Berkowitz may not be a household name to most investors, but he should be. During the past decade, Fairholme has produced an annualized return of 11.6% over a span in which the S&P 500 (SPX) has risen a paltry 0.7% a year on average. Since the fund launched in 1999, Berkowitz has beaten the market every year except one (when Fairholme was up 24%, vs. the S&P’s 29% rise in 2003), and he’s on track (up 17% through early December) to easily beat it again in 2010. “The highest compliment I can give,” says hedge fund billionaire Leon Cooperman, who got to know Berkowitz when they both invested in telecom stocks earlier this decade, “is if he called me up to recommend a stock, I would pay attention.”

The fund’s outstanding returns — along with Berkowitz’s being crowned U.S. stock manager of the decade this year by investment research firm Morningstar — have attracted a flood of new money to Fairholme. Investors have poured in more than $4 billion over the past year. And they’ve added $330 million more to his Fairholme Focused Income Fund, which launched in January. He plans to open a third fund, one that focuses on smaller opportunities, early in 2011…

Can Berkowitz continue to beat the odds? Can a single investor, even one with singular focus and discipline, successfully manage a portfolio the size of Fairholme? “It’s a challenge for any manager to take in that kind of inflow and repeat,” says a large Fairholme investor. Says another: “You hope that when you buy a manager, it’s a seasoned team. Having a one-man band can be risky.”

Berkowitz acknowledges the concerns with his usual candor. “Right now,” he says matter-of-factly, “we’re at an interesting junction point where people can’t decide whether we’re about to blow up.”

Bruce Berkowitz: The megamind of Miami (Fortune)

Whenever you read about Berkowitz these days, the articles have consistently mentioned that Berkowitz is nearing the point when many star managers end up hitting a slump in their careers — notable examples include Bill Miller of Legg Mason and Ken Heebner of the CGM Focus Fund.

For me, I could see this going either way. Most hedge fund managers complain that as they grow larger, it becomes more difficult to find good investment opportunities. To a certain extent, I think that’s true. Just looking at Fairholme’s portfolio, you’ll mostly see investments in massive financial services companies. Citigroup is the perfect example of that. If you look at the average volume for Citigroup, almost $2.6B is traded daily. For Fairholme, that kind of liquidity is great because it means they can enter and exit positions with ease. Plus, the risk/reward break down, given the liquidity must be attractive, especially if you believe Citi is worth what Berkowitz says.

The benefit to size is that Berkowitz can really invest across the capital structure and use his size to influence the outcomes of distressed situations:

Second, stockpiling cash is in keeping with Berkowitz’s plan to evolve Fairholme from a regular, stocks-only mutual fund into a more versatile distressed-asset investment vehicle, and to profit from the coming wave of corporate restructurings he anticipates. He believes that dozens of overleveraged companies will need to fix their balance sheets in the next couple of years — commercial real estate is one industry ripe for it, he says — and he wants Fairholme to be ready to step in as a Warren Buffett-style lender of last resort, with highly favorable terms for his investors, of course. As Berkowitz puts it, “There aren’t many people in the world you can call who can write a check for $1 billion today.”

So in theory, it’s possible that Fairholme will be able to cope with its increasing size. Still, I’m a bit concerned at the lack of a real investment team at work there. From the sound of the article, it really consists of Berkowitz and Charlie Fernandez plus a support staff. It’s true that the firm will hire experts to come in and advise on different industries, but I don’t know if that’s enough. A team can help provide varying perspectives which could be critical when making a bit, concentrated bet on just one sector of the market. A team might also be more helpful going forward, as Fairholme seems poised to enter more complicated areas of the market with their restructuring and bankruptcy activities.

So I thought it would be a good idea to interview Dave and get him to shed some light on how he analyzes insurers, I hope you enjoy the interview. Feel free to post follow up questions in the comments section.

1. Can you give us some background on why you got into value investing and what got you interested in insurance stocks?

I have to say that my road to value investing has been a series of unexpected turns. Despite growing up where the men on my dad’s side of the family would talk stocks at family gatherings, and my grandfather giving me a book on stocks for my 16th birthday, I had no interest initially in investing. When I started working after college, I began plowing money into mutual funds offered by the company 401K plan as my primary means of investing. When the division that I worked for was sold to another company, I had to make a decision about rolling over my 401K monies.

After spending a month trying to find the right mutual fund, I decided that if I was willing to expend this much effort on selecting a mutual fund, I might as well buy the stocks directly. A family member recommended reading the Investor’s Business Daily and from there I bought some stocks. One of them happened to be American Capital Strategies (ACAS). This was in 1999 and I had overheard people talking about Yahoo Finance message boards. So I started reading the posts on the ACAS board and found an interesting group of fellow amatuer investors. ACAS is a business development company, which not many people fully understand. We spent a lot of time dissecting how the company worked, and this led to other discussions on investing. A group of us enjoyed it so much that we decided to leave the noise of the message boards behind. Our little study group started talking about value investing and relating it to stock decisions. That mix of theory, discussion and application was powerful. From there it just clicked – I was and am a value investor.

My interest in property and casualty insurance stocks is a much simpler story. It was an occupational hazard from working in the industry and why I tend to be cynical about the industry.

2. Why do you think there is increased M&A activity in the specialty underwriting space? Fairfax has done a few of these acquisitions. Do you think they have some kind of moat that allows them to have better underwriting operations? Or are they actually more similar to the rest of the P&C insurance business which has typically relied on investment income?

There are several dynamics influencing M&A at this point. The low valuation on insurers makes it an opportune time to be a buyer. With premiums flat, catastrophes minimal and bond yields anemic, buying another insurer represents a more attractive return. The interest in specialty insurers stems from 1) they tend to have better pricing and 2) there is less overlap because their underwriting focus is narrower. In terms of moat, the property & casualty insurance is largely a commodity business with few moats.

As for Fairfax having a moat, I would say that they have an inverse moat. Sounds crazy but hear me out. They know how to get rid of business, they know how to say no. That is not a moat but a behavior – to be disciplined. Every insurance exec says that they are disciplined underwriters, they’re all from LakeWobegon, but obviously they are not. Insurance is a product sold for which the costs of goods will not be known until a later date, so people can delude themselves by assuming better loss experience. Sort of like the mortgage securitizers who assumed that home prices could only go up. Insurance companies also have a decent amount of fixed costs because you need underwriters, claims people, etc. to support the business, whether you have 50 policies or 5,000 policies. There is a tendency to write any business just to sustain the infrastructure, something you also see in the for-profit education sector.

As for relying on investment income, yes, Fairfax does rely on it more than most. In their annual report, Prem Watsa mentions the net premiums written to statutory surplus ratio, a.k.a. the underwriting leverage ratio. The ratio at the end of 2009 was around 0.5 for Fairfax whereas most insurers are well over 1.0 and closer to 1.5. Watsa has purposely structured Fairfax so that the underwriting contributes less to results. That’s a good thing because it is a lousy business! This also means that the Fairfax insurance companies are overcapitalized relative to premiums written. Once they satisfy the regulatory/rating requirements for safe investments, they are free to invest the excess capital in things besides bonds. The Fairfax business plan comes straight from Buffett.

3. Is pricing and market position maintained through client relationships (i.e. its a small expense overall for the yacht owner and they like/trust their broker)? Is it through branding and market position (i.e. “everyone know that MKL is the place to go for yacht insurance”)?, or is there some actuarial knowledge (other participants aren’t sure they know how to price the business properly so they stay away).

Branding and marketing is a diverse subject within insurance. There are significant differences between personal and commercial, distribution method and line of business. A good portion of insurance is a commodity business, particularly personal lines. Does it matter whether I buy my car insurance from a gecko or a perky sales clerk? No, but the constant bombardment of advertising will at least drive people to get a quote from them. That is important because they rely on direct marketing.

The commercial side is where you see more relationship building, not so much with the insurance companies, but with the brokers, claims administrators, etc. When you get into specialty insurance, like yacht insurance, the number of insurance companies offering coverage shrinks dramatically. It is easier for one or two companies to dominate a market and that gives them an advantage in terms of experience and distribution. The actuarial advantage is a matter of numbers. If you insure 10,000 yachts, your loss experience will be a lot more predictable than the insurer covering 100 yachts. Insurance is all about the law of large numbers. Companies that can mine their own data can create an advantage.

4. What are your top metrics to look at when analyzing an insurance company? Most people seem to hone in on combined ratios and book value — what else do you look at?

Price to book and combined ratio are good starting points. Return on equity, underwriting leverage ratio and investments to equity are other metrics that I look at. On combined ratio, it is also useful to look at the difference between what is reported on a GAAP basis and what is reported on a statutory basis. The “stat” basis is more conservative than GAAP, it’s what the regulators look at, and is a better measure.

I also look at the lines of business written because that influences the combined ratio. For short-tailed lines of business, like property and personal lines, investment income is less of a factor, so the combined ratio should be lower because the driver is underwriting profit. Long-tailed lines, like general liability, can afford higher combined ratios because the investment portfolio is larger and is held longer – the magic of compounding.

5. With most insurers trading below book and it being a soft market — are you finding a lot of opportunities or do you think this is the time to be cautious?

I am more cautious. Insurance companies are essentially levered bond funds, so the extended low bond yields have a bigger impact on earnings. My focus has turned to special situations. I bought a small insurer, Penn Millers (PMIC) after its IPO because it was trading below book value despite having a significant portion of the book value being the IPO proceeds.

Another situation arose with Donegal Goup, which has a unique capital structure. It is a mutual insurer that owns a publicly-traded holding company with two series of shares. The mutual retains control through super-voting “B” shares, which have the same economic interest as the “A” shares. There was some confusion over a deal where they offered to buy a bank, half of which involved “A” shares held by the mutual. The result was the “A” shares trading at over a 35% discount to the “B” shares, which has since narrowed. The other situation is a small specialty insurer, Seabright, which I bought at less than 50% of tangible book value. There was a lot of fear after they took a reserve hit in the 2nd quarter that seemed unwarranted.

6. When you value an P/C casuality company, how do you establish that the reserves are accurate?

When it comes to P&C insurers, reserves are a black box. Outside of being an actuary who can review their claims, there is no way to know whether the reserves are adequate. All you can do is look back over time and see how reserves have developed and whether there have been reserve additions or releases. You have to assess behavior over time. Management can play games over the short-term but eventually the claims get paid and then we find out who is covered and who is swimming naked.

7. How long do you foresee the tail before the insurers adjust their rates for the low bond yields? Do you think we will see a hard market soon?

Let me start with the last question first. Hard or soft markets are determined by capital levels. Prices will harden when capital is destroyed or removed from the space. There is no direct tie to low bond yields impacting pricing but lower investment income means underwriting results will have a greater impact on capital.

8. How do you determine if an insurer is over-concentrated?

Over-concentration is a good question. Some situations are obvious, like Universal Insurance Holdings, a home insurer with most of their business in Florida. That is a binary bet on the hurricane season. Seabright is concentrated in workers comp, with slightly less than half their business in California. The regulatory risk is known by investors, as is their ability to compensate through company-level rate changes and other rating factors. Once you get beyond regional or line of business risk, however, it is difficult to spot concentration.

Even insurers struggle with concentration in their own books. On the property side, technology has allowed insurers to do a lot more catastrophe modeling and to better monitor risk but that depends upon having detailed and accurate location descriptions. The problem on the liability side is that a relatively small segment can have significant losses, as happened with E&O/D&O coverage on financials the past three years.

9. Some insurers are limited to only a few geographic areas — do you discount these because they might face some kind of black swan risk? (e.g.: if you were to only write insurance in TX and a hurricane came, damage could be high but your operations dont have areas outside of TX to draw premiums from to offset the losses)

What I find is that most regionals are very conscious of risk and will buy reinsurance to mitigate the risk. That does not mean that a storm won’t impact earnings but it does not blow a massive hole in their capital. Plus, you do not have to be a regional to suffer major losses – look at what happened after the 2005 hurricane season. In the P&C industry, the potential for a black swan is always present, whether natural disasters, unintended coverage or legislative/judical changes. It is not limited to regionals. I have told my friends that when investing in P&C insurers, cut your normal position in half because you are betting against nature.

You may be surprised that the most that I have ever been invested in insurance was back in 2009 following the March meltdown. I had about 30% of my personal account in insurance, with P&C being about 3/4th of that. Currently, I am about 15% in insurance, all of it P&C. Did I mention that P&C is a lousy business?

10. Have you ever looked at insurance brokers? Do you think they are a better way to invest if you assume the market will start hardening?

I have looked at insurance brokers but have not spent much time looking at them. The top 5 brokers represent something like 85% of the publicly traded market cap and you have at least a dozen analysts covering them. I am not going to add any value to the discussion. Of course, that won’t prevent me from expressing an opinion! My impression is that the brokers are focusing on client needs and have moved away from pure commission fee structures to using a mix that includes flat fees. The brokers will benefit from a hardening market but not to the degree that they once did.

11. Do you ever look at reinsurance companies? How do you get comfortable with the cat risks? Are there any metrics you focus on with a reinsurer that you might look at less when analyzing a short tail P/C insurer?

I do look at reinsurers on a periodic basis. As a group, they tend to track together, depending upon which way the wind blows. As for cat risk, you can see over time how they have diversified into other lines, particularly after 2005. Still, the concern is there and is why they trade at single digit P/E ratios. When it comes to metrics, I use the same ones for reinsurers as for insurers. The only difference is that they tend to trade at cheap than regular insurers.

12. When you value an insurer, what methods or models do you typically use? Is it mostly a matter of looking at multiples and comps? Or is there more to it.

Price to book is really the first metric that I look at, followed by price to earnings. It is simple and objective, as I want to know my margin of safety and then the earnings power. If it is cheap enough that I would be a buyer, then I start digging deeper. Usually, there is a reason that an insurer is trading cheap, so then I try to determine what can change with regard to investment income, underwriting results and expenses. That part is subjective. I do look at comps as a point of reference but not as a buying point.

October 18, 2010

Board of Directors (“Board”)
Fremont Michigan InsuraCorp, Inc.
933 East Main Street
Fremont, Michigan 49412

To the Board of Directors:

Loeb Arbitrage Management LP and Loeb Offshore Management LP, together doing business as Loeb Capital Management, and affiliated entities (collectively, “Loeb”) have management discretion over 160,600 shares of Fremont Michigan InsuraCorp, Inc. common stock (OTC: FMMH) (“Fremont”), or approximately 9% of the company. The recently-revised offer from Biglari Holdings Inc. (New York: BH) (“Biglari”) compels the Board to engage in a sincere process to maximize shareholder value; more to the point, Loeb thinks it is incumbent upon the Board, in keeping with its fiduciary duties to shareholders, to sell the company to the highest bidder.

Fremont, an illiquid stock, has scarcely traded at or above its tangible book value per share during its capital market history. Fremont is substantially dependant on one state for its profits. With an A- rating from A.M. Best Company (“A.M. Best”) and a premiums-to-surplus ratio of roughly 1.4x, prospects for growth, and therefore multiple expansion, are limited. The management of Fremont has put forth a strategic plan to achieve USD 100 million of direct premiums by 2013. It is not clear that the company can reach this level of premium production without an equity financing or loss of its current A.M. Best rating. Assuming everything goes according to management’s plan (a potentially unreasonable leap of faith) and assuming a 95% combined ratio, Loeb estimates that this premium level could produce operating earnings per share of $3.00. The offer from Biglari represents a P/E multiple of nearly 10x prospective 2013 earnings. Considering the earnings multiples of comparable regional insurers, Loeb thinks it unlikely that the company on its own merits would trade at a valuation of 10x P/E in the marketplace.

As a significant shareholder of Fremont, Loeb is not in favor of further tactics that put off potential buyers of the company. It is time to put aside mechanisms and campaigns such as a poison pill with a low trigger, a staggered Board and a concerted effort to secure legislation limiting shareholder rights. Again, the Board owes shareholders a fiduciary duty to maximize the value of the company, particularly in light of the current circumstances. A path has been provided for the Board to maximize value for the owners of an illiquid equity in the near term. Please note that this letter should not create the understanding that Loeb would accept an offer of $29.00 per share; rather, Loeb is simply of the opinion that Biglari’s offer is credible and that the valuation is high enough to be a springboard for a value maximization process. Loeb reserves its rights as a shareholder to take such actions to secure value maximization. Further, we hereby request a meeting with the CEO and Chairman of the Board of Fremont as soon as is practicable but in any event no later than October 29, 2010. Please contact Alexander H. McMillan, General Counsel at (212) 483-7069 to arrange such a meeting. Additionally, we request that Fremont raise the ownership threshold which triggers its poison pill, thereby allowing Loeb to increase its holdings (notwithstanding the necessary approvals from the Michigan Office of Financial and Insurance Services). Finally, please note that Loeb reserves the right to buy or sell stock.

Thank you for your immediate attention to our request.

Sincerely,

/s/ Gideon J. King
Gideon King
President, Chief Investment Officer

/s/ Blaine Marder
Blaine Marder
Vice

Biglari Holdings Inc. (NYSE:BH – News) today announced a proposal to acquire 100% of the issued and outstanding shares of common stock of Fremont Michigan InsuraCorp, Inc. (OTC Bulletin Board:FMMH.OB.ob – News) that it does not already own for a purchase price of $29 per share in cash. The purchase price represents a 41% premium over the closing price of Fremont’s common stock on October 11, 2010. Biglari Holdings is presenting its proposal to the Fremont Board, expecting its Board to exercise its fiduciary duties and therefore meet with Biglari Holdings to reach a mutually satisfactory transaction.

Press Release (Biglari Holdings)

To preface, I don’t own any Biglari Holdings stock anymore. Biglari’s struggle for Fremont has been well documented on my blog. Initially, Biglari offered $24.50 per share in a combination of cash and stock. At the time, many derided the offer and said it undervalued Fremont because he was only willing to pay close to 90% of book value for the company. Eventually, the management team used their political pull in Michigan to introduce legislation which would impede his ability to pursue a hostile offer against the company.

The new offer is $29 per share or about 1.1x book value, which might be fair given Fremont’s current troubles. Fremont’s underwriting has deteriorated recently and posted a combined ratio of 108 in the last quarter, which means its operations are generating losses. Combined ratios are calculated by taking underwriting expenses + loss adjustment expenses and dividing them by the amount of earned premiums. A combined ratio of less than 100 means underwriting operations are profitable. More broadly, the insurance market as a whole is feeling the pressures of the low yield environment. Most P/C underwriters have had the bulk of their profits come from their investment portfolios, not their underwriting. The problem with this is that insurance investment arms typically take a levered bond fund approach and safe bonds aren’t yielding a whole lot right now. This puts insurers who are bad at underwriting in a precarious position. They face losses on both ends and so far the soft market (weak insurance pricing cycle) is showing no signs of persisting.

So in a way, it’s possible that a capital allocator such as Biglari could be helpful. If he could adjust the company’s current allocation split between cash and bonds, Fremont might be able to generate investment gains that would offset their underwriting losses. Right now Fremont’s investment portfolio is just under $70M with about 83% of it in bonds. Biglari reportedly already has an insurance executive on staff who would be brought in to turn around underwriting operations which have so far run into losses as they’ve grown their personal lines business.

It’s easy to see why he wants Fremont. Being able to add an insurer would help diversify BH’s business from being so dependent on fast food and would also add a business line which brings recurring earnings to the table. Plus, the float from the insurance business (which is smaller because of the short-tail nature of their claims), could be used as dry powder when pursuing activist investments or takeovers. Similarly, Mark Schwarz of Newcastle Partners has taken this approach by gaining control of Hallmark Financial (NASDAQ:HALL) and using it to then gain control of Pizza Inn (NASDAQ:PZZI).

While I don’t have a stake in this situation, it’s still fun to watch given the tactics being employed by both sides.

Today is Liberty Media’s investor day and you can register for the webcast here. For those interested in the company and some of their business units, these webcasts are very helpful.

For now though, if you look at Liberty Media’s 8-K from the middle of September, you can get some great insights from Malone:

Jessica Reif Cohen – Bank of America Merrill Lynch – Analyst

What is your favorite tracker currently and why?

John Malone – Liberty Media Corporation – Chairman

Well, I love all my children and currently, I think that there are buybacks in two of the three that the company is engaged in, or is authorized to do. The third is really — LINTA, we really are not or have not been buying stock back pending a decision on whether or the separation of LINTA into a separate asset-backed company is going to be okay with the bondholders, but I would say each one is sort of different.

Starz on a multiple basis seems cheap to me. We now have strong operating management. Chris [Albrecht] came over from HBO. We’ve had good success with the first couple of major series that we’ve added to the programming lineup. Obviously, the Netflix deal with Epix kind of demonstrates the kind of economics that might be available for that component of the programming right, fairly big numbers. So I think in the short run, Starz is pretty cheap. [LCAPA] is — a sum of the parts analysis, it’s cheap, particularly if you are as enthusiastic about SIRIUS, SIRIUS XM, as we are and I’m quite enthusiastic about it.

And then QVC just continues to grind out massive amounts of free cash flow, that you’re talking there about a leveraged free cash flow asset with cheap leverage and good tax attributes. So that one looks to me like it’s pretty cheap. So I was explaining to somebody a little while ago that in 37 years in the business, we have never issued equity except twice. Once was in September of ‘87 and we bought it back in November of ‘87 after we issued it at about $0.[60] on the dollar and that was when we bought Heritage Communications.

So generally speaking, we’ve always believed that our company was trading cheap on the public market and we’ve been a net acquirer of shares, redeemer of shares, consistently. We’ve never paid dividends because we think shareholders should have the right to decide whether they want to take capital back or not. So buybacks have always been our preferred method for — and we’ve done tax-free distributions which are involuntary, but don’t involve a decision by the shareholders, so those are kind of our ways of returning capital. So I don’t know which one would be my favorite. . .

Audience Participant

Speaking of Starz, can you talk maybe about how the Epix Networks transaction has maybe changed some of the possibilities (inaudible) what you were just saying there as it relates to a higher value [of some of the entities] as it stands? What’s the thought process in terms of a billion dollar balance sheet, etc.?

John Malone – Liberty Media Corporation – Chairman

Well, of course, Starz is unlevered. It sits with a billion of cash within the Liberty Starz tracking stock entity and we are not well noted for under-levered enterprises. So it’s unlikely that we’re going to sit with Starz paying a full statutory tax load for very long, so we’ve got to do something. Exactly what we’re going to do, I think, is in deliberation right now.

And clearly, the number one question for us is the issue of the bondholders in Liberty at large relative to the question of substantially all in the creation of the QVC-LINTA separation. That is kind of — as Yogi Berra said, “That’s the fork in the road that we gotta take.” So until we know the answer to that, we’re a little bit frozen in terms of what we do relative to realization on Starz, but as I say, it’s highly unlikely we’re going to let Starz sit there unlevered and sit with zero yield on the cash.

I mean, that’s not — that’s no good. So we’ll do something. We probably won’t really be in a position to do something until probably the first quarter of next year to actually execute something, but we’ll definitely do something. And of course, I’m very high on Chris and the kind of energy he’s bringing to that business, so we’ll see, but obviously, that whole industry is going through a lot of transition. Those digital rights that Starz sits on are clearly worth a lot and I don’t think it’s likely that we’ll sit there and be a passive player in the streaming over-the-top world for very long.

Starz is one I’ve posted about before back in July, so far I’ve been pretty happy with it. At the time, it traded at $53 which I thought was pretty cheap considering the potential up side from their plan to break into original programming now that Chris Albrecht (from HBO) is running the show. In August though, we got a bit of a bonus from the fact that Netflix signed their deal with Epix at a much higher multiple than what they currently pay Starz. If you adjust for that, LSTZA is probably trading around 5x 2012 EV/EBITDA which is not a bad multiple for a company that still has potential to grow and is totally unlevered.

At a more recent conference, Liberty Media CEO Greg Maffei discussed the cash on LSTZA’s balance sheet:

Jason Kim — Goldman Sachs – Analyst

Okay. And as a follow-up, as of the second quarter, Starz had about almost $1 billion of cash on the balance sheet and virtually unlevered at this point paying cash taxes. So what do you think the appropriate use of the cash is right now? Would you consider levering up Starz going forward? And if so, what do you think would be the appropriate leverage for a business like Starz?

Greg Maffei — Liberty Media Corporation – President and CEO

Well, I think you know that Liberty’s history is probably to put more leverage on companies than zero and so it is likely over time that we will add leverage to that company. One of the questions we have had is what is the right configuration for Starz both in terms of the capital side. Obviously the right-hand side of the balance sheet and looking at leverage but also what other assets, what other kind of partnerships do we want to be in? And we have been contemplating and looking at a variety of those.

We have a relatively new CEO as I mentioned in Chris, and led by him but in conjunction with Liberty. We have been looking at ideas about how that asset, how that service would be best positioned for the future and would that require more capital?

And that is why if we have had a hesitation in purchasing stock, in levering up Starz, and those kind of structurally balance sheet questions, that has been in part because looking at the left-hand side, what other assets, what other kind of partnerships did we want?

In addition, we have noted there have been certain milestones along the way to give us confidence in the business, some of which we have hit. The reattribution of Starz Media, the signing of our biggest distribution partner, biggest by number of subs in Comcast. Completion of other partnerships is still out there. Those were all probably important milestones that will give us confidence in the business and a better sense of what the long-term leverage ought to be.

Some people speculated that maybe Netflix would not renegotiate the contract, but I doubt it. They are in the process of dramatically expanding their margins with the shift towards instant streaming and are planning to use the cost savings to acquire digital content rights. Malone’s planned hard spinoff of LSTZA (rather than the current convoluted tracking stock structure) should help clarify the story a bit and get market participants to take notice.

There are some other businesses under Malone’s control that are worth looking at. QVC within LINTA with its free cash flow is pretty impressive when you consider the fact that only 10% or so of audience members are actual customers. If they can figure out a way to increase their conversions, the company could generate a ton of FCF. Then there’s Liberty’s stake in Sirius. Here’s what Maffei has to say:

Unidentified Audience Member

Question regarding the rationale for splitting Liberty into two companies. Isn’t at least over time most of the taxable income generated by the LINTA entity that will be separated from the other two tracker stocks, at least in a corporate form?

Greg Maffei — Liberty Media Corporation – President and CEO

Yes.

Unidentified Audience Member

And if that is the case, isn’t splitting the Company into two taking away part of the future potential benefit of if you were to buy enough — have enough of a serious stake that you could accelerate the use of Sirius’s NOLs?

Greg Maffei — Liberty Media Corporation – President and CEO

That is a great question. It is one of those ones you can look at and say if you were to own tomorrow 100% of Sirius, $9 billion of NOLs, wouldn’t that be a benefit and wouldn’t you want to keep the whole company together? That is a great question.

It is one of those ones probably that is more theoretical than realistic. Just if you look at the structure of our contract with Sirius, if you look at the Sirius earning capabilities, you look at the issues around making them go [solely], these NOLs. It is just probably a thicket too hard to get to imagine that we would get there. And if you ever did consolidate it, which who knows, there is probably enough other kinds of income at LCAPA that we could potentially shield like our shore against the box and some of the other things that when you look at that combined with the earnings of Sirius, it is just a bridge too far.

You are asking to hold that and say I won’t do a split we believe is beneficial and it is also by the way another issue is who is getting these tax benefits, which group of shareholders? There is just a lot of moving parts there to think about. But it is a great theoretical question.

For those of you that don’t remember, When XM Sirius was teetering towards bankruptcy, John Malone came in and infused the company with $530M of much needed capital via convertible debt, which also gave him a 40% stake in the business. That stake is now worth about $1.89B. Not a bad return in only 1.5 years. Liberty cannot accumulate more than 49.9% of Sirius until the second anniversary of their deal (Feb 2011). I’ve seen some speculation that the company could try to make an offer for the rest of Sirius in 2011 and then use it for a hard spin of LCAPA because it would give the company real operating earnings. Maffei seems to be arguing against such speculation though.

I think that going back and looking at some of Malone’s moves are worthwhile for investors, especially ones that are looking to get better at identifying potential special situations. Looking back at the complicated tracking stock structure that Liberty currently uses, it’s easy to see that an actual hard spinoff would probably unlock some value. And I think if you start thinking about potential balance sheet events, before they happen, when analyzing companies — you’re in a good spot.

Finally, I wanted to include this hour long interview Malone did with CNBC. It’s awesome.

Sorry for the light posting lately. I’ve been tied up with a couple of projects and have had to travel a bit. I should have a regular stream of posts coming up soon.

The folks over at CNBC asked him some questions about the current BP situation and I thought it would be worth sharing. This is not a transcript but just notes that I took from a recording.

I was actually looking forward to this because I believe it is the first time I’ve heard of a value investor talking about BP.

Now that there is a $20B escrow fund established by BP, is it time to look for value?

Barse: There is another level of certainty that value investors, or contrarians need.
Still too much uncertainty, contingent liabilities that are unknown, timeframes of repayment that are unknown. That can affect your return on investment. Not really safe and cheap, which is what Third Avenue does.

Some value investors have reported that they are taking a dip into BP. Do you think they are just taking a speculative trade here?

Barse: Probably. Because there is still great uncertainty. It is a tough call.

Any analogous situation here from your long investment career?

Barse: Let’s look at Texaco. A company that was solvent that used the bankruptcy process to stem an uncertain liability, stabilize the market, and reorganize the company in a rational way. That might be an avenue for BP.

When you look at the situation, you don’t know the overall. With Texaco you had the whole Pennzoil case. Do you think there would be any benefit for equity investors for filing?

Barse: Our laws are written to protect the debtor. In this case, they are the debtor. It is certainly something that behooves them to look at and analyze. Is it proper for the President to tell them how much to put in an escrow account? Right now it is a company owned by the shareholders.

How will they fund the $20B? Do you think they will do a debt offering?

Barse: Okay so, this is a company that has access to capital markets, but certainly the cost for that access is going to be higher than it was prior to the crisis happening. That is a factor they will work into that decision. This would be a debt offering that would get an oversubscription because it is a great company. It is a company that is certainly a survivor. Long term, this will cost less than the market cap.

So you think it will cost less than $100B?

Barse: Based on what we know, it seems like it will be less than that. But it is an uncertainty and that is why we are not investing in the equity.

Could some bond managers that are unhindered by requirements dealing with ratings look at BP?

Barse: In the market environment of last year when credit was wider in terms of spreads, we launched a focused credit fund to invest in situations like this. We call these special situations and certainly the yield for a BP… We would take a much closer look at a debt offering.

Barse ended with a recommendation that people should look at Hong Kong property stocks.

As you can see, one of the big topics of the discussion was on the newly announced $20 billion dollar escrow account that BP agreed to establish. The New York Times has details on it:

The White House and BP tentatively agreed on Wednesday that the oil giant would create a $20 billion fund to pay claims for the worst oil spill in American history. The fund will be independently run by Kenneth Feinberg, the mediator who oversaw the 9/11 victims compensation fund, according to two people familiar with the deliberations.

The agreement was not final and was still being negotiated when President Obama and his top advisers met Wednesday morning with BP’s top executives and lawyers. The preliminary terms would give BP several years to deposit the full amount into the fund so it could better manage cash flow, maintain its financial viability and not scare off investors.

The talks have been complicated by the fact that BP’s ultimate liabilities for the cleanup and lost business are unknowable since the two-month-old leak of its well in the Gulf of Mexico could be spewing oil for months more. To date, BP has spent more than $1 billion on containment, cleanup and claims from the Coast Guard, fishermen, oil workers and other businesses from Louisiana to Florida.

BP Agrees to Set Aside About $20 Billion for Spill Claims (NYTimes)

Overall, I think his approach is a good example of real value investing. A lot of pretenders are out there, looking at the stock, and they do these really simple (or poor) calculations. They will look at the operating cash flows and not the capital expenditures. Or they will assume a payout of $X billion dollars over 20 years when maybe the requirement will be payments in 5 years. Maybe as a result of this spill, BP will have a much more difficult time getting contracts to do deepwater exploration and as a result, their franchise will be permanently impacted. With all the uncertainties it is a really difficult call when you are trying to determine BP’s intrinsic value.

I think that Barse’s idea of looking at the debt is a good one. The recent downgrades by Fitch and others will preclude certain bond managers from buying their debt. Plus there will be a social stigma attached that might lead environmentalist groups to urge pension funds and endowments from BP related investments. These situations could make the debt offer an attractive yield to agile, unhindered investors.

Edit: Whitney Tilson is another value investor who has actually been bullish on BP for over a week. Still, I think Barse’s insights — especially from his bankruptcy background add a lot of value since it is a scenario that has been talked about.

Lawmakers in Michigan seem intent on curbing his efforts:

A bill wending its way through the Legislature aimed at protecting a small insurance company from a hostile takeover will have a chilling effect on investment and job creation in the state, an opponent said today.

Sardar Biglari, CEO of San Antonio-based Biglari Holdings, which owns 19 Steak ‘n Shake restaurants in Michigan, said the measure — which passed the Senate last month to block his company from acquiring Fremont InsuraCorp. of West Michigan — sends the wrong message to potential investors.

“This bill will send a signal that Michigan poses greater risks, greater uncertainty than other states,” said Biglari, who was in Lansing to meet with members of the House Insurance Committee, which is scheduled to take up the bill Thursday.

He said his holding company has no intention of moving the small insurer out of Michigan or of laying off its 75 employees. The only change in the works is to replace the company’s CEO, he said…

The legislation would require approval of two-thirds of outstanding shares of a company to elect director candidates who are not backed by a majority of that company’s board of directors. Biglari, who owns nearly 10 percent of Fremont InsuraCorp., said the bill would make it “nearly impossible to consummate the transaction.” He said the measure dilutes shareholder rights.

Biglari added he’s looking to acquire other businesses in Michigan and said the outcome of this legislation “will determine our level of interest.”

Cobb said the bill is narrowly tailored to block the takeover of Fremont and would affect only a couple other companies in the state.

“We don’t think it will have an effect on outside investment,” he said. “Shareholders will still have their say.”

Bill seen as roadblock to takeover of Fremont insurer

The really unfortunate thing here is that if a company in Michigan underperforms, with legislation like this in place, it will be extremely difficult to turn them around. Shareholders will have a say, but it will be weakened. Michigan should by now be well acquainted with how insulated management teams can run amok, after all, US taxpayers had to bailout their state when GM and Chrysler went bankrupt. It seems as if they haven’t quite learned the lesson yet.

From little more than a $1.8 million stake in a small chain of buffets, Sardar Biglari was now managing a holding company with a market value of more than $340 million. Though the company will likely end up growing through busi- nesses outside the restaurant industry, the Steak n Shake brand will continue to be its figurehead. And whether or not they thrive depends on if they can keep cus- tomers coming in the door. If the success of McDonald’s and In-N-Out Burger are any indication, a well-run restaurant chain like Steak n Shake can be both popular and profitable.

The Steak n Shake Company is now on solid footing. But the actual turna- round, one that may leave the company unrecognizable from its prior form, has just begun. “Naturally,” says Biglari, “we have a fairly lengthy journey before reach- ing our goals. We will do what it takes to prevail.”

The Restaurant Investor by Max Olson

What I wanted to do though, was highlight a few parts of the letter where I thought we could take a look at his methodology for looking at stocks. The idea here isn’t to find potential buys, but to see how he looks at companies.

Bank of America (NYSE:BAC)

-Paulson believes that by 2011, banks will have passed the write down cycle and return to growth in 2012.
-They are using a 10x normalized earnings multiple for large banks and the team estimates BAC to be worth $29.81 per share in 2011. Current shares trade at $16.35, so you are looked at almost 40% annualized.
-They expect provision for credit losses to come down quite a bit from 2008 levels, to 1.75%. That figure, $16,357 is about 61% of 2008′s numbers.

Then, there is Paulson’s gold position. If you looked at the latest 13F-HR filings, there are a lot of ways that investors have been playing gold. Some are going after miners, others are gaining exposure via ETFs, and then there are some that are trying to get their hands on the physical asset.

Paulson mentions two gold miners in his portfolio. This is how he looks at them:

-Five gold mining stocks comprise 14% of their portfolio.
-All five stocks would have upside in a flat environment, but an even higher upside in a rising price environment.
-AngloGold Ashanti (NYSE:AU) is the third largest gold producer in the world but trades at a lower Price/NAV than peers. So this is a value play based on comps.
-The company has a number of figures, which could contribute to its peer undervaluation:
1. Exposure to South Africa
2. Declining production profile
3. Large hedge book
4. Poor safety record.
-Paulson & Co. believe that the new CEO, Mark Cutifani would be a catalyst for change in the company and indeed: the company diversified out of South Africa, reduced their hedge book, increased their production profile, and improved their safety record.

So what we can take away here is that Paulson and his team were looking for a gold miner undervalued, relative to peers and viewed Cutifani, a great mining operator, as a catalyst.

Then, there is Gabriel Resources (TSE:GBU)

-Gabriel is another miner with an event catalyst
-The company is the largest potential goldmine in Europe and Paulson & Co. own 19.9% of it.
-NGOs have stymied the process for the mine to get their permit due to environmental concerns
-Newmont Mining and Electrum Strategic are other large owners of the company with 16% and 19% stakes
-Though the company trades at only $2 per share, the upside can go to $6-8 and $8-12 if they receive their permit and start production.

Gabriel appears to be a low risk high uncertainty situation with a binary outcome. Without their permit, the company is likely to trade flat while having a number of potential catalysts in place to unlock value.

Be sure to read the rest of the letter at the NYTimes Dealbook.