return on capital.

6. Debt and Liquidity – an analysis of a company’s current assets as well as its ability to service debt.

7. Measurements Relative to Industry Peers – key measurements of valuation and performance compared to average levels within a given stock’s industry.

The seven major factors and their related sub-factors are part of the objective, rules-based,proprietary Methodology. Each major factor has a specified weighting and the sum of all major factor weights is equal to 100%. Each sub-factor has a specified percentage weighting and each group of sub-factors under a single
major factor has a combined weight of 100%.

I think the initial list of large cap names should be of some interest to readers:

Abercrombie & Fitch
Alcoa Inc
Allstate Corp.
Altria Group
AmerisourceBergen Corp.
Analog Devices Inc.
Applied Materials
BJ Services
CBS Corp
Corning Inc
Eli Lilly
Exxon Mobil
Franklin Resources
Gap Inc
Garmin Ltd
Genuine Parts
Genworth Financial Cl A
Halliburton Co
Harley Davidson
Hartford International Group
Home Depot
Host Hotels & Resorts
Illinois Tool Works
International Paper
J C Penney
KLA Tencor
Legg Mason
Lowes
Magna International
Mattel
McGraw Hill
Merck
Murphy Oil
Noble Corp
Nordstrom
Nucor
Pfizer
Qualcomm
Seagate Technology
Sherwin-Williams
Southern Copper Corp
Staples Inc
Sysco Corp
Texas Instruments
TJX
United Parcel Service
Valero Energy
W W Grainger
Wyeth

There are three ETNs that have been created here with links to the respective prospectus:

* Benjamin Graham Large Cap Value ELEMENTS (NYSEArca: BVL)
* Benjamin Graham Small Cap Value ELEMENTS (NYSEArca: BSC)
* Benjamin Graham Total Market Value ELEMENTS (NYSEArca: BVT)

The management fees for all of these are 75 basis points annually. The notes mature August 14th, 2023.

Since ETNs do not pay any capital gains, dividends, or interest over their lifetime, they ought to be superbly tax efficient as what is termed a "prepaid contract," i.e. the difference between the sale and purchase will be classified as a capital gain, and no taxes are due until there is a sale. I do not believe that the IRS has made a definitive ruling into this assertion and a nasty surprise could await!

Finally, even though I have high regard for Deutsche Bank as a solid credit (I, my family, or clients do hold some Deutsche stock and preferred shares,) I cannot emphasize enough the importance of knowing that ETNs are an obligation of this issuer and there is no guarantee as to principal.

Disclaimer: I. my family, or clients have a current position in CBS, Corning, Exxon Mobil, Genuine Parts, Illinois Tool Works, Legg Mason, Pfizer, Sysco, and Wyeth.

Book Review-"Even Buffett Isn't Perfect"

2008-07-20T18:52:00.003-04:00

I am a complete sucker for investment books. My wife accuses me of owning several thousand books that have essentially the same title, usually some variant of Value Investing, valuation, or intrinsic value, or securities analysis. Of course, I have every Buffett or Munger book known to man as well as everything about or by Benjamin Graham. By the way, speaking of Graham, my good friend Geoff Gannon is putting together a series which will review Securities Analysis chapter by chapter. For those who are serious value investing students, I suspect that you will enjoy Geoff's always thorough and thoughtful posts.

Vahan Janjigian, a fellow CFA, is executive director of Forbes Investment Advisory Institute and publishes a number of newsletters with Forbes. He also has a blog and serves on the investment committee of a large RIA.

Dr. Janjigian's book gingerly attempts to criticize some of Buffett's mistaken investments and controversial points of view. I think the book is more successful with the latter than the former.

Janjigian admires Buffett's discipline and capital allocation methodologies. He admires Buffett's ability to manage executive talent. His last sentence in the book summarizes his viewpoint,"Based on the evidence, it is certainly fair to conclude that WB is one of the greatest investors-if not the greatest investor-of all time."

So where are Buffett's mistakes? Janjigian criticizes Buffett's views on taxation, especially those on estate taxes. I agree with Janjigian that there is an irony if not an artificiality or phoniness about urging the continuity of high estate taxes and concomitantly avoiding the situation through setting up trusts and foundations Evidence of avoiding income taxes is evident throughout Berkshire's life...the company and Buffett have always used the IRS Tax Code to their advantage. There is clearly nothing wrong with that but similarly. it is somewhat disingenuous to urge higher taxes after a career of avoiding them.

Like any investor, Buffett has made some mistakes. This is not a game of perfect, but rather one where investors should attempt to understand the downside risks in making an investment. The outcomes can be highly uncertain...the future always is hazy and usually, initial assumptions are plain wrong, either on the optimistic or the pessimistic side of expectations.

Janjigian addresses the Buffett diversification versus concentration question. "Buffett believes that if you can't invest enough money to have some say in how the company's capital is to be deployed, you are better off diversifying your portfolio." This is simply not true. Most Buffetteers and wannabes certainly attempt to focus their portfolios. WB does not say not to diversify...in fact, for the average investor who is not inclined to do sufficient due diligence, diversification is a salvation. For many professional portfolios, the great bulk of the portfolio is indexed. But in cases where one has specialized knowledge or skills, satellite investments outside the cord index are made and should add performance. Diversification is a protection against ignorance. If one is able to do due diligence, and select successful businesses at reasonable valuations, diversification will not serve you other than to reduce volatility and an unfortunate corollary, reduce returns.

VJ does a decent job in discussing attributes of diversification in a non-mathematical approach to statistical correlation. This is one of the strongest elements in this book.

Much of the rest of the book is in my view, completely obvious. "Buffett buys stocks cheap, not cheap stocks." "Successful investors must be able to distinguish between great companies and great stocks." VJ has an amazing grasp of the obvious and adds little insight into valuation of growth stocks. There are far better sources than this book for this element.

VJ addresses the fact that value works over the long run but growth or rather momentum can work over the short run. Buffett never trashes growth but views it as a partner in helping undervalued stocks recover when growth becomes temporarily disrupted. Other than Buffett's famous comments about lemmings, he has never discussed momentum investing per se, at least to my knowledge.

VJ makes some dangerous statements about PIPE stocks indicating that WB has been successful in buying special issue "Private Investment in Public Equity" holdings such as Salomon Brothers or US Air. True, these had special terms that a large buyer can extract but it is misleading to believe that what some brokers present as PIPEs will offer the average investor better returns. Most PIPE offerings are made in very small cap, highly risky businesses. VJ does suggest that the best access to such investments is through a hedge fund or through Berkie itself.

VJ makes the point that "Unless you have access to Buffett-like resources, it is better to think of yourself as a stock buyer than a business buyer." The argument that managements will rarely listen to outside advice is humbling for both institutional and retail investors. However, retail investors and small institutional investors can be very successful in motivating and organizing larger investors to add pressure to a board. The principle of thinking long term as an owner of a business rather than a punter of stocks is an important part of any real value investor's credo. I have known many managers who "played" stocks rather than owned businesses and who were looking for trends rather than valuation rationales for stocks. They are assuredly not value managers. I have had investee company managements who have indicated that I should just sell the stock if I didn't like what they are doing. Again, these are managements who just don't get "it." If the business has a strong moat that is not being defended, get rid of the management but hang onto the business. VJ's advice is ill-conceived at best in this topic.

Swinging for the fat pitch is WB's approach. WB does not suffer from analysis paralysis and VJ believes that some of WB's recent deals have had inadequate due diligence. Sometimes the obvious should not take very long!

WB readily admits to being "dead wrong." Salomon was a mistake that took an extraordinary amount of work to escape. Gen Re was much worse with poor judgment on WB's part re underwriting discipline and the derivatives book of GenRe securities. NetJets capital intensity does not seem to fit the usual Buffett textbook. Pier One had no moat. Mistkaes all. VJ actually misses the most egregious errors that I recall, namely Dexter Shoe which gave away 1.6% of BRK or about $3.5 Billion in value for what is now a tiny fragment of H.H. Brown Shoe Group, another BRK sub. Dexter, Buffett calls his worst mistake. VJ doesn't even address this. There have been others. WB was the largest investor in Handy and Harman, the silver processor and refiner. Unfortunately, it was also an auto parts supplier and metal bender. Buffett's endless fascination with silver attracted him to H&H. H&H ultimately merged into WHX, which went chapter 11 in 2003. Berky had escaped H&H many years before this ignominious end.

VJ dislikes WB's views about corporate governance. It is incorrect to say that Buffett opposes employee stock options. It was the accounting for them that he faulted as well as the low hurdles that most company's managements clear to get them. In many cases, the only requirement for managements to achieve is respiration, and there are even cases where compensation continues into the after-life! There is nothing misleading about WB issuing options in subsidiary companies with clear performance mandates versus his public statements about employee stock options issuance.

The composition of WB's board has been controversial in the past. No it certainly was not independent historically with Warren and Charlie, Susan and Howard Buffett; Malcolm Chace, Walter Scott were old business cronies; Ron Olson was a partner in Munger's old firm. But VJ missed the most obvious point, Buffett for most of the time that he was involved in BRK owned over half the stock. It was absolutely iron clad clear that management's interests were aligned with shareholders. Unlike most public corporations, management owned most of the stock. The role of the board is not to protect minority shareholder interests but rather to ensure that shareholders' interests are protected. This point is missed by VJ.

Bottom-line, if you are looking for advice to imitate WB's investment style, this is not the best source. If you are looking for a comprehensive list of WB's mistakes in judgment, this is incomplete. If you are looking for views on taxation contra to those of WB, read Steve Forbes rather than VJ's book.

The key takeaways after each chapter provide an excellent summary of each chapter. The final chapter, "Conclusion" successfully highlights the important points.

Dr. Janjigian has attempted to provide an antidote to the usual glorious heaping of praise that most Buffett books (and CNBC coverage) provide. The reality is that nobody walks on water (or parts the sea depending on your point of view.) Even great investors frankly screw up royally. But the incidence in the case of Buffett is remarkably low, the damage is a scratch or fender bender rather than a complete wreck. Should all of us be so fortunate, or disciplined!!

John Templeton- The Triumph of Optimism

2008-07-09T08:44:00.002-04:00

Sir John Templeton passed away yesterday. He died, much as he spent his life, peacefully.Geoff Gannon (and it is great to have him back in the blogosphere) has an extensive list of articles outlining Templeton's life as well as a list of his books. John Bethel of Controlled Greed also has a good post on Templeton, with reminiscences about Templeton's appearance on Wall Street Week immediately following the October 1987 crash.

Templeton's life was one of great inner reflection and his original sale of Templeton, Dobbrow and Vance was motivated partially by his resolve to never let himself get so busy in managing clients that he ran out of time to think, not only about investments, but also about the larger world, especially spiritual matters and religion. His investment career became focused on just one thing, a small Canadian domiciled mutual fund that Piedmont Management, the buyer of the rest of his firm had declined. So at age 56, Templeton started his career with a clean slate and a single client, the mutual fund.

I believe there is a valuable lesson in Templeton's life, the importance of keeping your perspective. The distance from his home at Lyford Cay to the floor of any global stock exchange was measured in psychological light years, not unlike the distance from Buffett's Kiewit Plaza office to those exchanges.John Train, in his book Money Masters describes this as "a silent reproach to excitement and hyperactivity."

One of the best books about Templeton's investment approach is,at least in my opinion, The Templeton Touch by William Proctor, published in 1983.In it, he highlights twenty-two maxims that Templeton said were his enabling principles. Let me highlight them:

For all long-term investors, there is only one objective-"maximum total real return after taxes."
Achieving a good record takes much study and work, and is a lot harder than most people think.
It is impossible to produce a superior performance unless you do something different from the majority.
The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
To put "Maxim 4" in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.
To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
Bear markets have always been temporary. Share prices turn upward from one to twelve months before the bottom of the business cycle.
If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and, when lost, won't return for many years.
In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.
In free-enter[rise nations, the earnings on stock market indexes fluctuate around the book value of the shares of the index.
If you buy the same securities as other people, you will have the same results as other people.
The time to buy a stock is when the short-term owners have finished their selling, and the time to sell a stock is often when the short-term owners have finished their buying.
Share prices fluctuate more widely than values. Therefore, index funds will never produce the best total return performance.
Too many investors focus on "outlook" and "trend." Therefore, more profit is made by focusing on value.
If you search worldwide,you will find more bargains and better bargains than by studying only one nation. Also, you gain the safety of diversification.
The fluctuation of share prices is roughly proportional to the square root of the price.
The time to sell an asset is when you have found a much better bargain to replace it.
When any method for selecting stocks becomes popular, then switch to unpopular methods. As has been suggested in "Maxim 3," too many investors can spoil any share-selection method or any market-timing formula.
Never adopt permanently any type of asset, or any selection method. Try to stay flexible, open-minded, and skeptical. Long-term top results are achieved only by changing from popular to unpopular the types of securities you favor and your methods of selection.
The skill factor in selection is largest for the common-stock part of your investments.
The best performance is produced by a person, not a committee.
If you begin with prayer, you can think more clearly and make fewer stupid mistakes.

Templeton was never afraid to maintain cash reserves when he got edgy about market opportunities, though he always said he had little ability to time markets. He was a pioneer in international investing, as much at home in Japanese and Canadian exchanges as he was in American exchanges. His funds frequently had positions in small, less familiar names.Basically, it came down to this:

"Search among many markets for the companies selling for the smallest fraction of their true worth."

He was always ware of socialism and regulation, which he viewed as disguised expropriation...entanglements that inhibit business and destroy the investor's incentive.

Like Buffett, he greatly feared the impact of inflation on his investments and sough beneficiaries of inflation, companies that possessed the ability to pass through cost increases.

A confident optimistic outlook and a willingness to not follow the crowd over the cliff with momentum stocks served his clientele very well.

And hopefully, following such discipline will continue to serve all of us well. I am grateful for the contribution he made to to world.

May he rest in peace.

An Interesting Screen-Deteriorating Operating Margins and Increasing Capital Intensity

2008-04-20T18:51:00.002-04:00

As one would expect, deterioration in operating margins will occur in economic slowdowns. Marginal competitors frequently will try to clear inventories at ever lower margins in order to generate cash flow. I am particularly interested concerned if a company exhibits not only operating profitability deterioration but also a build up in working capital intensity (i.e. accounts receivable and inventories may be building and cash is not coming in as quickly as one would like.) Finally, if at the same time, the company is building capital expenditures, free cash flow generation can be impeded.

In this screen, I am taking trailing four quarter observations and comparing these to trailing four quarter observations lagged back one year prior. I have confined my screen to non-financial stocks in the S&P 1500.

There is no attempt to scale the amount of deterioration. For example, in 3M, a company which I continue to like, the operating margin has decreased from 22.57% to 22.53%, hardly alarming. Operating working capital to revenue has increased to 14.1% from 10.35% which still represents significant improvement from working capital levels which hit 20%+ levels of two years ago. Similarly, capex at 3M as it undertakes its international expansion is at 7.52% of revenues versus 6.94% four quarters prior, again, not an alarming pace. Bottom-line, this is a screen which is designed to raise some questions and further analysis, not to prompt an instant sell or a short.

The data is from Cash Flow Analytics, a company founded by Professor Chuck Mulford of Georgia Tech.

Finally, the ultimate test of investment is a test of market price versus intrinsic value, clearly a judgment that each investor should make for him or herself.

You will find the screen in this link: http://tinyurl.com/3oayag

Disclaimer: I, my family, or clients have a current position in 3M

Recurring Revenues and Financial Services- The Competitive Moat of Fiserv

2008-04-08T14:00:00.003-04:00

In our last post, we discussed the notion of recurring revenues as it pertains to companies in the industrial sector. The genesis of this idea was a reaction to the prevailing wisdom of many investment strategists to find recurring revenue streams in consumer staple or health care stocks. It is my contention that there are recurring revenue themes across many sectors that remain unrecognized in the marketplace.

As a brief aside, I will mention that our posture on MSC Industrial Direct (MSM) has received some nice support from Mr. Market since our post. Today's earnings release and conference call continue to support our thesis.

Though financial services revenues from a 30,000 foot perspective seem to be one of the last sectors one would consider to have recurring revenues, particularly in light of recent experience, there are some companies whose competitive advantages provide some assurance that business remains relatively stable despite the vagaries of the economy. Switching costs are a major advantage for many companies in this sector. Even small community banks can have a reasonably sacrosanct deposit base and provided that their lending operations remain conservative and sound, they can fit a recurring revenue theme. We think some insurance companies also fit this theme especially when their business is specialized or niche in nature.

Today's post is written by my colleague and friend, John Moran. John joined us as a portfolio manager in January. As a fellow CFA, he brings considerable analytical skill to our firm. Previously with Cohen & Company, he was a portfolio manager and senior research analyst focused on financial services in an alternative asset platform. Between 2001 and 2006, he was employed by Ryan Beck and a predecessor firm (Gruntal & Co.) as an equity analyst in various sectors including financial institutions, consumer products, and healthcare.Before entering the investment industry, John worked for Lucent Technologies in real estate finance and at Chubb Corporation, a leading property and casualty insurance company, where he held various accounting and finance positions.

Here are John's thoughts regarding Fiserv (FISV), in our opinion, a strong moat company in financial services.

Intro.

Fiserv trades at 12.5x 2009 cash earnings and 8x EV/2009 EBITDA. This is a small price to pay for a business that should grow earnings in excess of 15% per year with several sustainable competitive advantages leading to a highly recurring revenue stream. Down nearly 15% since credit issues began to take a toll on its core customers in the financial industry, market price reflects a discount of 30% to the value of the business.

Business Description.

Fiserv Inc. (FISV) is a leading provider of IT services to U.S. banks, thrifts, and credit unions. The company also provides administrative support services and processing to the insurance industry. The business was repositioned late last year through the sale of selected nonbanking businesses and the $4.4 billion acquisition of CheckFree, the market leader in electronic billing and payment (EBP) market. Just over 80% of Fiserv’s 2008 sales will come from its main business of core processing and related products for financial institutions and CheckFree. The balance will be derived from the company’s insurance service segment, which provides policy, rating, and claims administration as well as billing and reinsurance services.

Core Processing.

Core processing is the nuts-and-bolts infrastructure that allows checks to be posted, payments to be tracked and processed, and accounts to be managed. The company’s products and services form the backbone of its client’s back-office systems and are critical to conducting business – they are not discretionary in nature. Moreover, changing core processing systems is costly and time consuming in implementation and employee training for customers. System changes also increase the risk of potential interruptions and service issues. Clients are therefore unlikely to leave due to a modestly cheaper or slightly superior product – once a contract has been added, the client relationship tends to be fairly sticky and pricing is reasonably inelastic. Longer-term contracts with early termination fees are the norm and renewal rates consistently run 90+%, leading to a revenue stream that is highly recurring and reasonably predictable.

The high switching costs for core processing, arguably the company’s best sustainable competitive advantage, is a double edged sword since the company’s competitors also benefit from installed bases. As such, Fiserv’s biggest challenge in this segment is generating organic sales growth. The company controls 34% of the core processing market, more than 2.5x its nearest competitor. Cost advantages from this scale position combined with a diverse and tightly integrated product set positions Fiserv better than many of its competitors to win new business. This is evidenced from the company’s 40% win rate on new core processing deals – exactly 2.5x greater than its nearest competitor according to the 2007 Automation in Banking report. Organic revenue growth has averaged just over 5% over the last five years and the business has generated operating margins near or above 20% on a consistent basis.

Consolidation among core processing companies has led to a concentration of larger players and several smaller competitors that are increasingly disadvantaged due to limited product sets and scale. The market is dominated by six major competitors with a combined 75% share down from 24 major companies in 1987 and 55% of the market is now controlled by the top three companies. While there are few compelling or willing acquisition candidates remaining, there are still some 15 independent processing companies with a little less than 25% market share – some are owned by their customers and some are small segments of larger companies. As industry dynamics continue to shift toward an oligopolistic structure, it seems highly likely that smaller competitors will either exit the business or lose clients to larger competitors due to service, product capabilities/breadth, pricing, or some combination thereof. Moreover, consolidating competition has intensified barriers to entry and should lead to higher marginal returns on incremental business for the companies that remain.

Electronic Billing and Payment (EBP)

Fiserv repositioned its business late last year and early this year by selling certain nonbanking businesses and acquiring CheckFree for $4.4 billion. The strategic rationale for moving away from businesses where the company lacks scale in nonbanking businesses (Fiserv Health, Investment Support, and two mortgage/lending services related businesses) and moving more aggressively into higher growth businesses where it does is compelling. The acquisition also reinforces Fiserv’s position as the leading provider of technology solutions for financial institutions and proceeds from the sales of other segments will be used to pay down debt.

CheckFree is the market leading electronic bill payment and Internet banking service provider and one of only three scale providers in a growing industry. The company was an early mover in the EBP market and has a 27% market share – more than 3.5x the share of its nearest competitor. Like the company’s competitive advantages in processing, CheckFree benefits from high switching costs and has a marked cost advantage due to scale economies of the EBP business. Also like FISV’s core processing business, more than 90% of revenues are recurring in nature.

Historically, Fiserv’s clients tended to be small and mid sized institutions that had limited internal technology groups and contracted for a fairly wide range of its services. While it maintained client relationships with larger institutions, the top 25 banks tended to buy only a handful of Fiserv’s services. With CheckFree, the company has increased exposure to larger bank clients and, as the CheckFree products are fully integrated with its existing offerings, FISV might have the opportunity to sell a broader range of existing services to larger institutions. These upstream sales opportunities are likely somewhat limited – besides which, incremental sales to top 25 banks would likely come with pricing concessions and increased customer concentration risk (pro forma for CheckFree, we estimate that Bank of America is the largest customer at somewhat under 5.5% of combined revenues). However, the company appears to have a tremendous opportunity to increase penetration of CheckFree’s bill payment and internet banking solutions within Fiserv’s core client base, where 52% of customers have yet to install an EBP solution and 25% use a competitive product.

Also, CheckFree has a reasonably long runway in the bill payment and internet banking space. Consider the following:

- Just over half of the 70 million U.S. households with access to internet banking are actually using it; customers appear to be fairly early in the adoption cycle.
- Of those 36 million households that use internet banking, only 13.4 million households (or just under 40%) currently pay bills online, suggesting that online bill payment is even earlier in the adoption cycle.
- The vast majority of those that have adopted online bill payment are served by the top 25 banks.
- CheckFree has historically grown revenue at 16% compound annual rate with high teen operating margins and 30% EBITDA margins.

Insurance.

The company’s insurance segment focuses on transaction processing and administrations services for the life, property and casualty, and workers’ compensation segments of the insurance industry. It is the largest third party administrator of flood insurance policies and claims in the U.S. and a leader in workers’ comp processing. Outside the flood insurance platform, the company’s competitive advantage in these businesses is somewhat limited as compared to the core processing and CheckFree businesses and competition is more intense. Organic revenue growth in the insurance segments had averaged well more than 5% with operating margins low teen operating margins until the last few years, when internal growth was 0% to slightly negative and operating margins for the business collapsed to a bit under 8%. The segment has faced headwinds as higher margin flood claims processing revenue decreased and lower margin workers’ compensation businesses increased. The 2007/2006 decline in flood claims processing revenues created comparability issues that should not be a factor this year.

Financials.

Full-year 2008 internal revenue growth is expected to be 5% to 7%, with the financial segment at the upper end of the range and the insurance segment at the lower end of the range. This is possibly conservative given that 25% of the financial segment will now be comprised of revenue from the faster growing CheckFree business. Moreover, downstream revenue synergies that could begin materializing in the back half of this year could increase the revenue growth rate.

Fiserv has completed nearly150 transactions since its inception in the mid 1980’s, with acquired companies historically operating their businesses more or less independently. CEO Jeff Yabuki, now entering his third year at the company, has focused more on centralization, cross selling, and operational efficiency. Last year that focus yielded $50 million in incremental operating income or about 130 bps of operating margin ($30 million from integrated sales and $20 million in operational efficiencies). The company has more opportunities in this area and potential cost saves from the CheckFree acquisition should accelerate operating margin improvement – management guides to savings of $100 million, about 24% of CheckFree’s existing cost structure, which strikes us as achievable by the middle of 2009. Moreover, the company will not be up against difficult comparisons in the insurance segment this year. All things considered, the 75 basis points in operating margin improvement that management is currently guiding to for this year appears reasonably easy to achieve and the company should be generating operating margins of about 20% by 2009.

Over the next two years, the company will generate in excess of $1.1b in free cash flow, with the majority being used to pay down debt. By the end of 2008, EBITDA should be at a run rate of $1.5+ billion and the earnings run rate should be in excess of $4/share. Returns on invested capital will be depressed for the next few years due to the increased debt taken on in conjunction with the CheckFree acquisition, but should ultimately revert back to historic low/mid teen levels, well in excess of the company’s cost of capital. Financial technology and outsourced processing businesses with sustainable competitive advantages have traded for between 9.5x-12x EBITDA (on an enterprise value basis) and between 15x-20x earnings – seemingly reasonable for FISV given the competitive landscape. On either basis, the current market price looks like it provides a comfortable discount to underlying value of a high quality business.

Disclaimer: I, my family, or clients have a current position in FISV and MSM.

Recurring Revenues and Industrials

2008-03-29T17:28:00.005-04:00

Economic uncertainty generally steers investors toward steady eddy businesses such as foods, consumer staples, healthcare and utilities. But what investors should be seeking is recurring revenues, predictable and stable revenues with a high degree of certainty.

Recurring revenues are highly desirable and frequently carry a higher level of margin than capital equipment businesses. Even industrial companies can demonstrate a high level of recurring revenue and a fairly low level of capital intensity, both very desirable qualities for these times.

Manufacturing in the States, largely as a function of the weak dollar continues to progress at a fairly decent pace, especially for export related manufacturing. But industrial distributors can benefit greatly from this strength as well. Uniquely, most distributors end up as significant beneficiaries of inflation on two fronts.

Unlike many manufacturers who largely pass on cost increases dollar for dollar, distributors typically have been able to pass on gross margins on top of cost increases, meaning that these companies don't lose their margin percentage. The second point related to inflation is that distributors can sometimes be fortunate enough to get ahead of the curve in dealing with higher costs. These companies can obtain a shorter-term benefit in terms of a one-quarter or longer pickup in their gross margins if lower cost inventory is sold at the higher price points.

I think one of the better opportunities in industrial distribution exists in MSC Industrial Direct, a company I recently reviewed in Marketthoughts.com

MSC Industrial (MSM) is one of the nation's leading industrial supply distributors. With a network of 4 regional Customer Fulfillment Centers and over 90 branches nationwide, the company assures its customers same day shipping, at no extra cost, with over 99.99% availability. The company truly recognizes the importance of satisfying its customers' needs. If they fail to meet the service deadline standard, they send their customer $100.

The company's history dates back to 1941 but became a more significant factor as a direct sales organization with the publication of its first catalog in 1964. In 1994, the company began to expand into maintenance, repair and operations (MRO) products, which provide a more stable demand stream of sales and cash flow for the business. In addition to its master catalogs, the company also publishes 123 specialty catalogs tailored to specific industries or products.

The vp-finance of MSM described in the Wall Street Transcript (TWST.com-subscription required) a couple of years ago the steady demand for this business:

"...we have the ability to reduce the total procurement cost of MRO (maintenance, repair and operating) supplies for our customers. Every business uses MRO. It encompasses everything from abrasives and cutting tools and measuring instruments to lubricants, sanitary supplies, cleaning supplies, chemicals, solvents, hand tools, power tools, hardware, electrical supplies, plumbing supplies, HVAC and more; essentially, if you can think of an MRO item, it's likely that we have it in our catalog."

This is a highly fragmented industry. Again from the interview:

"Why do we grow and why have we grown so fast? Well, the industry that we compete in, the one for industrial supplies, is very, very fragmented. The total MRO marketplace in the United States alone is approximately $300 billion. If you exclude the demand from original equipment manufacturing, you probably have a $150 billion marketplace. that $150 billion represents what we call semi-planned and unplanned needs. Unplanned needs are pretty much self- explanatory ' something breaks and you need to replace it. So you call a distributor and they have the part and you get it. Semi-planned are those things you know you are going to use up over time; you just don't know when you are going to need it and how much you are going to need. Generally, these are things that people stock in tool cribs or in supply
rooms and historically they keep large inventories of these items just in case they need them. They are not things you want to be out of, because you can shut down a machine or a line or an entire factory. I mentioned the industry is very fragmented. There are approximately 150,000 distributors that share the $150 billion marketplace and they employ a sales force somewhere in the neighborhood of half a million sales people. Most of those distributors are very small and have very few SKUs (stock keeping units) on hand. And they generally are niche players. So they may be a safety distributor or an electrical distributor. These people play in a very small marketplace and historically, since MRO in any one particular business has not been paid a lot of attention, people are doing a lot of manual sourcing of MRO
supplies and dealing with a lot of different distributors. MSC is a superior business model because we have 590,000 SKUs in stock compared to the 15,000 or so a small distributor stocks. this allows an individual or a business or an educational institution or a government agency to consolidate their buying to one very reliable vendor that has it in stock and can get it to them quickly. "

The company has a particular competitive advantage in its extensive e-commerce abilities that enable customers to lower their procurement costs. This includes many features such as swift search and transaction abilities, access to real-time inventory, customer specific pricing, workflow management tools, customized reporting and other features. The systems can also interface directly with many purchasing portals such as ARIBA and Perfect Commerce, in addition to Enterprise Resource Planning (ERP) Procurement Solutions such as Oracle, SAP and Infor. Consequently, the firm offers its customers inventory management solutions that reduce sourcing costs, out of stock situations, and inventory investment, all of which become even more important when business slows.

MSM's valuation has contracted significantly of late; likely discounting further manufacturing and economic weakness, yet investors may be ignoring the potential benefits from share gain trends. On a trailing P/E basis, the company is as cheap as it has been in the last decade:

1998....32.8 X
1999....18.4
2000....23.2
2001....34.0
2002....34.8
2003....35.7
2004....30.8
2005....25.0
2006....18.4
2007....15.6
TTM.....15.4

The company is currently trading at an EV/EBITDA of about 8 times despite earning 20% return on invested capital last year. In the last five years, ROIC has averaged better than 15%. Here's a look at the ratio analysis courtesy of tenkwizard.com

Google Docs - msm ratios-marketthoughts

Check out the relatively low level of capital intensity that this company has demonstrated over time. The company has generated over $700 million in cash flow from operations since 2000 and has spent only $128 million in capex over that period. As well, the company has treated shareholders as partners. Share buybacks have returned over $280 million to shareholders. Here is a look at the deployment of cash flow and returns to shareholders since 2000 courtesy of Reuters Knowledge:

http://tinyurl.com/yvfvv2

Dividends, which were instituted in 2004, have grown steadily from an initial rate of $0.32 per share annually to a current annual pace of $0.72 and have returned $231 million to shareholders. The current yield is about 1.9%.

In January, the company announced that it has authorized an increase in its stock repurchase plan to 7.0 million shares, which includes the approximately 1.9 million shares remaining under the previous authorization.

The company has shown steady improvement in working capital utilization and currently operates on a cash cycle of 98 days versus 113 days three years ago.

Effective voting control of the firm is held by the founder and his sister who cumulatively hold 63% of the vote. Lone Pine Capital, run by Steve Mandel, a well-known hedge fund manager holds about 7.9% of the company.

Overall, this is a high ROIC business with a reasonably steady growth in recurring revenues. It is a business that seems to becoming more important to its customers and is grabbing market share in a very fragmented industry of mom and pop shops. Its competitive advantages come from scale and technological prowess as well as logistics. Some slowdown will occur in economic times such as we have but the valuation appears to compensate adequately.

Disclaimer: I, my family, or fclients have a current position in MSC.

A Lemons Market- Information Asymmetry and Bear Stearns

2008-03-14T15:42:00.002-04:00

Asymmetric information gets to the root of today's market problem in Bear Stearns. George Akerlof, Michael Spence, and Joseph Stiglitz won the 2001 Nobel Prize in Economics for their work in this area.

Akerlof, who wrote the earliest paper in this area, "The Market for Lemons: Quality Uncertainty and the Market Mechanism" describes the market for used cars as a market that is distorted by quality uncertainty. Owners of decent used cars are unable to get a "decent" price to make selling these cars worthwhile, therefore they don't place these cars in the market. Because "quality" is not readily ascertainable, the quality of traded automobiles should be sub-average.

A lemon market will be produced by the following:

1. Asymmetry of information
- no buyers can accurately assess the value of a product through examination before sale is made
- all sellers can more accurately assess the value of a product prior to sale
2. An incentive exists for the seller to pass off a low quality product as a higher quality one
3. Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)
4. Deficiency of effective public quality assurances (by reputation or regulation)
5. Deficiency of effective guarantees / warranties

The market in financial services stocks has become a lemons market. Questions about asset value prevail, liquidity concerns arise, and the true condition of the assets is enigmatic. Despite 225 basis points of Fed Funds rates and co-ordinated central bank liquidity, and a broad Term Security Lending Facility, the impact on market sentiment and credit spreads has been negligible.

There is but one solution to the problem... transparency and disclosure, being more open in what is going on and why. The mystery that surrounds the arrangement between JP Morgan and Bear Stearns contaminates the rumor mill and raises investors' concerns.

Bear Stearns may have $84 in book value which certainly gets the Ben Graham instincts going, but the reality is much more uncertain. Valuation in a financial services stock is wholly dependent on future cash flow streams. There is precious little in tangible assets. There is huge uncertainty about valuation of assets comprised of pyramids of paper assets. Given the uncertainty, Bear Stearns' counterparty ratings are clipped and may be viewed by some as almost toxic.

I cannot imagine how difficult it is for BSC employees as they watch their franchise quake in the crisis. We have friends and associates who either work there or have spent part of their careers there. My thoughts are with you.

But in the grand scheme of things, the market will survive this much as it has prior brokerage and banking crises. Great names like Drexel, LF Rothschild, Robertson Stephens, Gruntal, Hutton, and Continental Illinois are no longer part of today's world, having blown up.

Great investors understand the businesses in which they invest and ignore the noise. Focus, do your own work, and understand what it is you own. Emphasize the underlying economics of what you own and avoid the expensive distractions of today's tape.

Disclaimer: I. my family, or clients do not have a position in any of the securities mentioned in this post.

Beliefs, Perceptions and Reality-Semiconductor Capital Equipment

2008-03-12T14:20:00.003-04:00

Growth has a seductive charm. There is a widespread belief that momentum drives growth and that a succession of knocking down challenges and consequent victories is what characterizes a successful business. But sustained growth is seldom straightforward. Sustained growth frequently occurs as a result of changing course, breaking rules, and changing the rules of the game. I think some of the rules have changed for the semiconductor capital equipment companies.

Years ago, within the semiconductor industry, there was a strategy that merging companies would result in a reduction in the historic overcapacity issue. This trend certainly developed as Texas Instruments sold its DRAM capability to Micron and Hyundai and LG merged their operations. Small players would be wiped out or have to find niches to survive.

Last month, the Semiconductor Industry Association (SIA) reported that global sales of semiconductors grew last year by 3.2%. It really is an amazing figure given the fact that cell phone unit shipments grew 20%, that laptops grew 32.2%, that LCD TVs grew 50%, and consumer appetite for electronics seems unabated globally.

Total bit shipments for DRAMs nearly doubled in 2007, but total revenues declined by 7.4 percent due to a decline of more than 39 percent in ASPs. NAND flash revenues were up 26 percent but unit shipments grew even faster at nearly 46 percent, while ASPs declined by 13.7 percent.

Increased concentration in the industry simply has fanned the flames of competition and price cutting rather than quell them. To quote Steve Pelayo of HSBC who recently was interviewed in The Wall Street Transcript (subscription required):

"DRAM manufacturing has been in a state of oversupply, which resulted in greater than 75% average selling price (ASP) declines last year. As a result of the significant ASP pressure, many DRAM players today are now reporting operating margins that are significantly in the red, as much as negative 50% operating margins. So clearly too much excess supply in DRAMs and a lack of profitability is causing a massive contraction in their capital spending plans this year."

Post tech bubble, semiconductor capital spending did a face plant, down 40% in 2001 and another 30% in 2002. The equipment companies responded by diversifying their revenue sources into other segments such as solar equipment and flat panel displays. In past cycles, whenever semiconductor demand slowed or caught a sniffle, pneumonia ensued for their capital equipment suppliers. This time may be different!

Growth has slowed but in fact these businesses have improved. Let's look at the capital intensity of some of the semiconductor companies versus that of their equipment suppliers:

Capital spending as a percentage of revenues (TTM)

Micron (MU) 59.3 %
Intel (INTC) 11.25 %
Advanced Micro (AMD) 24.75 %

Applied Materials(AMAT) 5.08 %
ASML Holding (ASML) 7.46 %
KLA-Tencor (KLAC) 5.09 %
Novellus (NVLS) 2.12 %

With this lower fixed cost intensity, equipment companies should not see their margins crater and improved what Pelayo calls their "cyclical resiliency."

All of the semiconductor capital equipment companies I have cited above generated free cash flow in the last twelve months. Pelayo adds:

"The cash flow generation capabilities have proven much more improved too, with some consistently generating 20% plus returns on operating cash flow, and in some cases similar returns even on a free cash flow basis (including cash outlays for capital spending). All of this positive cash flow just continues to add to the companies' treasure chests of cash, which has resulted in many of the larger players starting to pay dividends and buy back stock. The dividend yields are still less than 2% or so, but I think they have the opportunity to increase over time. So far, equipment suppliers have been really focused on buying back their stocks. Companies like Applied Materials have bought back a tremendous amount and decreased their shares outstanding by as much as 15% or so."

The solar opportunity for these suppliers seems to receive very little attention by investors. Solar manufacturing has many similarities to semiconductor production and presumably, can provide significant fewer growth for these companies. As I suggest earlier, getting knocked down, getting beaten up by too high a reliance on traditional customers helped the semiconductor capital equipment companies approach other niches. Changing course and changing the rules of the game has made them better businesses.

Disclaimer: Neither I, my family, or clients have a position in the securities mentioned in this post with the exception of Intel.

Renaissance and Revival

2008-03-08T21:19:00.002-05:00

It has been an extraordinarily long time since I last published thoughts here for which I truly apologize. Needless to say, capital markets have been challenging and clients prefer a higher level of care and attention when markets are rocky. Businesses evolve through these challenges and create opportunities to add skillsets and analytics and establish an even firmer foundation and discipline. Renaissance and revival are frequently the result of such times.

I particularly want to thank a fellow Canadian, Jay Walker, the Confused Capitalist for his gentle cajoling me back into the blogosphere. Jay has just celebrated the second anniversary of the start of his excellent blog and I congratulate him for his terrific work. His understanding of real estate appraisal and investments make his blog a valuable resource in these times.

One especially interesting e-mail from an anonymous reader suggested that I am Geoff Gannon of Gannon on Investing whose publishing frequency has also been impacted by other projects. I am not, nor is he. Geoff, your insightful commentary and wisdom are missed.

A few other friends that I wish to thank for their help and indulgence in this period of absence. Henry To at Marketthoughts.com continues to provide investors valuable reflections on the stock market and the global economy as well as an outstanding forum. I am pleased to be a monthly contributor to his service. David Korn, who with Henry and Kirk Lindstrom publish the Retirement Advisor, a timely resource for people who are either approaching or in retirement has also been kind enough to publish some of my thoughts in his website, BeginInvesting.com.

To my loyal readers, I appreciate your patience, your readership, and in particular the continued interest in past topics and posts. I endeavor to improve the frequency in sharing our thoughts.

Back to stocks. Many years ago, I was introduced to Alleghany Corp (Y) by a lucky accident. I had previously worked for the Canadian subsidiary of Lincoln National (LNC) which had just sold off its title insurance subsidiary, Chicago Title to Alleghany at what appeared, at least to me, to be a bargain price. Housing back in the early to mid- 80's was reviled as much as it is currently, in fact, in our mortgage department, we were recipients of people's keys that were being mailed in as people were giving up their homes. Title insurance was considered a terrible red-haired step child at the parent company with little chance of earning a return. John Burns, then the CEO of Alleghany saw opportunity in this distress sale. The payback on this investment was 18 months, absolutely remarkable for what was viewed as a no-growth business. Needless to say, I became a big fan of Burns and of Alleghany. Chicago Title was ultimately spun-off to shareholders and later became part of Fidelity National (FNF).

Visiting Burns at Alleghany over the years reinforced the value discipline that this remarkable gentleman has. He is an avid student of value investing and of course Buffett. His attention to detail, his keen awareness of valuation,and his knowledge of the insurance industry were always very impressive.

Many of us value hounds collect stories of Berkshire, White Mountains (WTM), Leucadia (LUK), and Markel (MKL), yet too infrequently is Alleghany mentioned. The objective of the firm sounds very Buffett-like:

"Alleghany's objective is to create stockholder value through the ownership and management of a small group of operating businesses and investments, anchored by a core position in property and casualty insurance. Alleghany is managed by a select company staff which seeks out attractive investment opportunities, delegates responsibilities to competent and motivated managers, defines risk parameters, sets management goals for its operating businesses, ensures that managers are provided with incentives to meet these goals, and monitors their progress.The operating businesses function in an entrepreneurial climate as quasi-autonomous enterprises.Conservatism dominates Alleghany's management philosophy. Alleghany's philosophy shuns investment fads and fashions in favor of acquiring relatively few interests in basic financial and industrial enterprises that offer the potential to deliver long-term value to the investor."

Alleghany has brought some very unique insurance businesses into the fold. Capital Transamerica of Madison, WI was an insurance company with a magnificent underwriting record in specialty lines and a history of shareholders equity growth that George Fait, its founder and president would remind me at insurance conferences actually outgrew Berkshire's record. It was true!

Another successful specialty insurance franchise was acquired with RSUI, Royal Specialty Underwriting, Inc. , the Atlanta, Georgia-based excess and surplus underwriting subsidiary of Royal & Sun Alliance Insurance Group plc.

Alleghany holds a majority ownership in Darwin Professional Underwriters (DR) a company tightly focused on Directors and Officers, and Errors and Omissions insurance. Stephen Sills, the founder and CEO of DR, was the chief underwriter and founder and ultimately the CEO of Executive Risk, a very highly regarded company in this field. Executive Risk eventually went public. Chubb (CB) acquired this business in 1999 at a very full price. Alleghany, on the other hand, established Darwin with Sills in 2003 as an 80/20 venture as an underwriting manager under Capital Transamerica, as usual, avoiding paying a huge acquisition premium.

Years before Berkshire bought its position in Burlington Northern Santa Fe (BNI), John Burns had accumulated a large position in the 1990's. The cost basis, about $12.07 versus today's $88.00.

Strong executive leadership continues to impress since Burns' retirement (he remains Chairman.) Wes Hicks has extensive experience as a senior executive, capital manager and research analyst in the insurance and investment industries. He joined Alleghany from Chubb Corporation, where he was CFO. Prior to Chubb, he was a senior research analyst covering the property-casualty and multiline insurance industries at J.P. Morgan Securities (where he was also a managing director) for two years and Sanford C. Bernstein & Co., Inc for eight years.

Going through the recent 10-K, results remain quite strong. Ex cats and cap gains they earned $30.29 in 2007 vs. $28.20 in 2006. Cash and invested assets are $4.9b and the company's book value grew by almost 16% yoy. All the insurance subs wrote at an underwriting profit for the Q except CATA, which was due to higher loss and loss adjustments (but was offset somewhat by higher net premium). Overall they did a very respectable 77% combined ratio.

Trading at about 1.1x book value, the company appears very well capitalized if not over-capitalized. RSUI’s (66% of underwriting profit) most admired peers (MKL, RLI, and CGI) command multiples of book value between 1.5x and 1.8x – CGI is the object of $2.3b takeout at 1.6x – and a well run, growing, profitable insurance company should go for more than 1.1x. In addition, the firm carries the Darwin (DR) stake and real estate owned in the Sacramento, CA area at below-market historic price, providing hidden asset value and additional upside to book value. This hidden asset value may in fact equate to the stock trading at book.

In my estimation, the fair value for this business is $425-$475. The potent combination of multiple expansion and book value growth as well as outstanding investment ability could prove very profitable over the coming years. The company also recognizes its value and has recently announced a $300 million share buyback.

One negative aside. Standard & Poor's downgraded slightly Alleghany's credit rating to BBB from BBB+, in my view casting more doubt on S&P's credit ranking abilities than on Alleghany's credit. The slight downgrade was done without any discussion with Alleghany executives perhaps leading some of us to question the degree of due diligence that may have been demonstrated here. Wes Hicks also expressed some surprise and disappointment in this.

In my view, among the financial services stocks, the company stands out for its conservatism, its strong underwriting discipline, and its great executive team which has masterfully allocated capital over the years.

Disclaimer: I, my family, or clients hold a position in Alleghany, Berkshire, and Markel.

Happy Thanksgiving!!

2007-11-22T10:00:00.001-05:00

Happy Thanksgiving wishes to our American readers! Certainly, no matter what the circumstances that life may bring you, there is always much for which to be thankful.

It has been said that the hardest arithmetic to master is that which enables us to count our blessings. Albert Schweitzer described the importance of gratitude,

" To educate yourself for the feeling of gratitude means to take nothing for granted, but to always seek out and value the kind that will stand behind the action. Nothing that is done for you is a matter of course. Everything originates in a will for the good, which is directed at you. Train yourself never to put off the word or action for the expression of gratitude."

America's National Day of Thanksgiving actually was proclaimed by President Lincoln in October of 1863 which set apart the last Thursday of November "as a day of Thanksgiving and Praise." The nation was still in the midst of civil war and the battle of Gettysburg had occurred just several months prior. Lincoln had not yet delivered his Gettysburg address.

Despite the horrible anguish of war, Lincoln delivered the following proclamation:

"The year that is drawing towards its close, has been filled with the blessings of fruitful fields and healthful skies. To these bounties, which are so constantly enjoyed that we are prone to forget the source from which they come, others have been added, which are of so extraordinary a nature, that they cannot fail to penetrate and soften even the heart which is habitually insensible to the ever watchful providence of Almighty God"...

"It has seemed to me fit and proper that they should be solemnly, reverently and gratefully acknowledged as with one heart and one voice by the whole American People. I do therefore invite my fellow citizens in every part of the United States, and also those who are at sea and those who are sojourning in foreign lands, to set apart and observe the last Thursday of November next, as a day of Thanksgiving and Praise to our beneficent Father who dwelleth in the Heavens. And I recommend to them that while offering up the ascriptions justly due to Him for such singular deliverances and blessings, they do also, with humble penitence for our national perverseness and disobedience, commend to His tender care all those who have become widows, orphans, mourners or sufferers in the lamentable civil strife in which we are unavoidably engaged, and fervently implore the interposition of the Almighty Hand to heal the wounds of the nation and to restore it as soon as may be consistent with the Divine purposes to the full enjoyment of peace, harmony, tranquility and Union."

Though war rages in many parts of the world, though terrorism remains an ever-present concern to all of us, though there remains "lamentable civil strife" in many nations, the magnificent words of Lincoln ring true today.

My Thanksgiving wishes for all of us include for you and yours the full enjoyment of peace, harmony and tranquility.We have much for which to be grateful and thankful. I count your loyal readership among my blessings! Have a good one!

Fear Brings Opportunity and Digging for Value

2007-11-14T09:01:00.001-05:00

Whitney Tilson is the founder and Managing Partner of T2 Partners, a hedge fund, as well as a mutual fund operation. He has co-founded a terrific newletter and established a semi-annual investment conference, Value Investing Congress, where he features a number of legendary investors. As an extension of the conference, he has introduced a new blog to highlight value investment thinking. One of the recent posts is, in my opinion, quite demonstrative of the "inverse emotionalism" that is required to be a successful value investor.

Zeke Ashton of Centaur Capital describes the fear that has infected financial services stocks very aptly:

"Clearly, we’ve got fear now, and at the epicenter of that fear is the U.S. real estate market. This fear is reflected in extraordinary volatility and stock price declines for those companies seen most vulnerable to the real estate bust – most notably homebuilders, mortgage lenders, and mortgage guarantors – coupled with all-time high prices for disaster protection on these names."

If there is a single mantra for value investors, Ashton nails it here:

"But as all value investors know, fear brings opportunity. One of the axioms of fear-based selling is that everything viewed as being in proximity to the danger gets sold."

Indeed, fear brings opportunity, and panic is never discriminating. Damage occurs at the periphery of the disaster and securities are unjustly marked down. True value investors sift through the rubble to unearth the bargains that were caught in the cross-fire. Timing is impossible, but strict adherence to a discipline and patience will provide great long-term returns. In a behavioral sense, it is always difficult to overcome the social pressure to conform. Being ostracized by others (especially clients who don't yet "get it") is a difficult position to maintain. No wonder closet-indexing is so prevalent; closet indexers turn out to be momentum players, just like the indices they hug! But, doing your own thing, ignoring the noise, celebrating the fear of others is a good high probability bet if your decisions are disciplined.

Here is the direct link.