Street Capitalist: Event Driven Value Investments

I woke up at 7AM yesterday to have a chance to read Warren Buffett’s Berkshire Hathaway 2009 letter to shareholders (PDF). This year’s letter did not disappoint. I would like to highlight a few key ideas from the letter.

Intrinsic Value

At the beginning of each letter, you will see a table of how Berkshire Hathaway’s growth in book value fared versus the S&P 500′s. Now, as Buffett states below, book value does not precisely peg intrinsic value but it comes close:

The ideal standard for measuring our yearly progress would be the change in Berkshire’s per-share intrinsic value. Alas, that value cannot be calculated with anything close to precision, so we instead use a crude proxy for it: per-share book value. Relying on this yardstick has its shortcomings, which we discuss on pages 92 and 93. Additionally, book value at most companies understates intrinsic value, and that is certainly the case at Berkshire. In aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value. By this measurement, as the opening paragraph of this letter states, our book value since the start of fiscal 1965 has grown at a rate of 20.3% compounded annually.

Whitney Tilson takes a different approach for figuring out the company’s intrinsic value: you take the company’s per share investments and add them to pretax earnings per share with a multiple attached. This is closer to what Warren Buffett has recommended for pegging Berkshire’s intrinsic value, but it is also more difficult to determine. For most people, the book value approach should be sufficient enough.

Float

Most people don’t understand float, but it is probably the key factor in Berkshire Hathaway’s growth over the last 40 years. Let’s say you are a value investor and you manage to take control of a company. In general, your opportunities range from reinvesting in the business you have acquired, to looking at outside opportunities. These can be acquisitions of other businesses or simple investments in securities. Normally, such investments must be paid for using free cash flow or debt. But if you were to acquire an insurance company, you would have one more weapon in your arsenal, float:

Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.

If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float…

Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.

Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses. Our insurance CEOs deserve your thanks, having added many billions of dollars to Berkshire’s value. It’s a pleasure for me to tell you about these all-stars.

Bolded for emphasis. The $16M to $62B figure is absolutely amazing and speaks to the power of a disciplined insurance operation. Not to detract from the 2009 letter, but I think the following discussion on National Indemnity from the 2004 is quite insightful here. Indeed, in Buffett’s 2004 letter, he said that without the acquisition of National Indemnity, Berkshire would be nowhere close to its size today:

So, you may ask, how do Berkshire’s insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage? We’ve attacked that problem in several ways. Let’s look first at NICO’s strategy.

When we purchased the company – a specialist in commercial auto and general liability insurance – it did not appear to have any attributes that would overcome the industry’s chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.

Many insurance companies end up chasing premiums without adequate risk management and blow up. They never have the time to really endure and grow, the way that Berkshire has done with National Indemnity and its other operations. Now, back to the 2009 letter.

Buffett uses the rest of the insurance section of the letter to praise Ajit Jain’s activities at Berkshire Reinsurance and mentions that GEICO has gone from the country’s 6th largest auto insurer to the third largest in just 15 years. One of the best things about Buffett is he always owns up to his mistakes. It seems as if a foray into the credit card business did not work out so well for GEICO:

And now a painful confession: Last year your chairman closed the book on a very expensive business fiasco entirely of his own making.

For many years I had struggled to think of side products that we could offer our millions of loyal GEICO customers. Unfortunately, I finally succeeded, coming up with a brilliant insight that we should market our own credit card. I reasoned that GEICO policyholders were likely to be good credit risks and, assuming we offered an attractive card, would likely favor us with their business. We got business all right – but of the wrong type.

Our pre-tax losses from credit-card operations came to about $6.3 million before I finally woke up. We then sold our $98 million portfolio of troubled receivables for 55¢ on the dollar, losing an additional $44 million.

GEICO’s managers, it should be emphasized, were never enthusiastic about my idea. They warned me that instead of getting the cream of GEICO’s customers we would get the – – – – – well, let’s call it the non-cream. I subtly indicated that I was older and wiser.

I was just older.

That kind of honesty is unparalleled in shareholder letters, which usually read more like corporate propaganda than honest assessments of the business.

Burlington Northern Santa Fe

(Flickr: SP8254)

The regulated utilities section of the letter provides some insights on why the Buffett chose to acquire Burlington Northern. I think that for the most part, guys like Bruce Berkowitz were right in their assessment on Burlington Northern:

CONSUELO MACK: Let me ask you about the Burlington Northern acquisition, the largest acquisition that Berkshire Hathaway has ever made. The Wall Street Journal coverage of it saidWarren Buffett is turning Berkshire Hathaway into a big industrial operator and it’s no longer thenimble investment firm that it was once. What’s your view of what Warren is doing in buying thesebig industrial companies?

BRUCE BERKOWITZ: Berkshire has a tremendous amount of flow from the premiums received from long-term insurance policies. That flow has to be invested in very secure, sound financial instruments such as: electric utilities cost plus or a railroad business which has the stability unlikemany businesses. So here he’s taking money that’s actually got a zero cost to it and then investing itat a reasonable, not at an egregious yield, but at a reasonable investment yield. But when the cost iszero, the returns are phenomenal. He’s brilliant. Warren Buffett is being Warren Buffett in that he’smarried another great big business to Berkshire Hathaway that’s going to make a sizeable difference overtime

Buffett believes that BNSF should be looked at as a utility as well:

Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come. Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant…

In the future, BNSF results will be included in this “regulated utility” section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital.

Buffett does not say explicitly what he thinks the returns on invested capital will be for the railroad business but that it should increase over time. Burlington Northern should definitely have the kind of pricing power it needs to ward off the frictional forces of inflation, should regulators act properly.

NetJets

(Course Correction: NetJets)

When David Sokol took the reigns at NetJets, I think people looked at the situation in two ways. 1. This would be a test for Sokol, to see if he has what it takes to be the CEO of Berkshire Hathaway. 2. Berkshire’s businesses aren’t infallible and may need guidance from time to time. Here is what Buffett said of the situation:

We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that both operating and capital decisions are occasionally made with which Charlie and I would have disagreed had we been consulted…

The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our dominance in the field remains unchallenged.

NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.

Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of NetJets in August. His leadership has been transforming: Debt has already been reduced to $1.4 billion, and, after suffering a staggering loss of $711 million in 2009, the company is now solidly profitable.

Most important, none of the changes wrought by Dave have in any way undercut the top-of-the-line standards for safety and service that Rich Santulli, NetJets’ previous CEO and the father of the fractional- ownership industry, insisted upon.

With the debt reduced to $1.4B and the company profitable, David Sokol looks as if he has passed the test. Sokol has gradually had the opportunity to get more face time with the media. We saw this with his activities at NetJets and the investment in BYD. I think he is poised to be the right operations guy at Berkshire, with Ajit Jain handling the insurance operations and the still unnamed CIO handling investments.

Financial Products and Derivatives

On occasion, Buffett has criticized the government’s lending policies with good reason. Berkshire is unable to get the kinds of lending rates that TARP recipients received in the past, which put the company at a decided disadvantage when it came to bidding on parts of companies such as AIG. But in this year’s letter, Buffett sheds light on another problem:

The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 51⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.

In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton’s homes offer terrific value. If the buyer needs mortgage financing, however – and, of course, most buyers do – the difference in financing costs too often negates the attractive price of a factory-built home…

Our product is first-class, inexpensive and constantly being improved. Moreover, we will continue to use Berkshire’s credit to support Clayton’s mortgage program, convinced as we are of its soundness. Even so, Berkshire can’t borrow at a rate approaching that available to government agencies. This handicap will limit sales, hurting both Clayton and a multitude of worthy families who long for a low-cost home.

These kinds of double standards hurt buyers of Clayton’s homes, especially considering that Clayton’s buyers are not speculators. Most are simply people looking to buy a home and live in it. They aren’t the gluttonous home flippers that helped fuel the excess supply in the housing market.

One of the problems with the media and Warren Buffett is that they often try to over simplify what he says, boiling things down into sound bytes that don’t give the full picture. This is definitely the case with derivatives.

A number of commentators have criticized Buffett for investing in derivatives contracts after calling derivatives weapons of mass destruction. The thing is, Buffett was criticizing how most financial institutions were using derivatives. For the most part, companies like AIG were writing billions upon billions of dollars worth of CDS contracts using faulty math behind defaults. They were totally unrealistic. We see now that Greece tried to use contracts to fudge their budgetary accounting and make their deficits appear artificially lower. These kinds of uses of derivatives are pretty stupid and can cause the mass destruction that Buffett described. Actually, if you look at AIG and the state of Greece, you could argue that they have already caused that destruction.

The Berkshire approach to derivatives is different. For the most part, Buffett looks at these like he does insurance. He is trying to find mispricings where the risk is limited and the duration from now till when money must be exchanged is sufficiently long enough to earn enough from the float to limit any kind of damage that would occur if Berkshire is on the losing side of these contracts:

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.

It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.

Most people incorrectly assume that value investing means just investing in well run large cap stocks. It doesn’t. Value investing is buying a dollar for 50 cents. Where that dollar exists should not matter. A good investor should be willing to travel across asset classes in search of these bargains, and that is what great investors like Seth Klarman, Prem Watsa, and Warren Buffett have done in the past.

The entire letter is worth reading, especially for getting a more detailed insight into some of Berkshire Hathaway’s lesser known subsidiaries and overall performance for 2009.

Vertical integration appears to be a continuing trend in the business world, with Coca-Cola’s (NYSE:KO) decision to acquire Coca-Cola Enterprises (NYSE:CCE) being the latest example:

Coca-Cola Co. agreed Thursday to buy the bulk of its largest bottler in a deal valued at about $12.17 billion, including debt, to gain more control of manufacturing and distribution.

Under the terms of the deal, Coke would give up its 34% stake in Coca-Cola Enterprises Inc., worth $3.4 billion, and assume $8.88 billion in debt, and all North American assets and liabilities. CCE agreed in principle to buy Coca-Cola’s bottling operations in Norway and Sweden for $822 million, and acquire a 83% equity stake in its German bottling operations in the near future.

CCE’s shares surged 30% to $25 in premarket trading, while Coca-Cola fell 2.6% to $53.65.

With the transaction, Coca-Cola Chairman and Chief Executive Muhtar Kent said the company was converting “passive capital into active capital.” He added it would give Coca-Cola direct control over its investment in North America to accelerate growth.

CCE shareholders will get one share of a new Coca-Cola Enterprises company focused only on European bottling and will get a one-time $10-a-share payment. The company plans to issue debt to finance this payment and the European acquisition.

Coke will control about 90% of the bottling of its products in North America. It expects cost savings of $350 million over four years and that the acquisition will add to earnings per share by 2012. The transactions are expected to close in the fourth quarter.

Coca-Cola Strikes Deal With Bottler (WSJ)

Dana Cimilluca, Betsy McKay, and Jeffrey McCracken go on to note how this is a big reversal in strategy by Coke. We saw the first example of this earlier with Pepsi:

PepsiCo announced last April that it aimed to subsume Pepsi Bottling Group Inc. and PepsiAmericas Inc. Pepsi said the $7.8 billion deal will allow it to have greater control over development, distribution and marketing of new products with the acquisitions, which are expected to close Friday.

Owning its bottlers allows PepsiCo to negotiate alone with retailers, rather than sharing that task with representatives of separately publicly traded bottlers…

When PepsiCo Chairman and CEO Indra Nooyi launched that company’s similar move in April, she said owning the two bottlers would give it the flexibility to decide how its beverages should be distributed. As the industry moves from a heavy reliance on carbonated soft drinks into water, juice, teas and other noncarbonated drinks, some soft-drink bottlers don’t have the equipment to manufacture the noncarbonated drinks and many are sold in small volumes. “We can accelerate revenue growth and be more agile and flexible,” Ms. Nooyi said at the time.

PepsiCo has said it expects to save $400 million by 2012 from the deals. But Bill Pecoriello, chief executive of ConsumerEdge Research LLC, believes the company may actually reap more than $600 million.

These deals make sense for Pepsi and Coke as consumers shift away from soft drinks. With consumers becoming more health conscious, they are looking towards healthier drink options, think Vitamin Water or juices and teas. This is problematic for Pepsi and Coke because they didn’t have the power to bring such drinks to market. By shedding their bottling units in the 80′s, they were able to take assets off of their balance sheet and become more akin to marketing companies — thus boosting their ROIC. Now though, even if they generate good returns on invested cash, they still face the problem of lagging behind upstart competitors. Coke needs control over bottlers so they can push new investments in equipment and strategy, to bring non-carbonated beverages to market. The price of that lag can be staggering, Coke’s decision to acquire Vitamin Water for $4.1B is evidence of that.

The main problem stems from the fact that the bottling business is expensive and very capital intensive making it difficult to quickly deploy resources in trying new and untested beverage concepts. I would guess that Coca-Cola Enterprises is reluctant to do this, given the nature of their business, and would rather have Coke shoulder the risk. How does that shouldering of the risk occur? Coke sells Coca-Cola Enterprises its syrup at a certain price. Longer term fixed prices for syrups would have enabled the bottlers to raise prices and increase margins on their end, without having to resort to increasing the volume of their sales. But, it seems as if such an agreement was not possible, and Coke had to follow Pepsi’s lead in a bottler acquisition.

Still, there is some savvy dealmaking behind the transaction. Unlike Kraft’s decision to sell its Pizza business to Nestle in a poorly structured manner that incurred a high tax rate, this deal looks as if it may be a tax fee exchange in which their equity position in the bottler is swapped for operating assets. However, deal will undoubtedly dilute Coke’s return on invested capital. Coke’s ROIC appears to be at about 22% whereas the bottling unit CCE achieves a low 7%. But, this may make strategic sense in the longer term as Coke and Pepsi fight to expand beyond their carbonated offerings and continue their dominance as

Overall, this looks to be the continuation of an ongoing trend where companies are integrating vertically as their margins are pressured by shifts in the market and consumer demand. I loved Ben Worthen, Cari Tuna, and Justin Scheck’s piece in the Wall Street Journal on it:

…executives [are] reviving “vertical integration,” a 100-year-old strategy in which a company controls materials, manufacturing and distribution. Others moving recently in this direction include ArcelorMittal, PepsiCo Inc., General Motors Co. and Boeing Co.

The reasons vary. Arcelor, the world’s largest steelmaker, wants more control over its raw materials. Pepsi wants more authority over distribution. GM and Boeing are moving by necessity, to assure quantity and quality of vital parts from troubled suppliers. Some are repurchasing businesses they only recently shed.

“The pendulum has shifted from disintegration to integration,” says Harold Sirkin, global head of the Boston Consulting Group’s operations practice. He attributes the change to volatile commodity prices, financial pressures at suppliers and quests for new revenue — challenges exacerbated by the recession…

Such steps don’t necessarily portend a return to the early-20th-century vertical conglomerates of Andrew Carnegie and Henry Ford. Then, Carnegie Steel Co. and Ford Motor Co. each owned iron-ore mines, while controlling everything from manufacturing to sales.

“The historical view of vertical integration was that you had complete control of the supply chain and that you could manage it the best,” says Bain & Co. consultant Mark Gottfredson.

Today’s approach is more nuanced. Companies are buying key parts of their supply chains, but most don’t want end-to-end control.

Companies More Prone to Go ‘Vertical’ (WSJ)

If the trend continues, investors could go hunting for some of these key supply chain players that are publicly traded. If they are undervalued, an acquisition would undoubtedly be a catalyst for that value being unlocked. For investors in the acquirers, you can expect some of that ROIC being sacrificed.

Eddie Lampert has released his 2010 Sears Holdings (NASDAQ:SHLD) chairman’s letter and I thought I’d highlight a few points that I thought were interesting. Over the last few years, Lampert has been hit harsh criticism from the business press, mostly because they perceived that he was failing in his turnaround at Sears. Mostly, I think a turnaround has happened, but its evidence is more visible on a financial level.

I visited Sears stores a couple times last summer and was not impressed, the stores aren’t as nice as competitors Walmart and Target, the employees did not seem as knowledgeable, and there wasn’t a great selection of inventory available. These kinds of observations may cloud an analyst’s judgement when looking at Sears objectively. Indeed, the results over the last year have been pretty good:

Today we announced our financial results for our 2009 fiscal year. I am pleased to report that we delivered both stability and progress, resulting in roughly $1.8 billion of Adjusted EBITDA, an improvement of more than $200 million over 2008. While this may be surprising to some, it isn’t to me. The dedication of our associates and leadership team led by Bruce Johnson and the diversity of the Sears Holdings business portfolio—Sears Full Line stores, Kmart stores, our Home Services business, Sears Auto Centers, Outlet Stores, Hometown Stores, the Kenmore, Craftsman, DieHard and Lands’ End brands, our majority interest in Sears Canada, and our online business properties including sears.com—have allowed us to successfully manage through the economic and financial crisis of the past two years.

Edward Lampert: Sears Holdings 2010 Chairman’s Letter

If you look back at Sears over the last few years versus competitors, you will see that Lampert decisively cut capital expenditures and investments in store expansion while most others gluttonously spent their way into the crisis. Competitors were forced to abruptly change their course and slash spending, inventory, or restructure/file for bankruptcy. Sears was nimble enough to evade most of the fallout from the financial crisis:

In 2009, we kept expenses under control and stayed focused on our vision and strategic, operational, and financial goals. We were both prudent and opportunistic in spending money and in allocating capital at a time when many others had to make major adjustments.

Early in the year we amended and extended our revolving credit facility through June 2012. In one of the most difficult financing markets in recent memory, we found significant support from numerous financial partners led by Bank of America, Wells Fargo and General Electric, and we executed one of the largest revolving credit facilities in the past couple of years. Our substantial asset base and our strong cash flow management were important factors in this successful deal. When people take a close and objective look at our company, our strengths are not difficult to see.

Sears was not totally unscathed by the crisis though. Store closures in retail are a reality, especially during downturns:

On a less positive note, we regret the closing of roughly 60 stores in 2009. Most of those stores have underperformed for some time and, despite focused efforts to improve them, we felt that we could no longer afford to wait for those stores to turn around. With expiring leases, we have been able to reduce our money-losing stores while at the same time generating cash from the liquidation of inventory and the monetization of some of the stores that we closed. We continue to evaluate our store portfolio, over 2,200 Kmart and Sears Full Line stores combined, and experiment with new and different ways to serve our customers and avoid additional store closings. Like any retailer, we would expect that our store portfolio will require continuous evaluation and transformation as we strive to have every store contribute to the creation of future value.

In the middle of last year, I responded to an errant published story that repeated unfounded claims from a Wall Street analyst regarding the cash impact of our store closings. As I explained, in most cases, when we close stores we generate cash, net of any cash required for severance and other store closing expenses. The GAAP accounting losses arise from the markdown of inventory, write-off of fixed asset balances, associate severance and any remaining payments on leases that expire in the future. Our ability to close stores is in no way hampered by any cash requirements. Instead, our preference is to operate stores profitably and to transform unprofitable or marginally profitable stores into money makers by evolving our formats to better meet the needs of the communities in which we operate. We know that when we operate our stores well, we have the ability to serve our customers well and to make money.

What’s important to note here is the fact that Lampert looks at stores as investments. Every store requires some level of capital investment and so they need to be judged from a perspective of how much return on cash they generate. Some stores will be posting good numbers, others may post negative ones. Lampert appears to take an experimental approach to store investment, where capital expenditures vary by store and concept. By doing this, in theory, he should be able to see what works and then adopt that more widely.

The biggest problem for an investor looking at retailers is properly gauging management. Management teams sometimes become consumed by their own egos that they engage on ruinous store expansion campaigns, financed by debt, at the top of the market. We know that Lampert isn’t like that, so the key is to discern whether he is deploying capital in the right ways. Given his share buybacks into the crisis, it looks like he has been doing well. That same type of capital allocation is not happening at competitors:

While we continued to repurchase shares during the economic crisis because the value was attractive and because we had significantly lower leverage than others in our industry, many of our competitors suspended their repurchase programs to appease credit rating agencies only to resume them again after their share prices recovered significantly.

We can understand rating agency caution surrounding economic events, the retail environment, and the potential for things to get worse. In our case, it turns out that our performance far exceeded many observers’ expectations and we hope to receive credit for this performance in the form of higher credit ratings and more balanced analysis.

Rating agencies play an important role in how investors allocate capital by “qualifying” debt for certain investors. By overrating companies and securities, rating agencies can lead to systemic issues and investor losses. Similarly, by underrating companies they can lead to lower growth, less risk taking, and less job creation. Simplistic analyses, which automatically prefer capital investment to share repurchases as a use of cash that “benefits“ bondholders, ignore the fact that negative or below market returns on invested capital are as harmful to creditors as to shareholders.

When we inquire why our ratings are not higher than some competitors with credit metrics that are weaker than ours, one factor cited is that some analysts prefer their business models. Meanwhile, we have a higher market capitalization and less debt than many of these competitors. We increased our earnings, while many others have seen their earnings decline. We have a diversified business portfolio and a significant revenue base and scale. Obviously, we don’t agree with all of the critical qualitative conclusions and the quantitative metrics speak for themselves.

We do some things differently than others, and we have certain beliefs that differ from theirs. Our culture is owner-oriented, because we have owners who serve on the board that governs the company. We believe that ownership makes a difference, especially when owners have significant financial interests in the company and a long-term perspective. Instead of this raising concern, rating agencies should welcome and value owners with a demonstrated track record of long-term value creation and conservative capital policies, even when some of the capital allocation preferences differ from those that others believe lead to higher long-term credit performance.

The criticism Lampert lodges at ratings agencies is pretty valid. Ratings agencies largely do not reward sharp capital allocation skills. They will view it as a positive when a company suspends its share buyback program as its stock price crashes, even though (as we learned from John Singleton) that is precisely the best time to buy. Such behavior reinforces bad practices among executives and ultimately destroys shareholder wealth.

Lampert goes on to talk about growth strategies for Sears. He plans to expand the already successful Land’s End brand, domestically and internationally. Others include Sears’ online initiatives like the Sears My Gofer plan. One I found interesting was their plan for franchising auto centers:

Sears Holdings Corp. today announced the launch of a new strategic initiative for the Sears Automotive business. The Independent Sears Auto Center franchise program offers automobile dealers the opportunity to operate licensed Sears Auto Centers, bringing the Sears brand, buying power, distribution network, systems and corporate support to automotive aftermarket businesses. Coleman Auto Group of East Windsor, New Jersey, is the first dealership to take advantage of this opportunity and will open a Sears Auto Center in March 2010.

Sears Auto Centers Introduce Franchise Business (PR Newswire)

The franchise business is often a good one, because of the high returns on capital. It is easy to see from the numbers given:

Franchises must pay an initial fee of $30,000 for the franchise and $3,000 a month in brand license fees for the first year and $2,000 monthly thereafter. A service license fee of 2% of prior year revenue is charged after the first year, and franchisees contribute 3% of net revenue to a marketing fund to support national advertising and activities.

Several thousand auto dealerships in the U.S. have lost their franchises as auto makers have consolidated amid efforts to become profitable.

“There is a lot of very good talent in rejected Jeep, Chrysler, Dodge, Saturn, Pontiac and Saab dealers that already have the facilities in place, the manpower and years of experience to help Sears sell their products,” said Bruce Coleman, president of the Coleman Auto Group dealership in East Windsor, N.J., and a partner in what will be the first Sears Auto Center franchise.

UPDATE: Sears Begins Franchising Of Its Auto Centers (Dow Jones)

At the end of his letter, Lampert recommends Thomas Sowell’s book Intellectuals and Society, here is the Amazon description:

The influence of intellectuals is not only greater than in previous eras but also takes a very different form from that envisioned by those like Machiavelli and others who have wanted to directly influence rulers. It has not been by shaping the opinions or directing the actions of the holders of power that modern intellectuals have most influenced the course of events, but by shaping public opinion in ways that affect the actions of power holders in democratic societies, whether or not those power holders accept the general vision or the particular policies favored by intellectuals. Even government leaders with disdain or contempt for intellectuals have had to bend to the climate of opinion shaped by those intellectuals.

Intellectuals and Society not only examines the track record of intellectuals in the things they have advocated but also analyzes the incentives and constraints under which their views and visions have emerged. One of the most surprising aspects of this study is how often intellectuals have been proved not only wrong, but grossly and disastrously wrong in their prescriptions for the ills of society—and how little their views have changed in response to empirical evidence of the disasters entailed by those views.

He reflects on the government intervention in financial markets over the last year or so, questioning its logic and contrasting it with his own conservative leaning views on business and regulation. Those ideas fit in line with his book recommendation last year, The Road to Serfdom by F. A. Hayek:

An unimpeachable classic work in political philosophy, intellectual and cultural history, and economics, The Road to Serfdom has inspired and infuriated politicians, scholars, and general readers for half a century. Originally published in 1944—when Eleanor Roosevelt supported the efforts of Stalin, and Albert Einstein subscribed lock, stock, and barrel to the socialist program—The Road to Serfdom was seen as heretical for its passionate warning against the dangers of state control over the means of production. For F. A. Hayek, the collectivist idea of empowering government with increasing economic control would lead not to a utopia but to the horrors of Nazi Germany and Fascist Italy.

Now the question is, does Lampert’s letter change my mind on Sears? At current levels, no. The company is held by many savvy investors and has a great capital allocator at its helm, but still resides in a cutthroat sector where I’d rather look for a larger margin of safety that isn’t so dependent on its chairman. Still, I like to watch the company and study its turnaround for insights when examining the larger universe of investment opportunities.

When I saw the 13F for Fairfax Financial Holdings (TSE:FFH) come out, one of the things I wondered was when Prem Watsa would do another acquisition. With Fairfax’s success over the last few years and good financial shape, I thought the company would be poised for an acquisition. Watsa has publicly said that they are not interested in straying too far out of the insurance business when it comes to acquisitions. They don’t want to build another Berkshire Hathaway.

So, I’m pretty happy to see this acquisition of Zenith National Insurance (NYSE:ZNT). Zenith is in the workers’ compensation insurance business, which means that policies are generally long tail, meaning that payouts happen over longer periods of time. To contrast, short-tail insurance usually has payouts over shorter periods of time and more frequently. This is typical when you look at the likelihood that a person will get into an accident in their car versus an injury at the workplace.

So why is acquiring long-tail insurance operations so beneficial to a company like Fairfax? For one, Zenith is well operated. Moreover, the long-tail policies enable Fairfax to increase the size of its float — which is the amount of Zenith receives in premiums that it does not have to be paid out immediately or held in reserves. That capital is often invested in securities, in Zenith’s case mostly bonds, which could potentially be redeployed into more attractive securities by smart capital allocators like the people at Fairfax. Fairfax is not the only smart investor to have acquired workers’ compensation insurance companies, Warren Buffett’s Berkshire Hathaway owns National Indemnity which has workers’ compensation operations in California.

The one stickler for the Zenith deal is the fact that Fairfax will have to issue a little equity to complete the deal but will still have about $1 billion in cash on hand after the acquisition.

Via Bloomberg:

Fairfax Financial Holdings Ltd., the Canadian insurer run by Prem Watsa, agreed to buy Zenith National Insurance Corp. for about $1.3 billion in cash, adding sales in California.

Fairfax will pay $38 a share, the Toronto-based company said today in a statement. That’s 31 percent more than Woodland Hills, California-based Zenith’s $28.91 closing price on the New York Stock Exchange yesterday. The deal is expected to be completed in the second quarter.

Watsa, 59, is betting on a rebound in a workers’ compensation market pressured by rising medical costs and falling payrolls. Like Warren Buffett at Berkshire Hathaway Inc. and Loews Corp.’s Tisch family, Watsa built his company by investing the assets of insurance operations, often in out-of- favor securities.

“Workers’ compensation is probably the softest of all lines right now,” Bob Hartwig, president of the Insurance Information Institute, said at a conference in November, using industry parlance for a market where rates are falling. “Rate accounts for the vast majority of premium reduction we have seen in workers’ compensation.”

…Zenith, run by Chairman and Chief Executive Officer Stanley Zax since 1978, said in its 2009 annual report that it has “a long-term record of outperforming the industry.” Zenith’s workers’ compensation loss ratio, a measure of how much of each dollar of premium is paid in claims, was lower than the industry average every year from 2002 to 2008, according to Zenith’s annual report.

“There will be no changes in Zenith’s strategic or operating philosophy,” Watsa said in the statement.

Watsa’s Fairfax Agrees to Buy Insurer Zenith for $1.3 Billion

(Flickr:rickz)

Investing in commodities is usually a hotly debated area among value investors. In theory, being able to obtain commodities at a deep discount is just what value investing is. But, there is a tendency for investors to circle around this corner of the market only when commodity prices really heat up. It is easy to accidentally invest into a bubble and watch your margin of safety disappear. Still, I believe it is insightful to study how great commodity investors work, and MaryAnn Busso’s awesome Bloomberg article about Tom Winmill provides us with a glimpse of his approach:

Gold had a good year in 2009. Tom Winmill’s Midas Fund had an even better one.

The $125 million fund, which invests in companies that mine or process metals or other commodities, was up 83 percent last year. That return beat 95 percent of the fund’s peers, according to data compiled by Bloomberg.

Winmill, 50, says his training as a lawyer helps him sift through engineering reports on mining deposits, Bloomberg Markets reports in its March 2010 issue. “That’s much more important than putting on your hiking boots and walking around the mine,” he says.

Among the items high on Winmill’s checklist when picking stocks: a miner’s ability to start production on time and on budget and to preserve the value of its shares. “I like to see a mining company that pays a dividend, occasionally does a stock buyback — instead of constant stock issuance — and doesn’t make dilutive acquisitions in order to extend their empire,” Winmill says. Those three things, combined with a good project, are key, he says.

As of January, Winmill had the majority of the fund’s assets in stocks of gold-mining companies. Returns on miners’ shares tend to amplify the returns on gold because of the companies’ operating leverage, Winmill says. That gave the fund a boost from a bullish market as investors sought to protect the value of their holdings. “The devaluation of the dollar and the bursting of the bond bubble are going to hurt a lot of investors,” Winmill says. “And inflation is going to hurt a lot of savers.”

Midas Fund’s Winmill Turns Gold Rise Into 83% Return on Miners (Bloomberg)

Some of the key takeaways here are that an investor should spend a lot of time getting acquainted with understanding the engineering reports issued by these miners, to properly gauge the situation. Note that he does not find actually visiting the mines to be useful. There is probably good reason for that, someone who is untrained at gauging physical mining operations may inaccurately perceive activity. Engineering reports are a way to more objectively determine the mine’s prospects.

After looking at gold through his four filters of U.S. fiscal policy, U.S. monetary policy, market supply and demand, and geopolitical events, Winmill analyzes individual gold miners, hoping to take advantage of the operating leverage they provide. I thought Winmill’s checklist for mining companies was worth noting:

1. The ability to start production on time and on budget
2. Pays a dividend
3. Pursues share buybacks
4. Does not pursue dilutive acquisitions

A company with all of these characteristics would be one that is run by a sound capital allocator. After the commodities bubble burst in 2008, Rio Tinto was one miner that was hit particularly hard. The company engaged in a ruinous acquisition plan, financed by mountains of debt. The company was like a homeowner who purchased homes that they could not afford, with the hope that its price would rise, and that they would be able to refinance their mortgages. Eventually, the music stopped playing and Rio Tinto scrambled to find ways to infuse its balance sheet with capital and pay down debt.

I can’t say I have a lot of knowledge of good managers of miners and other commodity companies, but I do know that many investors like Ken Peak, who runs Contango Oil and Gas (AMEX:MCF). In the Bloomberg article, Winmill goes on to mention a few companies that he likes:

Among the miners that meet Winmill’s investment test is Northern Dynasty Minerals Ltd. (AMEX:NAK) The Vancouver-based company is developing Alaska’s Pebble gold and copper project in partnership with Anglo American Plc. Shares of Northern Dynasty, which is 20 percent owned by Rio Tinto Group, rose 124 percent in 2009. This year, the stock rose 3 percent to trade at $8.52 on Feb. 10. “They’ve got experienced, well-capitalized partners who really know how to get the ore out of the ground,” Winmill says.

Midas also owns shares of Jaguar Mining Inc.(NYSE:JAG) The Concord, New Hampshire-based company is bringing older gold mines in Brazil back into production. Winmill says Jaguar’s output might reach 600,000 ounces in about five years, up from 115,000 ounces in 2008. He says the company is likely to be acquired. Jaguar’s shares jumped 114 percent in 2009. This year, they fell 14 percent to trade at $9.60 on Feb. 10…

Midas’s holdings also include Silvercorp Metals Inc. and Fresnillo Plc. Shares of Vancouver-based Silvercorp, which has been buying high-grade mines in China, rose 210 percent last year. Stock of Mexico City-based Fresnillo, which operates silver mines in Mexico, was up 244 percent in 2009.

Midas Fund’s Winmill Turns Gold Rise Into 83% Return on Miners (Bloomberg)

Be sure to read all of the article, it’s a great look at how one investor operates. Warren Buffett has invested in commodities in the past, specifically silver, so it is worth taking some time to study. It’s always good to expand your circle of competence and a good value investor should be willing to travel through asset classes in search of value.

Former Treasury Secretary Hank Paulson has a new book coming out, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, which looks like an interesting account of what happened from his perspective. As Paulson describes:

The pace of events during the financial crisis of 2008 was truly breathtaking. In this book, I have done my best to describe my actions and the thinking behind them during that time, and to convey the breakneck speed at which events were happening all around us.

I believe the most important part of this story is the way Ben Bernanke, Tim Geithner, and I worked as a team through the worst financial crisis since the Great Depression. There can’t be many other examples of economic leaders managing a crisis who had as much trust in one another as we did. Our partnership proved to be an enormous asset during an incredibly difficult period. But at the same time, this is my story, and as hard as I have tried to reflect the contributions made by everyone involved, it is primarily about my work and that of my talented and dedicated team at Treasury.

–Henry M. Paulson

Warren Buffett recently had an opportunity to interview Paulson in Omaha, and didn’t spare any tough questions, choosing to even ask about whether the TARP would be repaid (Paulson said yes).

Below is a video of the interview:

via: Paulson: Acts averted disaster (Omaha World Herald)

(Click for video)

The play here looks familiar to other theses that I’m seeing from hedge funds. Namely, that after TARP and the government’s intervention, the worst is over for a company like Citi. It does not have to worry about failing and now, an investor just has to look at their prospects for income generation from newer loans to pay for loan losses:

Michael Breen: Speaking of mulligans, you just bought a firm that probably wish it had one for the past couple of years: Citigroup. Maybe you can let us know how you got comfortable with that, because a few years back, you were speaking about how you couldn’t get transparency on the big banks and the financials.

So is it a case of the blind now being able to see, or have things been shored up to a point that anybody can get comfortable with it? Why don’t you give us the thesis for Citigroup?

Bruce Berkowitz: I think it’s a bit of both. In the U.S., this was not a bankruptcy, but it’s gone through a scrubbing process, very similar to a bankruptcy, by the U.S. Treasury. Citigroup has spent a good amount of time with the U.S. government and many of its financial regulators, going through every liability and asset in the books.

After such a period of time, you normally are able to count the cockroaches. That is, the liabilities have been under a microscope for quite a period of time. There’s been huge capital injections by the government. There’s been a massive amount of dilution to old shareholders. And you’re starting to see some stability, the beginnings.

It’s very much what I call now the pig in the python. You have to look at their liabilities. So you have to look at their bad debt, and you have to continue to watch how the company is digesting its bad debt.

At the same time, you have to see the new debt that’s coming in, the new loans that they’re giving out. It’s fascinating. It amazes me, with financial institutions, the extent, the amount of new loans that are being created in relation to the total loan portfolio.

So it’s just now, in my opinion, a question of time, an ingestion period, where how many more quarters is it going to take before the new loans start to outweigh the old, existing loans?

…

Breen: And so for Citigroup, it’s safe to say they are far enough out of the woods that you’re comfortable with the equity, where, with the real-estate debt, with the bankruptcy, it’s a different situation, and you’re taking a different spot on the capital structure.

Berkowitz: Right. We’re in there. Our major partner is the U.S. government. I mean, Citigroup is woven into the fabric of the United States. Citigroup will be around. I hope it will be around in a smaller form. It will be around in a better form, it most likely will be around with different management, and Citigroup will move on.

How Berkowitz Got Comfortable with Citi (Morningstar)

(Flickr: Mikey G Ottawa)

Drake Bennett at the Boston Globe has an interesting article on cognitive fluency. Basically, he cites research that says the more simple or familiar something is, the more persuasive it becomes:

One of the hottest topics in psychology today is something called “cognitive fluency.” Cognitive fluency is simply a measure of how easy it is to think about something, and it turns out that people prefer things that are easy to think about to those that are hard. On the face of it, it’s a rather intuitive idea. But psychologists are only beginning to uncover the surprising extent to which fluency guides our thinking, and in situations where we have no idea it is at work.

Psychologists have determined, for example, that shares in companies with easy-to-pronounce names do indeed significantly outperform those with hard-to-pronounce names. Other studies have shown that when presenting people with a factual statement, manipulations that make the statement easier to mentally process – even totally nonsubstantive changes like writing it in a cleaner font or making it rhyme or simply repeating it – can alter people’s judgment of the truth of the statement, along with their evaluation of the intelligence of the statement’s author and their confidence in their own judgments and abilities. Similar manipulations can get subjects to be more forgiving, more adventurous, and more open about their personal shortcomings.

Because it shapes our thinking in so many ways, fluency is implicated in decisions about everything from the products we buy to the people we find attractive to the candidates we vote for – in short, in any situation where we weigh information. It’s a key part of the puzzle of how feelings like attraction and belief and suspicion work, and what researchers are learning about fluency has ramifications for anyone interested in eliciting those emotions.

“Every purchase you make, every interaction you have, every judgment you make can be put along a continuum from fluent to disfluent,” says Adam Alter, a psychologist at the New York University Stern School who co-wrote the paper on fluency and stock prices. “If you can understand how fluency influences judgment, you can understand many, many, many different kinds of judgments better than we do at the moment.”

Easy = True (Boston.com)

I can definitely see the use of rhymes and folksy/familiar manners of speaking increase the persuasiveness of your writing. If someone is writing in a very complicated manner, filled with jargon, the reader should be more focused and scrutinizing than if they were presented with a simple letter between friends. Note how Warren Buffett speaks in his letters.

For investors, understanding cognitive fluency could be helpful. I don’t know if I buy the companies with easy to pronounce names argument, but I do believe strong brands are helpful. Companies that are able to evoke familiar images and feelings may have a strong affect on consumers. This could be similar to Warren Buffett’s ideas about how See’s Candies manages to do so well on Valentine’s Day sales.

Read the full article for more details.