Street Capitalist: Event Driven Value Investments

Many of you enjoyed my previous transcript of a talk Li Lu gave at Columbia University. Thanks to Joe Koster, you can now view a more recent lecture he gave to Bruce Greenwald’s value investing class in April of 2010.

Based on Berkshire’s investment in BYD, the fact that Lu manages Charlie Munger’s money, and that even Buffett would give money to Lu if he ever retired (according to Greenwald) makes me think Li Lu is an investor worth watching.

With that in mind, I believe it is insightful to study whatever you can find about him and his approach. I think this lecture from 2010 is great. The recording has some audio issues making it difficult to hear and I thought that some of you might enjoy reading notes from the talk. This is not a true transcript, but an approximation of what was said. I think it comes pretty close, having listened to the lecture a few times. I think you will find it helpful and Lu’s talk rewarding.

Bruce Greenwald: Warren Buffett says that when he retires, there are three people he would like to manage his money. First is Seth Klarman of the Baupost Group, who you will hear from later in the course. Next is Greg Alexander of the Sequoia Fund. Third is Li Lu. He happens to manage all of Charlie Munger’s money. I have a small investment with him and in four years it is up 400%.

[Applause]

Li Lu: Columbia is where my whole life in America started. I could barely speak the language. In Columbia it was where I had a new life. It was really in the Value Investing class where I got my career start. I was really worried about my student loan debt at the time and a friend told me about this class and said I need to see a lecture from Warren Buffett.

What I heard that night changed my life. He said three things:

1. A stock is not a piece of paper, it is a piece of ownership in a company.

2. You need a margin of safety so if you are wrong you don’t lose much.

3. In the market, most people are in it for the short term. It allows you a framework for dealing with the day to day volatility.

Those were three powerful concepts. I had never viewed the stock market like that. I viewed it negatively as a place made up of manipulators who were lining their own pockets. I embarked on an intensive two year study learning everything about Buffett.

Two years after that I bought my first stock. After I graduated I worked at an investment bank for a year and realized it was a mistake. I tried to start a fund but I didn’t have a track record. The first year I managed money I lost 19%.

Being a value investor means you look at the downside before looking at the upside. Before becoming an investor you need to look at how you can fail at this game. There are all sorts of ways you can fail. You need to examine who you are and see if you could be good at it. If you could ever find something you can do well that you really like — that will be your best investment. You will do better than competitors. If you can do it with intrinsic passion, that really over time will add enormous value to you.

Back to the game of investing. This concept of margin of safety is an essential concept to be a good investor. The future is unpredictable, you will always be dealt surprises, some positive most negative. You need to build in a level of safety so that whatever happens, you will not get crushed. If you can really successfully know what you are getting into, you can pretty much navigate. Most people are troubled by what they don’t know. The world is divided by those who know and those who don’t know. If you really know — you will not pull triggers like Wall St. traders. If you are truly intellectually honest, you would not do anything.

This class teaches you to know what you are getting into, especially accepting what things you don’t know. The game of investment is really continuous learning. Everything affects an investment, it constantly changes. You are not investing in the past but the accumulative cash flow of the future. You have to want to find a certain set up where you can know something that most people don’t know. There are plenty of things I don’t know but they don’t factor into the purchase because I am using a huge margin of safety. Buying a dollar at 50 cents. So if things turn against you, you will be okay. That is not easy. This business is brutally competitive. It is so impossible to know everything and know exactly what is going to happen to a business from now till the end that you really have to accept that what you don’t know.

Finding an edge really only comes from a right frame of mind and years of continuous study. But when you find those insights along the road of study, you need to have the guts and courage to back up the truck and ignore the opinions of everyone else. To be a better investor, you have to stand on your own. You just can’t copy other people’s insights. Sooner or later, the position turns against you. If you don’t have any insights into the business, when it goes from $100 to $50 you aren’t going to know if it will back to $100 or $200.

So this is really difficult, but on the other hand, the rewards are huge. Warren says that if you only come up with 10 good investments in your 40 year career, you will be extraordinarily rich. That’s really what it is. This shows how different value investing is than any other subject.

So how do you really understand and gain that great insight? Pick one business. Any business. And truly understand it. I tell my interns to work through this exercise – imagine a distant relative passes away and you find out that you have inherited 100% of a business they owned. What are you going to do about it? That is the mentality to take when looking at any business. I strongly encourage you to start and understand 1 business, inside out. That is better than any training possible. It does not have to be a great business, it could be any business. You need to be able to get a feel for how you would do as a 100% owner. If you can do that, you will have a tremendous leg up against the competition. Most people don’t take that first concept correctly and it is quite sad. People view it as a piece of paper and just trade because it is easy to trade. But if it was a business you inherited, you would not be trading. You would really seek out knowledge on how it should be run, how it works. If you start with that, you will eventually know how much that business is worth.

When I started in the business in 1997, it was in the middle of the Asian Financial Crisis. A few years later there was the Internet bubble. A couple years ago was the Great Crash of 2007 – 2008. They are billed as once in a century disasters but happen every few years. Every time it goes against you, your net worth or value of your investments might go down 50%. This is really where that insight and temperament comes in. In a sense, you have to have a certain confidence in your own judgement and not be swayed by other people’s views. It is not easy. But that is life. It is just a given. It happens to everyone. Berkshire had at least three times when the stock went down 50%. It happened to Carnegie too. It happened to Rockefeller. It happens to everyone. If you really made a mistake, it would not stop at 50% but go to 0.

This happens to even mighty companies. Look at the top 50 companies in America every 10 years. By the time 20-40 years go by, 2/3rds of them will be gone. By the time it goes to 100 years, there might be only a couple left. It’s just the way it is. Look at what happened to the once mighty General Motors. So thats why I’m saying is, investing is a continuous learning process because your investments are constantly changing

So for those of you that have curiosity and the temperament, this game couldn’t be better. Capitalism rewards people who are talented at capital allocator. So if you have the aptitude and temperament, it is the great game. If you don’t have that then I urge you not to go and become a nuisance. That is really what Wall Street did, they don’t really create anything they just move money around. Letting the financial industry get too big is bad for the economy, it is just as bad as getting addicted to casinos, drugs, and alcohol. None of them are really useful, they just transfer wealth. That is what I think happened on Wall Street over the last several decades. So avoid being harmful.

With that I am open to questions.

Q: Mohnish Pabrai recently spoke about his reluctance about investing in China due to the multiple accounting books / the possibility of fraud. How do you deal with this given your own investments in China?

Li Lu: Well, you know I think he is right. Every thing has an exception though. Just because a next door neighbor is a fraud doesn’t mean you are. That is one question to ask — whether you can trust the accounting and people running the business. That can have a huge impact on the business. I suggest you spend a lot of time looking at these factors, especially if you are investing for the long haul.

Q: Why did you decide to go into venture capital? How is that different than your other investing?

Li Lu: I always had this bent that I want to build a real business. I started a venture and it was really a lot of fun. Overall, it is a tougher game than simply investing in securities because you have to evolve to the day to day changes in operations and it is just not as easy to build great businesses. Every generation has a handful of great businesses that come from no where and come to dominate their fields. It is much more rewarding as an investor to pick those. Also, you are more likely to find managers much more capable than yourself. Overall, I learned a lot. I learned a lot in how businesses succeed and how businesses fail. It really was a lot of fun. I probably carried it too far — I eventually ran one of the businesses and it was of course a mistake.

Q: I read that when you look at an industry, you look at the most miserable failures of that industry to see whether you will invest in it. Can you talk a bit about that?

Li Lu: It goes back to understanding the business. Once you have that understanding you can extend it to understanding an industry. A certain industry might have characteristics that make it different than others. In certain industries you might have better prospects than others. Find the best of the players in the industry and the worst players. And see how they perform over time. And if the worst players perform reasonably well relative to the great players — that tells you something about the characteristics about the industry. That is not always the case but it is often the case. Certain industries are better than others.

So if you can understand a business inside out you can then eventually extend that to understanding an industry. If you can get that insight, it is enormously beneficial. If you can then concentrate that on a business with superior economics in an industry with superior economics with good management and you get them at the right price — the chances are that you can stay for a very long time.

Q: Did you have any specific example?

Li Lu: I have studied many over the years. As I have said, don’t copy other people’s insights because it doesn’t work. Automobiles are amazing. If you look at the early days it started with several players and concentrated with just a few players that became enormously profitable. Then they became miserable. You then see how the life cycle turns with new automakers in China and India. Everything has a reason. If you want a good idea — look at General Motors from the early days, look every 5 years and see how the performance metrics change. The Graham and Dodd Center should collect all the data and perform some kind of commentary on it.

Bruce Greenwald: Do you want me to give you the answer to that? In the 1960s, their return on capital was 46%. In the 1970s their return on capital was 28%. In the 1980s it was 9% in the 1990s it was 6%. You want to guess how negative it is now?

Li Lu: So that is really fascinating. If you have that data, the amount of insight that would yield would be astonishing. So instead of just accepting the conventional wisdom that the auto business is bad — that is just not true. Or if you say well those guys just unbelievable money machines — that is not true either. So if you can really examine those statistics and understand it that will give you an advantage for analyzing new situations like in China and India. That is really what turns me on. Understanding this gives you a tremendous leg up.

Q: I wanted to ask you about BYD. I heard that you thought it was important for them to introduce a model to the US and wanted to know why you thought that.

Li Lu: That might be a better question to ask the BYD chairman than myself. Well, If you are just talking about electric vehicles, you know the key — the heart and soul of the electric vehicle age the heart is the battery. There is the battery, electric motor, and the electric control control panel. The electric motor has been there for 100 years, control system is software that can be improved over time.

The battery is really where you get the biggest appreciation and is what determines the value of the electric vehicle. 100 years before the Model-T was introduced, the competition between electric vehicles and gasoline was not nearly as optimistic. Up and till then, 1/3rd of cars being produced were electric. It wasn’t until Rockefeller got oil extracted easily enough that it worked. Henry Ford was able to make the internal combustion work even though it wasted 85% of the energy. He was able to build the engine and produce automobiles that were cheap enough for people to buy and it took off. That is where you find the real winners.

Now, years later, we know that the way that oil is burned contributes to global warming. If it continues, the planet might still be here but all the human beings might not. Human beings have only been on the planet for a tiny bit of the earth’s history. So there are all sorts of good reasons for electric cars. Battery development has advanced so much that it is now comparable to the price and performance of traditional cars. So now with the help of companies like BYD, the balance is about to tilt towards where performance and price are getting to the level that makes them a desirable alternative. It will be desirable everywhere. Eventually, if you have a car that does all that, it will be sold everywhere.

Q: What about BYD versus others in the industry?

Li Lu: The market will determine that.

Q: Yeah – but why BYD versus others?

Li Lu: Well because we also studied all those other guys. We will see when the winner emerges whether we are right or wrong.

Q: Right – but what did you look at to reach that view?

Li Lu: There are a lot of people who have worked over 100 years making great cars. The technology for building a traditional car has been refined enough to where it can be learned in a short period. The place we are still seeing a curve of continuous rapid improvement is with the batteries for cars. Whoever is leading the charge will have a major advantage. There is really only one company that is a leader in battery manufacturing and automobile manufacturing. There is only one company. To put this together you need a Ford to put that together. So far those two elements need to be put together. It is not an easy process.

Q: So you went to BYD in 2005 and then you brought Berkshire as well. I saw that you sold a small amount of your BYD position at the end of last year. Was it just rebalancing? Can I just wanted to get your thoughts on that.

Li Lu: Actually I started my BYD position in 2002. I sold a small amount of shares because an investor of mine had an emergency redemption.

Q: We read your profile online. I had a question – do you have any problems when trying to invest in China?

Li Lu: Yeah I do have some difficulty. I did not really see a factory plant at BYD until the end of 2008. I really did not have a better understanding till then. That really causes you to question what it is before you make an investment. With investing, you have to work with imperfect information because you are buying a piece of the future. I did not really get a chance to get more information because the problem in Asia till much later but it did not stop me from making my investment decision. So there is a point, where if you have enough margin of safety– that is why I kept coming back to the elementary concept of margin of safety– you can allow much more uncertainty and unknowns. So the answer of the question is does that stop you from making the investment? No.

Q: So I did some research on lithium ion batteries, and I saw that BYD has a manufacturing advantage with consumer batteries. But I saw that automobile batteries are much more complex. I did not think that the idea of a good consumer battery manufacturer + an automobile maker made much sense. So when Buffett looked at the stock maybe it was a better deal but today it is this dream of vehicles that is really priced in. It does not feel like a good value investor stock. So why would you own it today?

Li Lu: Well that is interesting. One of the most fascinating things about being an investor is that surprises are part of the game. When you get into situations like BYD, you see lots of good surprises. Chuanfu and his team have this fabulous culture, everything people thought they knew turned out to be a few years late. He got into battery manufacturing in that particular way because he really had no other option. He had no money, he only had $300,000 in venture capital funding before IPO and that was it. He raised money in an IPO and Buffett gave him $200M, now they have 160,000 employees. $6-7B in revenues, $500M in net profit. It is amazing. So he has this ability to adapt in a competitive environment. He has demonstrated that ability again again and again. The way he does automation is far cheaper than anyone else and more reliable. He continues to surprise me with his ingenuity, to figure out ways to do something better than everyone else. What he is currently doing is very different than what everyone else has done. At the end of the day, you might look at what he has done.

So how do you look at it as an investor with imperfect information? Well I suggest you look at what he has accomplished. 8 years ago I had no idea they would go into the automobile or laptop or cellphone battery business. So that demonstrates how he is. This investment is not easy to understand because it is changing so fast, at such a large scale. An almost unheard of speed. Their manufacturing capabilities will double soon. This year they will hire 10,000 college graduates, 8 or 9 thousand engineers. The scale is almost unparalleled. So this is why the study of history, of all the great corporations will give you a good insight in seeing what will happen with BYD. I suggested that we start with GM and analyze its performance every 5 years for 100 years to understand at least one aspect of BYD’s business.

Q: One investor came in and said talking to management is a waste of time. They will say what you want them to say. Obviously it sounds like you don’t agree with that. What do you think? Will you pay a premium for a business with a moat?

Li Lu: There is no general rule. The key in investing is to know what you know and know what you don’t know. You can know about management teams without meeting with them. Every situation is slightly different. So I come back to the point that if you know enough on other things that there is enough margin of safety. Even if you meet with management, you may not learn something. Obviously, actions speak louder. You want to see what they have done. Everything being equal, the more you know about management, the more honest and upfront they are, the more motive they have, the better the situation is and the deeper the discount. You have to analyze it all. The key to analyzing it is you have to ask: do I really know what I think I know, do I really know what I don’t know? If you can’t answer that question, chances are you are gambling.

Q: What kind of preparation do you do before meeting a management team?

Li Lu: I don’t really have a set method. Because I usually am just curious about the business and don’t know a lot. So you are prepared and not prepared. If you are really curious, you want to learn more and study it more. When working at a hedge fund or mutual fund, you are expected to learn a business in one week. You can’t truly understand everything about a business in one week. It took me 10 years and I am still learning new things about BYD. It is a continuous learning process. You could spend a lifetime studying a business or industry, but in a few seconds I can tell you whether or not I like it. You want to build knowledge by continually learning. There is not set preparation.

Q: Recently, Jim Chanos gave us his thesis on the China Syndrome with there possibly being a bubble.

Li Lu: Well, it is too big of a question for me. I don’t know

Q: 20 years ago you said you challenged conventional wisdom in China. Out of curiosity, in terms of value investing what do you challenge in the conventional wisdom?

Li Lu: Well, the fundamental philosophy of value investing is very sound. Its basically the three things:

1. A stock is not a piece of paper, it is a piece of ownership in a company.

2. You need a margin of safety so if you are wrong you don’t lose much.

3. In the market, most people are in it for the short term. It allows you a framework for dealing with the day to day volatility.

That is really an intelligent approach. So therefor any intelligent investing is really value investing. There is a certain level of intellectual honesty. If you have all that insight going into analyzing businesses I don’t have any arguments with it.

Q: What is your point of view on long / short positions in value investing?

Li Lu: The most profitable kind of investing is long term investing. You want to allow the time that it might take because you don’t know when the market will catch on. If you can find a business with good management with good industry fundamentals blowing it forward, you have a good opportunity and you can save money on taxes.

A short cannot be a fundamentally long term position. In the long game, the upside is unlimited. Your downside is 100%. In shorting it is opposite. Shorting is also essentially borrowing, so you need money and time on your side. If time is not on your side, you can be right but lose all your money. The best kind of short usually has some kind of fraud. In those situations, management is determined to keep the fraud. Look at Bernie Madoff, 20 years time. You cannot afford to borrow money for 20 years. So shorting is a short term game. When those positions go against you, there is huge leverage that can utterly crush you.

In theory, long / short is okay, but if you are trading all the time you need to be in tune with all the things moving the market. None of them might be fundamental to the actual business. So you spend all your time chasing noise than studying a long term situation. If you cannot concentrate on things in the long term, and spend all your time thinking about the short term, you will not be able to develop the kinds of insights necessary to identify great investments.

From time to time, you will lose some money on paper. But it is just part of the game. This is why I closed long / short. You know I went through three bubbles. The Asian Financial Crisis, the Internet Bubble, and this most recent financial crisis. The biggest mistake I made is not being able to pick up undervalued companies where I had a unique insight but was tied up with this whole long / short thing. The money I left on the table is still adding up. I am still paying for those mistakes.

Q: In a bull market environment, how do you re-evaluate your thesis?

Li Lu: I don’t ever want to profit from a bubble. Soros does that, that is just not my game. I don’t profess any ability to understand how long a crowd will buy into a bubble. I invest in things that appear to be compelling values that continues. So that is why this game is a continuous learning process – because everything affecting the investment is constantly changing. Including the price. Including the prospects and elements of business success. You really do want to never stop learning. This game looks to be easy but it is not easy.

Q: Given your focus on international investments, how do you think about diversifying your investments regionally?

Li Lu: First of all, I did not really specialize in international investments. I started off doing most of my investments in the US and Canada. In recent years, I just find better bargains outside of it. One of the great things about being an investor is you can look anywhere and find great pockets of opportunities. You cannot do that as a venture capitalist as I experienced myself. So you can look anywhere for opportunities. I do not take a regional approach to diversification. I have views towards certain countries and currencies, but it is not the driving force for a potential investment. If you have your fundamental things right, if you happen to have macro economic factors behind you, you can run a great wave.

Q: How is your investment style different today than when you started the fund?

Li Lu: A lot of things have changed. One bonus about this profession is you get better over time. Most professions, as you get older, you get out of the game. Take the example of competitive sports. If you are a figure skater or gymnast, after your teenage years you are out of the game. With investing, if you are doing it the right way, you get better over time. Your knowledge accumulates exponentially. When I look back at everything I have done, I would have done it all slightly differently, but that is because I am better at it today. So if you approach it in a fundamentally sound way, as you mature, you become better and better. That process and progression is like compounding money. In fact, you can compound knowledge faster than money. If you truly love this game, I would suggest that you don’t take short cuts. It might take longer but it is more rewarding.

Q: What is the difference between being a top political criminal in China versus a hedge fund manager today (referring to the ire directed at Wall Street)?

Li Lu: I don’t consider myself a criminal. I don’t think China considers me a criminal. What I think we are doing today with our investment in BYD in China is really helping China march towards a modern era of prosperity. BYD is providing a solution to both China and the US, to migrate from the past to a way that gets us out of the unsustainable carbon age that we live in. Global warming is a vital concern to every human being, so China is providing a great contribution to everybody with BYD. America has had a great history of invention and here is a great company in China that is about to make a major contribution to human civilization with cheap electric vehicles and solar power.

Ultimately we will have to get our energy from the sun. Most of the energy, even fossil fuels (plants that die and then go into the ground), all originally come from the sun. So if you can figure out a way to take energy from the sun and power vehicles, while using batteries to store it, inexpensively — will really make renewable energy power everything. The combination of those things holds the key to the future of industrial civilization that we are about to embark on. We didn’t set out with BYD with this in mind, it just happened that way. With great companies, it only looks logical in retrospect. Think about how Bill Gates started Microsoft. I don’t think he knew up front that he would take the entire market — at that time it did not exist. It is the same way with our investment in BYD. Ultimately, I think finding an inexpensive way to store energy that we harness from the sun will be a huge contribution for both China and the US, but more broadly our entire civilization.

Fortune has a good article today about Howard Schultz and his turnaround efforts at Starbucks (NASDAQ:SBUX):

He started the Starbucks turnaround with what for many companies is the hardest thing to do: confessing its sins. Schultz had to tell his employees that the company had made mistakes and would pay the price by taking $600 million in costs out of the business. Part of that would come from laying off employees and shutting down 600 stores. 80% of them had been open for less than two years.

Even amid the cost-cutting Schultz refused to drop health care for his employees, a line item that tallies $300 million. That’s more than the company spends on coffee. A shareholder called Schultz and said the crisis would provide him the perfect cover to cut benefits for part-time employees. He refused, and told his investor if he felt so strongly about it he should sell his stock. (The shareholder ended up cutting his position.)

Much to the dismay of Wall Street, Schultz decided to stop reporting monthly same-store sales in an attempt to move the pressure from producing good numbers to producing good coffee. “Monthly comps are like a harness around your neck,” he says…

Starbucks’ premium image also started to backfire. “Starbucks became the posterchild for excess,” Schultz says. Consumers who had once embraced the brand’s cachet now started to view the $4 latte as frivolous and a not very smart purchase.

Today Starbucks has managed to avert crisis and is diving into new areas of growth beyond simply opening new stores. Schultz says its VIA instant coffee line, which many saw as a move of desperation, will have 37,000 points of distribution by the end of the month. The company sees a hungry market in China and India, and in the U.S. the company is pushing out its newly rebranded Seattle’s Best line.

Starbucks Spends More On Health Care Than Coffee (Fortune)

I’ve always been pretty fascinated by turnarounds. Yes, Warren Buffett says that turnarounds often keep turning. Sometimes though, a great brand will make a misstep which kills the stock price, but can be corrected with some diligent work by management. So when Starbucks ran into trouble, I was interested.

I often tell friends that I think what Starbucks did is introduce America to casual coffee drinking. Before Starbucks, I think most people drank coffee in the mornings, before work. Starbucks really changed that by introducing beverages like frappuccinos and iced coffee drinks. But during the financial crisis, their business really came under assault. Starbucks did all the heavy lifting with introducing consumers to coffee and figured out what kinds of drinks sold well. All that was out in the open for the taking. And it was taken.

To put things in perspective, a $6 canister of instant coffee can yield around 120 cups. That comes out to $0.05 a cup. You might be able to get a tall coffee at Starbucks for $1.80. Starbucks’ management team miscalculated in expecting that their product was so ingrained in popular culture that spending habits would remain consistent during an economic downturn. McDonalds and every other major fast food chain came out with their own new brands of coffee drinks that were sold at lower price points than the ones at Starbucks. The margins on coffee are pretty high so every major chain wanted to get a piece of that market. Then, there were some customers who kept consuming coffee, but brewed it themselves.

What I find most interesting about the Starbucks case is how low it traded during the crisis, hitting a level below $8.00 per share. At that price, I estimate that the company had an enterprise value of around $6.7B (market cap + total debt – cash). If you looked backwards, you would assume that the company was trading at a really rich multiple north of 20x Enterprise Value / Free Cash Flow. But, investing is often a matter of analyzing what cash flows will be like in the future.

Here is where the Starbucks story really improves. When the company was growing their store count, capital expenditures were quite high. They had to be to cover the expansion costs. By slowing down store expansion rates and closing newer underperforming stores, capital expenditures were slashed by more than half. Accordingly, FCF tripled (from $274M in 2008 to $943M in 2009), meaning you could have purchased SBUX at only 8x. Getting a double digit free cash flow yield on a world class business with a great brand is a good opportunity.

So far, Schultz has helped improve Starbucks. The company is in much better shape than before and there are new opportunities for growth such as new supermarket lines like Via which require only a fraction of the capital expenditures as store expansions. These kinds of offerings also leverage the already established brand, keeping it fresh in the minds of consumers. I highly suggest his book (Pour Your Heart Into It: How Starbucks Built a Company One Cup at a Time) to get an idea of how the brand was built and how a great entrepreneur operates.

So what is the lesson here? As an analyst you need to look at businesses as if they are organisms. They aren’t these static beings, frozen in time. Looking at Starbucks during that one slice of time in the crisis would have been scary. With the heavy capex required to keep up the pace with new store openings and the decreased sales, the business looked bad — especially if you were using a short term perspective like most sell side analysts. But if you looked at the business as something truly variable, you could have sat down and modeled out what would happen if things like the pace of expansion slowed down. Or if new stores were closed.

Performing this kind of sensitivity analysis is highly useful and should be done whenever you analyze a potential investment. That is the kind of thought process used by most activist investors think and it is incredibly useful for analyzing businesses that are in turnaround mode. Obviously, you need to also look at what the management team is committing to doing during the turnaround. If Starbucks didn’t plan on closing underperforming stores, that would severely handicap your lower capex scenario. But because they did, that particular scenario would gain a greater likelihood of occurring.

Whenever there is widespread market turmoil, even great businesses will see their stock prices decline. When that happens, you need to keep your head above the crowd and look out at what the business is capable of doing versus what it is currently doing.

I’m not in Omaha this year to attend the Berkshire Hathaway annual meeting. But, I saw Warren Buffett’s advice for entrepreneurs at the meeting and thought it was worth sharing:

There’s nothing like following your passion. Find your passion and don’t let anything stop you. $500 built Nebraska Furniture Mart’s 78 acres of store in Omaha. Rose Blumkin loved what she did. Think about what that produced. It is incredible.

For those of you unfamiliar with Nebraska Furniture Mart:

Nebraska Furniture Mart is the largest home furnishing store in North America selling Furniture, Flooring, Appliances and Electronics. NFM was founded in 1937 by Mrs. B (Rose Blumkin) in Omaha, Nebraska. She worked in the business until age 103. In 1983, Mrs. B sold a majority interest to Berkshire Hathaway with the famous handshake deal with Warren Buffett. NFM now has three stores. The Omaha store is over 420,000 square feet (39,000 m2) of retail space and is on 77 acres (310,000 m2) of land. The Kansas City, Kansas store is also 420,000 square feet (39,000 m2) of retail space and is on 88 acres (360,000 m2) of land and sits across from the Kansas Speedway. The third store is in Des Moines, Iowa and is 24,000 square feet (2,200 m2) and sells appliances, flooring and televisions.

From the 1983 letter, we get a good idea of just how great of an entrepreneur Rose Blumkin really was:

Last year, in discussing how managers with bright, but adrenalin-soaked minds scramble after foolish acquisitions, I quoted Pascal: “It has struck me that all the misfortunes of men spring from the single cause that they are unable to stay quietly in one room.”

Even Pascal would have left the room for Mrs. Blumkin.

About 67 years ago Mrs. Blumkin, then 23, talked her way past a border guard to leave Russia for America. She had no formal education, not even at the grammar school level, and knew no English. After some years in this country, she learned the language when her older daughter taught her, every evening, the words she had learned in school during the day.

In 1937, after many years of selling used clothing, Mrs. Blumkin had saved $500 with which to realize her dream of opening a furniture store. Upon seeing the American Furniture Mart in Chicago – then the center of the nation’s wholesale furniture activity – she decided to christen her dream Nebraska Furniture Mart.

She met every obstacle you would expect (and a few you wouldn’t) when a business endowed with only $500 and no locational or product advantage goes up against rich, long-entrenched competition. At one early point, when her tiny resources ran out, “Mrs. B” (a personal trademark now as well recognized in Greater Omaha as Coca-Cola or Sanka) coped in a way not taught at business schools: she simply sold the furniture and appliances from her home in order to pay creditors precisely as promised.

Omaha retailers began to recognize that Mrs. B would offer customers far better deals than they had been giving, and they pressured furniture and carpet manufacturers not to sell to her. But by various strategies she obtained merchandise and cut prices sharply. Mrs. B was then hauled into court for violation of Fair Trade laws. She not only won all the cases, but received
invaluable publicity. At the end of one case, after demonstrating to the court that she could profitably sell carpet at a huge discount from the prevailing price, she sold the judge $1400 worth of carpet.

Today Nebraska Furniture Mart generates over $100 million of sales annually out of one 200,000 square-foot store. No other home furnishings store in the country comes close to that volume. That single store also sells more furniture, carpets, and appliances than do all Omaha competitors combined.

One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.

Mrs. B is wise as well as smart and, for far-sighted family reasons, was willing to sell the business last year. I had admired both the family and the business for decades, and a deal was quickly made. But Mrs. B, now 90, is not one to go home and risk, as she puts it, “losing her marbles”. She remains Chairman and is on the sales floor seven days a week. Carpet sales are
her specialty. She personally sells quantities that would be a good departmental total for other carpet retailers.

We purchased 90% of the business – leaving 10% with members of the family who are involved in management – and have optioned 10% to certain key young family managers.

Berkshire Hathaway – Letter to Shareholders (1983)

Rose Blumkin was an amazing entrepreneur. She continued to be involved with day-to-day operations until shortly before her death at 104 years old.

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.

I’ve always thought that investing in Apple (NASDAQ:AAPL) would be a terrifying experience. The company’s 20X P/E ratio and fierce scrutinization by Wall St. analysts makes it so that they must constantly iterate and come out with new devices to meet earnings expectations.

When you have an iPhone and an Apple computer, what else do you really need from Apple? That is where the iPad comes in. By using the iPhone OS, Apple is able to dig a moat around the device’s software. To develop rich applications for the iPad you are going to have to sell through Apple’s app store. And every application sold gives Apple a 30% cut. To be fair, this is not entirely new ground here — the iPhone came out with the app store first, but now we are seeing Apple’s attempt at using this same approach to software for general computing.

Look at Apple’s current revenue streams:

About 83% of revenues are coming from what I would characterize as hardware sales. If Apple can grow their App Store, they have the potential of getting a new revenue stream that is actually much more attractive than their hardware business. Creating a distribution channel for applications, where Apple simply takes a 30% cut, makes a new business line that requires little actual capital to operate. The returns on invested capital are huge and they have the potential to offset the need for constantly innovating on the hardware side of things. Instead, Apple could position itself to start receiving a healthy income stream from consumers on an annual basis.

The potential here is great. With his announcement yesterday, Steve Jobs positioned the iPad as a media consumption device. He wants you to use the iPad to browse the internet, watch TV/Movies, and read books. For content providers, Apple’s control over the user experience is a big deal. You don’t have to worry anymore about ad blockers and you might actually be able to create some truly creative advertising experiences by leveraging the device’s abilities.

For publishers, the iPad is no silver bullet. What you might see though are publishers who step up to the plate to make applications worth paying for. For most local newspapers that are bleeding to death, this scenario is unlikely. For larger publications, like the New York Times or Wall Street Journal, there could be value.

Then there are ideas that people in manufacturing or sales could use the iPad to roam around factories or give demonstrations on the fly. These sorts of ideas seem possible and all involve having to go through Apple. If the iPad is widely adopted, developers are going to have to increasingly work with and split revenue with Apple. If you thought Microsoft had a competitive advantage with Windows, think about what Apple could have in the future by totally controlling the user experience and applications market.

This week’s New Yorker has a great article (New Yorker digital subscribers click here) by Malcolm Gladwell on entrepreneurship. Gladwell finds that entrepreneurs are actually not the high octane risk-takers that they are made out to be. Instead, successful entrepreneurs are highly rational actors, akin to predators who follow systemized patterns and go after safe prey. The article prominently features John Paulson’s CDS trade but also refers to a number of other fascinated entrepreneurs like Sam Walton and Ted Turner. While the article wont be available online for a while, I thought I’d quote some excerpts that I feel are worthy of discussion.

At 24 years old, Ted Turner became the CEO of his family’s outdoor advertising business after his father committed suicide. The business was actually quite good and threw off a lot of cash while requiring little by way of capital expenditures.

Turner sought to expand his empire and went after WJRJ, a UHF TV station that was down on its luck:

It was housed in a run-down cinderblock building near a funeral home, leading to the joke that it was at death’s door. The equipment was falling apart. The staff was incompetent. It had no decent programming to speak of, and it was losing more than half a million dollars a year. Turner’s lawyer, Tench Coxe, and his accountant, Irwin Mazo, were firmly opposed to the idea… The purchase price of WJRJ was 2.5 million. Similar properties in that era went for many times that, and Turner paid with a stock swap engineered in such a way that he didn’t have to put a penny down.

Most successful dealmakers that have built real empires all have the ability to find deals with great tax treatments. The Pritzkers of Chicago, John Malone of Liberty Media, and Sam Zell have all sought out these types of deals. Turner also recognized these benefits:

WJRJ’s losses could be used to offset the taxes on the profits of Turner’s billboard business. The television station, furthermore, fit very nicely into his existing business. Turner was very experienced at ad-selling. WJRJ may have been a virtual unknown in the Atlanta market, but Turner had billboards all over the city that were blank about fifteen per cent of the time. He could advertise his new station for free.

Most of these entrepreneurs use these deals to pick up NOLs at low prices which drastically reduce the taxes paid by the businesses they run. These boost profitability and gives them an advantage over competitors. Gladwell also seeks out academic research on entrepreneurship, in order to find patterns that are displayed my large groups of successful businessmen.

First, he cites the work of Michel Villette and Catherine Vuillermot (From Predators to Icons). One of the things that Villette and Vuillermot find is that most successful entrepreneurs are not one-hit wonders. Instead, they find some kind of inefficiency in the business landscape and actively exploit it:

There is almost always, they conclude, a moment of great capital accumulation — a particular transaction that catapults him into prominence. The entrepreneur has access to that deal by virtue of occupying a “structural hole,” a niche that gives him a unique perspective on a particular market.

Villette and Vuillermot go on, “The businessman looks for partners to a transaction who do not have the same definition as he of the value of the goods exchanged, that is, who undervalue what they buy from him in comparison to his own evaluation.” He moves decisively. He repeats the good deal over and over again, until the opportunity closes, and — most crucially — his focus throughout that sequence is on hedging his bets and minimizing his chances of failure. The truly successful businessman, is anything but a risk-taker. He is a predator, and predators seek to incur the least risk possible while hunting.

If you take a moment to think about businessmen and investors who have had extraordinary success, they all seem to exhibit this trait. Most great businesses occupy a space in their industry where they are protected by the wide moat of their competitive advantages. Usually, it is a result of growing and growing until you almost monopolize your sector.

John D. Rockefeller saw an inefficiency in the oil refinery market and quickly moved. He realized that by securing rates with the railroad companies, he could at least gain a cost advantage over competitors. He also realized the economies of scale that could be had by acquiring competitors. At the time, running an oil refinery was a terrible business, many became bankrupt. But Rockfeller was able to build Standard Oil with acquisition after acquisition and emerge with a monopoly.

Sam Walton saw that rural communities were not being served by large discount retailers such as Kmart. He didn’t just open one Walmart, he opened many, using airplane flyovers to find untapped markets that would also connect advantageously with Walmart’s supply-chain system. Walmart grew so large that competitors from urban areas were unable to penetrate his geographic foothold. Walmart was then able to enter urban markets with ease and topple competitors to become America’s most successful retailer.

Ray Kroc saw a market for America’s first nationwide fast-food chain as he sold milkshake machines around the country. What he found were great hamburger restaurants run by people with no entrepreneurial drive behind them to actually franchise them. After encountering McDonald’s in 1954, Ray Kroc sealed a deal to become the company’s sole franchisee and grew the hamburger chain outside of Arizona and California. Today, McDonald’s is the world’s biggest hamburger chain.

While Gladwell refers to John Paulson as an investor who has exhibited these traits recently, Sardar Biglari may be a better example. Biglari started his hedge fund using money from a tech company that he started and sold while in college. He then went on to one by one, target fast-food companies that had high concentrations of company-owned restaurants on their balance sheets. Many of these chains were quite old so it was likely that the real estate, recorded at a cost on the balance sheet, was dramatically undervalued relative to their current market values. All together, Biglari targeted five restaurant chains: Western Sizzlin, Friendly’s, Applebee’s, the Steak ‘N Shake Company, and Jack in the Box. Biglari was able to get on the boards and take control of both Western Sizzlin and Steak ‘N Shake, eventually merging the two. Applebee’s and Friendly’s were both bought out by other companies. Biglari’s least successful attempt was with Jack in the Box, but since he only agreed to exchange shares of Western Sizzlin for Jack in the Box, the cost was virtually nothing.

The other thing Gladwell finds is that most entrepreneurs are able to find inventive ways of financing their business ventures:

Giovanni Agnelli, the founder of Fiat, financed his young company with the money of investors — who were “subsequently excluded from the company by a maneuver by Agnelli,” the authors point out. Bernard Arnault took over the Bousac group at a personal cost of forty million francs, which was a “fraction of the immediate resale value of the assets.” The French industrialist Vincent Bollore “took charge of the failing family company for almost nothing with other people’s money.” George Estman, the founder of Kodak, shifted the financial risk of his new enterprise to his family and to his wealthy friend Henry Strong.

For the entrepreneur, cheap and secure financing can drastically improve the chances of an enterprise’s survival. By investing little of his own money, the entrepreneur can amplify returns on his own invested capital while keeping dry powder in reserve for new opportunities. Most successful real estate developers exhibit the same trait as do private equity firms, little equity is actually invested in the properties acquired in favor of debt. This often leaves the newly privatized properties in danger of default in the case of a sudden economic downturn, while keeping the fortunes of the owners largely in tact.

Gladwell emphasizes the fact that Ted Turner was also averse to using cash in his acquisitions. He explains by using Turner’s purchase of the Atlanta Braves as a case:

The team was losing a million dollars a year, and the owners wanted ten million dollars to sell…

He talked the Braves into taking a million down, and then the rest over eight or so years. Second, he didn’t end up paying the million down. Somewhat mysteriously, Turner reports that he found a million dollars on the team’s books — money the previous owners somehow didn’t realize they had… He now owed nine million dollars. But Turner had already been paying the Braves six hundred thousand dollars a year for the rights to broadcast sixty of the team’s games. What the deal consisted of, then, was his paying an additional six hundred thousand dollars or so a year, for eight years: in return, he would get the rights to all a hundred and sixty-two of the team’s games, plus the team himself…

Turner is a cold-blooded bargainer who could find a million dollars in someone’s back pocket that the person didn’t know he had.

Many successful businessmen and investors seek out hidden assets when doing acquisitions. Often, the value of assets are sometimes obscured by accounting or the market climate. One of Warren Buffett’s most famous investments was in the Sanborn Map company. In 1961 the stock made up 35% of his partnership’s assets and gave him a spot on the company’s board. Astonishingly, while Sanborn sold for $45 per share on the market, the company had an investment portfolio of more than $65 per share. At the time, a buyer of Sanborn stock received an undervalued investment portfolio and a map business thrown in for free.

Using research from economist Scott Shane, Gladwell delves into the notion that the entrepreneur is a risk taker and gives reasons for why entrepreneurs fail:

…many entrepreneurs take plenty of risks — but those are generally the failed entrepreneurs, not the success stories. The failures violate all kinds of established principles of new-business formation. New-business success is clearly correlated with the size of initial capitalization. But failed entrepreneurs tend to be wildly undercapitalized. The data show that organizing as a corporation is best. But failed entrepreneurs tend to organize as sole proprietorships. Writing a business plan is a must; failed entrepreneurs rarely take that step. Taking over an existing business is always the best bet; failed entrepreneurs prefer to start from scratch. Ninety per cent of the fastest-growing companies in the country sell to other businesses; failed entrepreneurs try selling to consumers, and, rather than serving customers that other businesses have missed, they chase the same people as their competitors do. The list goes on: they undermine marketing; they don’t understand the importance of financial controls; they try to compete on price. Shane concedes that some of these risks are unavoidable: would-be entrepreneurs take them because they have no choice. But a good many of these risks reflect a lack of preparation or foresight.

Some of the reasons for failure may seem counterintuitive to a person who is seeking to start their own business. Many may balk at the prospect of taking over an existing business, but if it is a forced sale due to owner’s health or a decision to retire, a budding entrepreneur may have the opportunity to acquire a good business at a low price. This kind of thinking requires the entrepreneur to employ the kind of rational judgment that is totally counter to the cowboy image the media perpetuates.

Another of these traits is not caring what other people think. Gladwell notes that many successful entrepreneurs are willing to risk their personal reputation for their business. He contrasts the behavior of banking CEOs who kept piling up bad investments because they feared standing out from the crowd with Sam Walton’s decision to seek financing from his in-laws a second time after failing at his first venture:

Villette and Vuillermot point out that the predator is often quite happy to put his reputation on the line in pursuit of the sure thing…

If an awkward family reunion was the price Walton had to pay for a guaranteed line of credit, then so be it. He went out of his way to take a personal risk in order to avoid a professional risk. Reputation, after all, is a commodity that trades in the marketplace at a significant and often excessive premium. The predator shorts the dancers, and goes long on the wallflowers.

If there is one thing that is really representative of the entrepreneurial stereotype, it is the unflinching persistence that seems to be exhibited by all the examples used in the article. Gladwell ends with a story about the lengths Turner went to, to take back his family’s outdoor advertising business:

He hired away the General Outdoor leasing department. He began “jumping” the company’s leases– that is, persuading the people who owned the real estate on which the General Outdoor billboards sat to cancel the leases and sign up with Turner Advertising. Then he flew to Palm Springs and strong-armed Naegele into giving back the business…

Naegele, by the way, asked for two hundred thousand dollars, which Turner didn’t have. But Turner realized that for some o ne in Naegele’s tax bracket a flat payment like that made no sense. He countered with two hundred thousand dollars in Turner’s Advertising stock…

“I had kept the company out of Naegele’s hands and it didn’t cost me a single dollar of cash.” Of course it didn’t. He’s a predator. Why on earth would he take a risk like that?

Here, Turner really serves as an example for all entrepreneurs. His father had sold General Outdoor and committed suicide shortly afterwards. Such an event must have been emotionally jarring for someone like Turner, but he managed not to be constrained by grief and moved into action. All of his decisions, from poaching personnel to exploiting his adversary’s tax status exemplified the kind of clear-sightedness that is necessary for long-term entrepreneurial success. For the entrepreneur and investor, being able to keep calm emotionally is an absolute need when faced with the daily competitive pressures and changing landscape of the market.

The entire article is worth the read, I would suggest seeking out a copy from your news stand or purchasing a digital subscription, these excerpts are just a small part of it. This is especially true if you are interested in John Paulson. Gladwell dedicates a large part of the article to discussing how and why Paulson managed to earn billions of dollars by purchasing credit default swaps.

One of the reasons that M&A deals end up performing so poorly is the fact that CEOs often allow their emotions and egos cloud their judgment during the process. This often leads to CEOs raising premiums or issuing shares endlessly, hurting the value of shareholders. Warren Buffett seems to believe that the current actions by Kraft (NYSE:KFT) in pursuit of Cadbury (NYSE:CBY) could do just that. And as a holder of almost 10% of Kraft, Buffett does not seem to agree with the current acquisition strategy (Bolded for emphasis by me) :

Omaha, NE (BRK.A; BRK.B)—Berkshire Hathaway has voted “no” on Kraft’s proposal to authorize the issuance of up to 370 million shares to facilitate the acquisition of Cadbury. Berkshire, taking into account both its own holdings and those of its pension funds, believes that the 138,272,500 Kraft shares it owns – 9.4% of the total outstanding – make it the company’s largest shareholder.

The share-issuance proposal, if enacted, will give Kraft a blank check allowing it to change its offer to Cadbury – in any way it wishes – from the transaction presented to shareholders in the proxy statement. And we worry very much that, indeed, there will be an additional change from the revision announced this morning.

To state the matter simply, a shareholder voting “yes” today is authorizing a huge transaction without knowing its cost or the means of payment.

What we know with certainty, however, is that Kraft stock, at its current price of $27, is a very expensive “currency” to be used in an acquisition. In 2007, in fact, Kraft spent $3.6 billion to repurchase shares at about $33 per share, presumably because the directors and management thought the shares to be worth more.

Does the board now believe those purchases were a mistake and that Kraft’s true value is only the current price of $27 per share – and that it is therefore fine to structure a major acquisition based upon that price? Would the directors use stock as merger currency if the price were, say, $20 per share? Surely the true business value of what is given is as important as the true business value of what is received when an acquisition is being evaluated. We hope all shareholders will use this yardstick in deciding how to vote.

Our understanding is that Kraft must announce its final offer for Cadbury by January 19th. If we conclude at that point that the offer does not destroy value for Kraft shareholders, we will change our vote to “yes.”
At this time, however, we believe no shareholder should vote “yes” when he can’t possibly know what he is voting for.

Berkshire Hathaway and its subsidiaries engage in diverse business activities including property and casualty insurance and reinsurance, utilities and energy, finance, manufacturing, retailing and services. Common stock of the company is listed on the New York Stock Exchange, trading symbols BRK.A and BRK.B.

Berkshire Hathaway Press Release (PDF)

When a CEO looks to use stock as currency, it is important to pursue a sound course of capital allocation that does not send value down the drain. One of the greatest corporate capital allocators was Henry Singleton of Teledyne. Singleton recognized when his own stock was overvalued or undervalued. When overvalued, he had no problem with issuing stock when it was overvalued and using it as currency for acquisitions. This is counter to Kraft’s strategy of buying back shares at $33 and issuing shares at $27.

If you would like to read more about Henry Singleton, feel free to check out the following article via Scribd.

An interesting look at the credit card industry: