A while back, I was asked whether or not a CEO can be counted as a moat for a business. I said yes. In rare cases, you can have CEOs that join early on and lead a company for many years. These CEOs are usually fierce competitors and are hungry to take their companies to new heights. Some examples would be not only Warren Buffett of Berkshire Hathaway, but also the CEOs of many of the businesses that he has acquired. In tech there is Steve Jobs, in insurance Bill Berkley, for retailers Sam Walton is one worth studying.
Right now though, Robin Raina at Ebix is someone to watch. I believe what he’s done there is remarkable. He took a company that was on the cusp of bankruptcy and turned it around. Now it’s in growth mode and is expanding internationally. The folks at Motley Fool have a wonderful interview with Robin Raina, be sure to read it. Here is an excerpt:
Sun: So Robin, you have obviously had some really extraordinary achievements. I am curious, as a younger person, how did you become you? Not only on your philanthropic side, but also from a business perspective. You joined Ebix when you were 30, I think, right? Then you were quickly promoted and …
Raina: Thirty-two.
Sun: And you have obviously taken Ebix to incredible heights in just the past decade, and yet you also harbor this strong desire to do right by humankind and the underprivileged. How does that develop? Was this something that came from a family background, or did this just come independently? I would love to hear about that.
Raina: Well, thank you. I think what I did gain from my father and my mom was … I think from my father I gained a lot of integrity. My father always taught us the value of sincerity and integrity and that hard work has no substitute. My family was extremely secular, my parents were Hindus, but I was given a Christian name on day one. I didn’t change my name in the U.S. I have studied in a convent in school. The names in my own family, my son has a Muslim name, my daughter has a Russian name, and so on.
My mom transferred a lot of her courage to me. I could see she was a housewife, but I saw the courage she had, that intense courage always that I grew up with. I will tell you an interesting story. When I was 23 years old, I had finished my engineering degree, and I was starting to work for Dell. Dell had a joint venture in India, and I was brought in as a management trainee. I was considered one of the top guys in sales in the country at that time. And my picture came up in the largest IT magazine as the top sales guy in the country. In those days, the numbers used to be different, but I was considered to have done well.
I got three promotions in one year, meaning I was young and I lived on it. At the age of I think 24 or so, Compaq asked me to be a managing director and go to Ho Chi Minh City and head Vietnam for Compaq, because I was quite well-known at that time … as a troubleshooter. People thought, “He will solve it; he will do some good stuff.” I rejected it, and most people at that time thought he is either too arrogant or he is absolutely nuts.
People used to say, what do you want to be when you grow up? And I used to say I want to be famous. And that was a standard line I used to say, and I just felt that when I was a kid, I had this yearning that I can do bigger stuff. I always felt if I walked into that Compaq job, I will be lost in that company and I will never be on my own. At that time I was a young kid who virtually didn’t know what I was doing, but there was an internal fire, and I think what has probably helped me to whatever little success I have had, has been that I go by my convictions. I have always believed that if you want to do anything in life, you should be able to match eyeball to eyeball and do it. Because you can only do it if you have integrity. You can only do it if you are a straight talker. You can only do it if you don’t have anything to hide.
Also, I have always believed that the simple way to success in business is hard work, sincerity, perseverance, and transparency. You have to be transparent with your clients. If you have a problem, don’t hide it; pass it on. Tell the client sooner rather than later. That client will respect you more. Let’s say you are trying to hide it and then the problem becomes a bigger problem. I have always felt that if you can be open with your clients, committed to your clients, sincere to your clients, and you believe in what you do, and lead from the front, everything will happen for you.
I, to some extent, feel that some of those values have gone through Ebix. That is probably my biggest achievement, forgetting all the numbers. I think my biggest achievement there has been that I have been able to hold my entire senior management team. My senior management team has stayed 10 years now. Secondly, I also have had the customer attention. Why don’t we lose any clients versus others? We have 300,000-plus users; we might be losing some retail brokers somewhere. But anybody who even accounts for $50,000 of revenue for us annually? In seven years, we haven’t lost that client.
So why haven’t we done that? I think it is the attitude of our employees, that they are absolutely transparent to their customers. I think that helps.
John Malone, Liberty Media’s chairman is one dealmaker I’ve been studying more closely these days. He’s really a master at figuring out tax efficient ways of doing deals that create value for shareholders. What I like about him is that in general, investors have made money investing alongside Malone. That’s not always the case when you try to follow other star capital allocators..
Today is Liberty Media’s investor day and you can register for the webcast . 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 , 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 , 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.
Many of you might remember my post Learning from Michael Burry where I looked at how he started out to get some insights on his investing process. Now, Bloomberg has a new article that talks a bit about where he is finding opportunities:
“I believe that agriculture land — productive agricultural land with water on site — will be very valuable in the future,” Burry, 39, said in a Bloomberg Television interview scheduled for broadcast this morning in New York. “I’ve put a good amount of money into that.”
Agricultural land is one area I’ve thought a bit about. With populations set to increase globally, there will be more demand for food. The thing I have not figured out is a way to play these trend as a value investor. In recent years we’ve seen short bubbles take hold of certain ag. commodities like wheat. Farmland, which is a bit less direct might actually make more sense. If you think about it, when commodities like wheat rise in price there is a real demand for increased production. Governments will try to do whatever they can to keep prices down, so that their people don’t riot. The value of farmland should increase in the long term even as commodities fluctuate, as long as we continue to see a rise in our population.
Another area Burry is looking at is small Asian technology companies:
“I’m interested in finding investments that aren’t just simply going to float up and down with the market,” he said. “The incredible correlation that we’re experiencing — we’ve been experiencing for a number of years — is problematic.”
Still, it’s possible to find opportunities among small companies because large investors and government officials focus on bigger ones, he said. He is particularly interested in small technology firms.
“Smaller companies in Asia, I think, are neglected,” he said. “There are some very cheap companies there.”
I am curious about whether he is looking at China. In some ways, the general disinterest in Chinese equities reminds me of the behavior he saw after the dot com bubble burst. At that time, the general investor community shunned technology firms, despite the fact that many had cash rich balance sheets with virtually no debt. Many of these companies eventually became net-nets or negative enterprise value companies. These were great investments for the value investors that were willing to ignore the words technology and internet, instead choosing to focus on their balance sheets.
If we look at Chinese microcaps today, many trade at incredibly low valuations. There is a good reason for that. The general investor community is worried about the potential frauds that are lurking beneath the surface. I don’t really know how to pick out Chinese frauds well enough to invest in Chinese microcaps. To some extent, I think it is almost a numbers game. Where if you diversify enough you can expect a certain percentage of your portfolio will go to 0 because of fraudulent activities but that a greater percentage will maintain or increase their value.
I wont invest in these Chinese microcaps, but I can imagine that whoever manages to pick the legitimate companies from the frauds will do extremely well.
Finally, Burry is looking at gold:
Gold is also a favored investment as central banks issue debt and devalue their currencies, he said. Governments haven’t adequately addressed the causes of the financial crisis and may be sowing the seeds for future problems by borrowing, he said. In the U.S., lawmakers showed they didn’t understand how to prevent another crisis when they gave the Federal Reserve and Chairman Ben S. Bernanke additional authority, he said.
“The Federal Reserve, in my view, hadn’t seen this coming and in some ways, possibly contributed to the crisis,” he said. “Now, Bernanke is the most powerful Fed chairman in history. I’m not sure that’s the right response. The result tends to tell me they’re not getting it right.”
To me, gold is really a trade where you are trying to profit from the fears/anxieties of the rest of the market. Some traders are very skilled at gauging that kind of sentiment and figuring out when it will shift so that they can then get out of gold and into other assets. I don’t know enough to be able to do that so I’ll stick with analyzing global businesses that have pricing power.
Bloomberg has a video up where you can hear from Michael Burry himself:
For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:/ TSE:) was my largest holding. It was in September and I was nervous about the potential for the sub-prime issue to spread to the rest of the economy. Fairfax represented a really unique opportunity because I purchased shares not only at 1/2 book value but also received the benefits of their credit default swap portfolio which was positioned against major Wall Street financial institutions. In a way, I had an undervalued company which also gave me the ability to hedge against the worst financial crisis in recent history.
Today, in the Wall Street Journal:
As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.
Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.
The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.
The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.
With and , investors went looking for cheap insurance against seemingly improbable events. Today though, that insurance isn’t so cheap. The massive waves of CDOs that were originated in the lead up to the financial crisis helped make a market filled with inexpensive CDSs. That isn’t true for today. To me, insurance is worthless if it is overpriced. Fairfax on the other hand is once again demonstrating their shrewdness. Spending only $174M to protect a $22B portfolio sounds like a good bet:
The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.
Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.
If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.
In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.
The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.
Right now there is a debate about whether we will experience deflation or inflation. It is my thinking that we will follow deflation briefly before inflating our way out of it — moving us into a period of inflation. That seems contrary to Watsa’s bet. But the thing to keep in mind is that Prem Watsa, Fairfax’s CEO, needs to protect his investment portfolio.
Most people don’t realize this, but investment income is what keeps most P&C insurance companies afloat. From 1975 to 2009 there have only been 5 years where the P&C insurance industry generated positive underwriting income. Over the same period insurers had an underwriting deficit of $445B. To make matters worse, we’re in a period of abnormally low interest rates. Most insurers have the bulk of their investment portfolios in fixed income securities. That income is likely to face some downward pressure given today’s yield curve. Some insurers try to chase better yields by going into munis, but I’d be cautious. Some municipalities have rather high budget deficits making the chance of default not entirely unlikely. One might find good short candidates by going through the investment portfolios of different insurers and finding the ones with the worst positioned investment portfolios that are coupled with bad underwriting.
So when I see Prem betting $174M to protect a $22B portfolio against deflation, I don’t necessarily take that as Prem betting the house. $174 million is only about 0.8% of the portfolio. I see this as a way to make sure Fairfax’s investment portfolio, which is crucial to the company’s survival, is protected. As long as their counter parties in the trade (Citibank Canada and Deutsche Bank) survive. It’s entirely possible that the team at Hamblin-Watsa will seek out other derivatives to help them hedge against other adverse macro-economic scenarios. I think that as long as the trades are cheap and offer asymmetric returns, Fairfax will probably consider them.
What does this mean for individual investors like you and me? I think that if right now, you see Fairfax as being undervalued without the derivative trade working out – you might want to consider it for your portfolio. Worst case: you have a cheap insurance company run by one of the best capital allocators in the insurance business. Best case: you have a cheap insurance company that should help hedge your portfolio against deflation. Most individual investors are unable to purchase the kinds of hedges that Fairfax employs, so this is one way to work around that. I would not buy solely on the derivatives trade because we don’t know how long it will take for Fairfax to actually realize their gains (if they realize any at all).
I’ve been getting tons of e-mails and comments asking for a link to this lecture. Columbia seems to have gotten the message and has put it up on their site:
Last week, Fairfax Financial had their latest quarterly conference call. Fairfax is a holding company of different insurance operations helmed by Prem Watsa, a value investor who is sometimes called the Warren Buffett of the north. I first discovered Fairfax about 3 years ago. I learned of the company’s investing talents and saw that they looked undervalued while trading at a heavy discount to book value. Fairfax also held a portfolio of credit default swaps against major financial institutions which acted as a great hedge against the financial crisis.
Since then, I always look to their commentary to see how they think about today’s markets and their perspectives about risk in the future. Here’s what Watsa said about their hedge ratio:
Prem Watsa
Yes, I’m sorry. So, in response to the in equity markets in 2009, and early 2010, the economic uncertainty in the U.S. our equity hedge ratio to approximately 93% of our equity exposure. The effect of this increase by entering into Russell 2000 and total return swap contracts, average index level of 646.5. This was in addition to the S&P 500. Russell’s total return swap contracts we had done in September 2009 at an S&P 500. Now, I’ll give you some information on the line financials, Thank you.
By hedging 93% of their equity exposure, the folks at Fairfax must really be concerned about the possibility of another downturn. In a recent interview with Value Investor Insight, Watsa outlined some of his worries:
What environment are you positioned for today?
Prem Watsa: The two historical periods we believe are relevant are the U.S. in the Great Depression and the Japanese experience over the last twenty years. In Japan, nominal GDP remained flat for 20 years even though total debt as a percentage of GDP went from 50% to 200%. People will say it’s different this time and that that can’t happen in the U.S. Maybe, but I remember being in Tokyo in 1989 and people were saying the same thing. It won’t be that bad because we have high savings rates, or because the Keiretsu cross-shareholdings provide stability. Look how that turned out.
The economic story was similar in the U.S. in the Depression. After falling dramatically, nominal GNP came back up at the end of the 1930s to where it was in 1929, so there was no growth for the entire period. If not for the war, that would have lasted for a longer time.
So we don’t believe the financial crisis is over. After 20 years in which most developed countries saw leverage going to record levels, we think there are many, many years of deleveraging to go. Governments have tried to step in to mitigate the pain of that process, but as you see already in Europe, attention is turning to cutting spending and raising taxes. We expect after the mid-term elections to see much the same thing in the U.S. With a $1.5 trillion deficit and near-0% interest rates, there aren’t many bullets left.
Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession.
Are you at all concerned about inflation and rising interest rates?
Prem Watsa: Right now we’re more concerned about deflation, which would reduce Treasury rates even further. If we have a repeat of the U.S. in the 1930s or Japan over the past 20 years, long Treasuries could keep going down – or at least stay very low – for some time.
If we look at Fairfax’s equity portfolio, we can see that it is heavily weighted towards large cap high quality companies like Johnson and Johnson, Kraft, and Walmart. A number of investors have come out saying that large caps present a good value proposition right now – you can find some companies with a steady history of dividend increases and buybacks trading at historically high yields. If you’re worried about inflation, these companies are likely to provide better value than most fixed income investments.
Still, Fairfax has a substantial hedge on their equity portfolio. We know that Seth Klarman of the Baupost Group has also expressed concerns about how fast the market recovered after the crisis. So maybe there is a need to hedge portfolios. Now, smaller investors are precluded from buying the derivatives that Fairfax is using. The simplest choice would be to increase your cash allocation. Klarman has sometimes gone as high as 50% cash in recent year. If you want to get more complicated, you can use cheap insurance by way of out of the money options. With those you can profit immensely if the market declines far more than people expect, you are betting on an improbable event. These options are inexpensive because the event is so improbable to most. The flip side is that you need to continuously rollover that protection because options are targeted to a specific point in time. And it’s a negative carry trade, meaning that each time you are wrong and have to rollover, you lose a little money. The method you choose should fit your investing style. The options approach is definitely going to require more time and a means of offsetting the negative carry (or a willingness to accept it).
Two of my most popular posts on Street Capitalist have been about Li Lu. The first post was: Li Lu: Berkshire Hathaway CIO Candidate? I followed up with a second post, transcribing a lecture that Li gave to Columbia students in 2010 (Li Lu’s 2010 Lecture).
In the first post, I speculated as to whether Li might emerge as one of the Berkshire CIO candidates:
This past weekend was the Berkshire Hathaway (NYSE:BRK.A / BRK.B) annual shareholder meeting. At one point during the Q&A, a questioner asked Warren Buffett about the status of Berkshire’s CIO candidates. Charlie Munger remarked that one candidate who he is particular close with was up 200% in 2009 with 0 leverage. Some people think that the person Munger is referring to is Li Lu, a fund manager who turned Munger and Buffett onto BYD.
Li personally owns at least 2% of BYD, which rose 400% in 2009. I don’t know anything about his investments beyond that one position, but I know he is a huge believer in taking concentrated, high conviction positions. If that is the case here, BYD’s spectacular results must have contributed a lot to his returns for 2009 which may make a 200% for the year possible.
(From left to right: David Sokol of MidAmerican, Warren Buffett, Wang Chuan-Fu of BYD and Li Lu. Photo: )
Today, which sheds light on Li Lu, speculating that he might be a CIO candidate. Pulliam managed to interview Charlie Munger and get some of his thoughts on Li Lu:
One of Mr. Li’s human-rights contacts was Jane Olson, the wife of Ronald Olson, a Berkshire director and early partner at a Los Angeles law firm Mr. Munger helped found. Mr. Li began spending time at the Olsons’ weekend home in Santa Barbara, Calif., and on Thanksgiving 2003 met Mr. Munger, whose home is nearby.
Mr. Munger says Mr. Li made an immediate impression. The two shared a “suspicion of reported earnings of finance companies,” Mr. Munger says. “We don’t like the bull—.”
Mr. Munger gave Mr. Li some of his family’s nest egg to invest to open a “value” fund betting on beaten-down stocks.
Two weeks later, Mr. Li says he met again with Mr. Munger to make certain he had heard right. In early 2004, Mr. Li opened a fund, putting in $4 million of his own money and raising an additional $50 million from other investors. Mr. Munger’s family put in $50 million, followed by another $38 million. Part of Mr. Li’s agreement with Mr. Munger was that the fund would be closed to new investors.
The company that got people talking about Li Lu, as a potential successor to Buffett is BYD. Most people thought it was strange that Buffett would be investing in an automaker, based out of China of all places. But, I think that one of the allures for early investors in BYD was the fact that it is known as one of the best manufacturers of batteries in the world. Wang Chuan-Fu, BYD’s founder and CEO had to work hard to build his company with limited access to capital and technology. As a result, he fostered a corporate culture that thrived on thriftiness and ingenuity. That’s the kind of corporate culture Berkshire likes to invest in. Pulliam gives us details on Li Lu’s timing on BYD:
Mr. Li’s big hit began in 2002 when he first invested in BYD, then a fledgling Chinese battery company. Its founder came from humble beginnings and started the company in 1995 with $300,000 of borrowed money.
Mr. Li made an initial investment in BYD soon after its initial public offering on the Hong Kong stock exchange. (BYD trades in the U.S. on the Pink Sheets and was recently quoted at $6.90 a share.)
When he opened the fund, he loaded up again on BYD shares, eventually investing a significant share of the $150 million fund with Mr. Munger in BYD, which already was growing quickly and had bought a bankrupt Chinese automaker. “He bought a little early and more later when the stock fell, which is his nature,” Mr. Munger says.
In 2008, Mr. Munger persuaded Mr. Sokol to investigate BYD for Berkshire as well. Mr. Sokol went to China and when he returned, he and Mr. Munger convinced Mr. Buffett to load up on BYD. In September, Berkshire invested $230 million in BYD for a 10% stake in the company.
BYD’s business has been on fire. It now has close to one-third of the global market for lithium-ion batteries, used in cell phones. Its bigger plans involve the electric and hybrid-vehicle business.
One of the interesting aspects of having Li as a CIO candidate is that because of his international focus, particularly on China, he might be able to find the next great wave of global businesses. In his 2010 lecture, Li talks about analyzing BYD by looking at the early history of GM:
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…
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.
This to me, is one of the advantages in having a CIO candidate that is focused on international opportunities. As nations like China and India develop, they’re bound to naturally mimic the development of Western countries in certain ways. They might actually start to have great businesses that arise out of necessity, “repeating” what’s gone on in America. This is particularly true in areas such as logistics and transportation which become more and more essential as countries develop. In a few years there might be domestic versions of FedEx or Sysco in China and India — if there aren’t already.
Just how much did Li and Buffett make off of BYD?
BYD is a big roll of the dice for Mr. Li. He is an informal adviser to the company and owns about 2.5% of the company.
Mr. Li’s fund’s $40 million investment in BYD is now worth about $400 million. Berkshire’s $230 million investment in 2008 now is worth about $1.5 billion. Messrs. Buffett, Munger, Sokol, Li and Microsoft founder and Berkshire Director Bill Gates plan to visit China and BYD in September.
Pulliam ends the article with Li’s analogy between investing and soccer:
Mr. Li declined to name his fund’s other holdings. Despite this year’s losses, the $600 million fund is up 338% since its late 2004 launch, an annualized return of around 30%, compared to less than 1% for the S&P 500 index.
Mr. Li told investors he took a lesson from watching the World Cup, comparing his investment style to soccer. “You may very well work extremely hard and seldom score,” he says. “But occasionally—very occasionally—you get one or two great chances and you make decisive strikes that really matter.”
Li’s approach to investing is really similar to Buffett’s own advice to wait for the market to give you fat pitches. I think most investors mess up by lacking that kind of patience.
In environments where there aren’t a whole lot of bargains, some value investors will begin to relax their standards in order to participate more in the market’s rallies. This almost always ends in disaster. If you are not disciplined with value investing you can get yourself into tight spots. It’s a strategy that often encourages taking high conviction, concentrated approaches to investing. An investor without discipline might end up with a portfolio of only 8 stocks at really expensive valuations. When the bubble bursts, their portfolio will take a massive hit and usually perform worse than the market indices because of that level concentration.
In his 2010 lecture, Li emphasized the need to know what you don’t know when investing. That might sound a bit like a riddle, but it’s really about acknowledging that you can’t know everything and there are going to be risks that you cannot anticipate. If you accept that idea, you’re always going to be looking for businesses with strong competitive advantages and seek to buy at a discount to intrinsic value. That way you have some protection against those unknown risks. With that intellectual framework and a willingness to employ rigorous analysis, you should be able to identify good investments and profit immensely.
My name is Tariq Ali, I run Street Capitalist. I recently graduated from the University of Texas at Austin. There, I stumbled onto value investing via the school library. I read everything I could and now I'm here, writing out my thoughts and investment ideas.
I have a lot of heroes when it comes to investing, it seems like every investor has some kind of niche. Some, whose books and writings have had the biggest impact on me are: , ,, , and .
Have any questions? Want to stay in touch?
Feel free to e-mail me at TariqTX@gmail.com
Recent Comments