Street Capitalist: Event Driven Value Investments

For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:FRFHF/ TSE:FFH) 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, Gregory Zuckerman has a wonderful article on Fairfax Financial 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.

Firm Makes Bold Bet on Falling Prices (WSJ)

With The Greatest Trade Ever and The Big Short, 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).

If you’ve been following the blog lately, one of the trends you will have noticed is the increasing amount of attention I’ve been giving to large cap blue chip stocks. I’ll be the first to tell you that these are not exciting companies. There is no event driven catalyst. But as best in class companies, they remain cheap and pay out strong dividend yields. Johnson & Johnson (NYSE:JNJ) is one that I’ve constantly talked about on here. The story is all rather simple – you are getting a best in class business at a 8.7% earnings yield and 3.7% dividend yield. Yesterday, I saw in the Berkshire Hathaway filing that Buffett has been a buyer as well:

OMAHA (AP) — Berkshire Hathaway partly rebuilt the stake in Johnson & Johnson it had reduced in the last two years to raise cash for other investments, and increased its investment in Wal-Mart Stores in the second quarter.

Berkshire, the holding company run by Warren E. Buffett, detailed its $46.4 billion stock holdings Monday in a filing with the Securities and Exchange Commission.

The document revealed several changes in the company’s portfolio from March 31 to June 30, including decreases in Kraft Foods, ConocoPhillips, Procter & Gamble and M&T Bank. Berkshire also increased its stakes in Becton Dickinson & Company, the Nalco Holding Company and Sanofi-Aventis. The biggest change was in its Johnson & Johnson stake, which grew to 41.3 million shares at the end of June, from 23.9 million shares in March. In 2008 and 2009, Mr. Buffett sold some of its stock in the company to help pay for other investments.

Berkshire held 64.3 million shares of Johnson & Johnson at the end of 2007.

Buffett Filing Shows Details of Holdings (AP)

Over the last few quarters I saw Buffett reducing his exposure to JNJ. I figured this was because he needed to raise his cash balance in his portfolio due to the preferred share deals he struck during the crisis and the Burlington Northern Santa Fe acquisition.

With most of that over, I think he is rebuilding his JNJ stake for a few reasons. One, JNJ is large enough to provide the kind of liquidity that is necessary for Buffett to increase his stake without distorting the stock price. Two, JNJ pays a heavy dividend yield that creates cash flow for Buffett to redeploy elsewhere. It’s much better than cash or most of his fixed income options. Finally, JNJ has the kind of long term prospects that Buffett likes in a business. They make products that people will need for a long time. This is a company that managed to survive even the Great Depression. There aren’t a whole lot of companies still around that can boast that fact. That does not mean JNJ or any other large cap blue chip is impervious to sharp market draw downs. Typically, these stocks will fall just like everything else. Sometimes the fall is a little less pronounced because capital flees riskier stocks and enters into some of these more defensive names.

On the credit side of things, JNJ seems to be doing well. The company just placed 10 year bonds at historically low rates:

Johnson & Johnson sold $1.1 billion of bonds at the lowest interest rates on record for 10-year and 30-year securities amid surging investor demand for the highest- rated corporate debt.

The drugmaker, in the first offering by a nonfinancial AAA rated company in 15 months, sold $550 million of 2.95 percent, 10-year notes and the same amount of 4.5 percent, 30-year bonds, according to data compiled by Bloomberg. That’s the lowest coupons for those maturities on record, according to Citigroup Inc. data going back to 1981.

“Even though some faith in the rating agencies has been blown, the triple-A is still sacred,” said Guy LeBas, chief fixed-income strategist and economist at Janney Montgomery Scott LLC in Philadelphia.

…In J&J’s most recent debt sale, it sold $900 million of 5.15 percent, 10-year notes that paid 103 basis points more than similar-maturity Treasuries and $700 million of 5.85 percent, 30-year bonds at a 113 basis-point spread in June 2008, Bloomberg data show.

J&J Sells $1.1 Billion Of Debt At Record-Low Rates (Bloomberg)

So why might JNJ be undervalued? I think that with all the analyst attention JNJ garners, a sort of short term mindset comes into play. JNJ had a few recalls which reduced sales and in turn forced analysts to lower their estimates. I see these as short term problems, the company has dealt with product recalls in the past. If the company can prove that they can resume their sales growth or simply boost their dividend, I could see the stock begin to trade back up towards its highs from the last few years.

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:

click to play: Video: Li Lu’s Spring 2010 Lecture

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.

Fairfax Financial Holdings Ltd. Q2 2010

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.

Li Lu: Berkshire Hathaway CIO Candidate? (Street Capitalist)

(From left to right: David Sokol of MidAmerican, Warren Buffett, Wang Chuan-Fu of BYD and Li Lu. Photo: David Yellen)

Today, Susan Pulliam has a great article in the WSJ 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.

Chinese Investor Emerges as Possible Buffett Successor (WSJ)

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.

I had a chance to interview Zeke Ashton of Centaur Capital and manager of the Tilson Dividend Fund. I think you’ll enjoy the interview. Ashton is a generalist, he is willing to short stocks, and looks across all types of companies — from microcaps to large caps. Plus, he’s based out of Texas. I’ve been hoping to showcase more Texas-based fund managers to prove that we’re not all energy traders down here.

Please give me your thoughts on the interview in the comments section or feel free to e-mail me. I’m always looking for new investors to interview.

You can find more about the Tilson Dividend Fund here or learn more about the fund’s performance via Morningstar.

My questions are in bold.

Can you give us a brief bio of yourself and how you came to run Centaur Capital?

I started my career in the financial software business as a consultant deploying complex treasury and risk management systems for large banks and conglomerates, mostly in Europe. At the time, I thought that my natural career progression might be to become a risk manager for a large bank or insurance company.

Somewhere along the way I developed an interest in the stock market and discovered Warren Buffett’s Berkshire Hathaway letters and was immediately hooked. I also was a big fan of the Motley Fool website, and when I decided that I wanted to change careers to investing, I was fortunate enough to land a job there. I moved back to the States and started working for TMF as an investment writer in early 2000 – just in time for the bear market. I spent two years writing articles and research on investing for TMF, which enabled me to learn and refine my own investing approach.

In 2002, I decided that I was ready to start investing professionally, and moved to the Dallas area and started Centaur Capital Partners. I set up a private limited partnership and opened for business with less than $1 million under management, and it took several years to get to the point where Centaur Capital was a viable business. In 2005, we launched a mutual fund called the Tilson Dividend Fund (TILDX) in partnership with our good friends Whitney Tilson and Glenn Tongue at T2 Partners, and that has done well. We’ve now been in business for eight years, and while it’s not been without its challenges, overall I feel very fortunate to be where I am today.

A while back in 2007 at the Value Investors Congress, you gave a presentation (PDF) about how you think about asset allocation at Centaur. Is it largely the same today? Or has the financial crisis influenced your take on capital allocation?

That VIC presentation was primarily a discussion about portfolio construction, and it was really in reaction to what I thought was a growing pressure amongst value investors to run excessively concentrated portfolios. Keep in mind that this was 2007, and the market had produced a long stretch of good returns from 2003 to early 2007. The book “Fortune’s Formula” had become quite popular, and there were many discussions amongst investors about the potential for employing the Kelly Formula as some sort of secret sauce that would allow investors to increase returns by increasing concentration.

My own view is that most investors are better off running portfolios of 15-25 stocks because such a portfolio would ultimately be a truer reflection over time of an investor’s skill. In other words, a 15-25 stock portfolio has enough concentration to allow a skilled investor to really stand apart from the market, but is not so concentrated that bad luck, bad timing, or one or two mistakes can sink an otherwise competent investor. One of the points of emphasis in that presentation was that concentration shouldn’t be a constant, but rather should be idea and environment dependent. It has always seemed to me that each idea in the portfolio should be sized based on a careful assessment of the body of evidence available for that idea, with particular emphasis on risk factors. This would include factors such as how deeply the security appears to be under-valued, how predictable and reliable the business is, how it is capitalized, the quality and track record of the management team, and even how familiar the investor is with the idea. Also, it should be influenced by the presence of clearly correlated ideas in the portfolio.

I believed then and I believe now that using the flexible 20-stock model portfolio position sizing exercise that I described in the presentation is a very solid framework to start with. In looking back over that presentation today, I wouldn’t change a thing regarding the content of that discussion. But I’d sure like to have the stock picks back – I presented four ideas at that conference and three of the four performed very poorly in the bear market that followed.

How long do you study a potential investment before you decide to buy? After initiating the position, do you continue your research process on the name?

We generally produce a research document that covers all the important components of the investment, both qualitatively and quantitatively, prior to investing. For a simple idea, the document may well be five pages long. For a very complex idea, the report will be longer. But regardless of the complexity of the idea, writing a research document using a fairly standard template serves as both a form of checklist for us and ensures that we both understand the idea and can articulate why the idea meets our criteria for both value and safety. It also allows for a “quality check” in that it can be reviewed by a second analyst internally and even potentially by contacts outside of our shop that may be able to review our work and provide some insight back to us.

You have mentioned in the past that you are increasingly looking at macro data when making an investment. What kinds of macro indicators do you look at? Has there ever been a situation where a stock looked cheap but you did not invest because of the macro?

I wouldn’t say necessarily that we look at macro “data” when making an investment. It is more the recognition that an otherwise compelling idea can get overwhelmed if the larger forces surrounding that idea are negative enough. Going forward, we will probably be a little more cognizant of looking for the larger risks that could really hurt us as investors. As for an example, we basically decided in mid-2008 that we weren’t going to invest in any bank or other leveraged financial business given our concerns about the credit environment, and we sold the one stock he held at that time that qualified, which was American Express (NYSE:AXP). Granted, this was an extreme case, but it did help protect us from the worst of the permanent capital losses that many of our value investing peers suffered in banks and other leveraged financial stocks.

I suspect that our approach going forward when assessing ideas where we have identified a major industry or macro risk would be to use smaller position sizes, demand more compelling prices, or actively look for a way to hedge out any obvious macro risk that we identify if it can be done in a cost-effective way.

When you use valuation methods like DCFs, what kinds of factors do you look at when forecasting? Is it mostly things in the current-year, the past, or your own predictions? How far out do you model?

We use DCFs more as a sanity-check and to reverse engineer current market expectations than to try to produce any kind of precise valuation. When basing our views as far as what the future might look like, we try to look at a longer view of the company’s operating history (normally five to ten years) to see how the business has done over time. As an example, one of our larger current positions is Lab Corporation of America (NYSE:LH). Qualitatively, this is an outstanding business with tremendous barriers to entry. There is something of a Coke / Pepsi dynamic in the laboratory services industry, with competitor Quest Diagnostics (NYSE:DGX) the slightly larger company in the industry and LH being a strong number two in terms of revenues. LH has been a consistent but moderate grower over many years, with revenue growth in the high single digits and free cash flow growth at around 10% for the last five years. In looking at the recent stock price of around $72, when we plug the numbers into a DCF spreadsheet, we find that the market basically assumes that LH will never be able to grow its free cash flow at more than 2% annually going forward forever. Our view of the company’s growth prospects is significantly more optimistic than that.

So that’s our first sign that LH is a potential opportunity for us.

If I drop in even 5% average FCF growth for LH going out for ten years before dropping down to a terminal growth rate of 2% after that, my spreadsheet tells me the stock is worth $96. Because I’ve owned LH in the past and am extremely familiar with the business, I am very comfortable taking the view that the company will be able to grow its FCF much faster than the current market price is discounting. I don’t have to be super precise. When the stock gets to $85-90, it will be a closer call and I will probably respond by reducing our position size somewhat. So we try to use the full body of evidence we have available about a company, but in general we just don’t buy stocks that require heroic growth assumptions to justify the current price.

You operate largely as a generalist. Sometimes that entails investing in unfamiliar industries. Can you give an example of a case where this happened? What were some of the things you specifically did to learn the ins and outs of the business?

Yes, being a generalist means that one needs to have a framework for getting up to speed quickly when looking at a company or industry that is new for us. So we have learned to quickly identify the business model, which gives us a huge head start in terms of how to approach the research. There really probably aren’t more than a dozen or so basic business models in existence and most companies employ a variation of one of them. Then we start our study of the targeted business and some competitors, and we start reading annual reports, industry publications, and whatever we think we need until we feel we have a good handle on the business. One of the good things about this business is that knowledge is cumulative and the longer I’ve been investing, the more businesses and industries I’ve become familiar with and the faster I am able to get up to speed.

What is one company that you think you would be comfortable with buying and holding for 15 years? Why?

That’s an interesting question, and I’m going to have to answer it by changing your question a bit. We’ve come to believe that if your goal as an investor is to compound at high rates (our goal is 15-20%), that a “buy and hold” philosophy for 15 years simply isn’t likely to work except perhaps in very rare cases. To get that kind of return, you have to buy stocks when they are undervalued and sell them when they are fully valued. Therefore, to give you a stock that I’d be comfortable buying and holding for 15 years simply doesn’t reflect our philosophy, since over a 15-year period we’d expect to have the opportunity to buy a stock at discounted prices and sell it back at full prices multiple times. Of course we are prepared to wait a long time if necessary to get fair value for our holdings, and there are other cases where the performance of the company results in ever-increasing estimates of fair value such that we can hold on to the position for a long time. But we are usually hoping that we will be able to get full value for our stocks within 2-3 years of purchasing them.

So let me give you a list of companies that we admire and that we very much like to own when the stocks are cheap: Fairfax Financial (TSE:FFH), because we admire Prem Watsa. Berkshire Hathaway (NYSE:BRK.A / BRK.B) of course. In our current portfolio, I like Lab Corp (NYSE:LH), Dreamworks (NASDAQ:DWA), and a small Canadian company called Ag Growth International (TSE:AFN). In all of these, I either have a great deal of comfort and admiration for the management team, or else the business is extremely unique and enjoys a strong competitive advantage.

One of the things that value investors often talk about with shorting is how it gives you potentially unlimited losses. How do you manage risk with shorts?

Shorting is a very tough business, and we continue to learn new lessons every year. I have come to the belief from talking to several guys who are more experienced than myself on the short side that the best way to manage risk is to keep position sizes small and have a slightly more diversified short book. We also limit the size of our overall short exposure. Unlike the long side, where we have no individual position loss limits, we have historically used a position loss limit on short positions, though over time it has probably hurt us as much as it has helped us.

Can you give an example of a past investment mistake? What do you think happened? What did you learn?

Sure. Rather than give you a specific mistake, I’ll give you a category mistake that we’ve made more than once and that I therefore think is one that investors are extremely vulnerable to. The mistake is one of commitment bias, where for example we will decide that a given idea is very compelling but due to its potential risk is justifiable only as a small position. For example, every once in a while we find ideas where there is a very wide range of possible outcomes, but where either the potential magnitude of the return in the good case scenario is very high or we think the probabilities are favorably skewed in our favor. On balance, we’ve done OK with this kind of idea. The problems have come when we’ve initiated the position at an appropriate position size (say, 1% of the fund, or 2% or whatever) but then the stock declines either because of some new development or for another reason. We’ve often added to the stock and built them to inappropriately large position sizes simply due to the lower price, rather than sticking to our initial game plan of limiting our bet. Because of this, we’ve occasionally made what would have been a small loser into a bigger loser.

Another and similar mistake is reacting immediately to a sharp decline in an existing holding on negative news without taking adequate time to fully review the new information to ensure that making the additional deployment is justified by the new development. We try now to be rigorous in ensuring that each incremental add to an existing position is truly justified by the existence of a widening discount to our expected range of fair value and not due to some embedded commitment to the name.

What are some of your favorite books? Investing or non-investing related.

I kind of like to follow good writers around. For financial-related books, I always like to read anything by Roger Lowenstein, with particular nods to his biography of Warren Buffett as well as his book Origins of the Crash that described the causes of the tech and large cap bull market of the late 1990’s. I think Michael Lewis does fantastic work – his latest of course is The Big Short, but I also loved Liar’s Poker as well as his non-financial books The Blind Side and Moneyball.

How do you look at the market cap of a company? Are you less willing to invest in large caps? Do you see more opportunities in one than the other?

No, we don’t care what the market cap is. We are looking to get the best combination of value and safety out of our investment dollars as we possibly can. I do think that large cap, high quality stocks are as cheap now relative to the rest of the market as I’ve ever seen them, and that being the case our portfolio is more heavily weighted to large company stocks than it has been for most of our history.

Can you give us a company that you think is undervalued/attractive right now? What is your thesis there?

Sure. Lab Corp is our biggest position, and I’ve already explained our thinking there. Let me give you an esoteric one. This one is a small position for us, because the stock trades on the pink sheets and isn’t very liquid. Therefore, I’m not making a recommendation, only naming a stock that I personally think is undervalued and attractive. The company is Mass Financial Corp (PINK:MFCAF), and it trades in the U.S. on the pink sheets under the ticker MFCAF. MFC is a merchant bank specializing in a combination of traditional financing services and proprietary investing, primarily involving commodities and natural resources. The business is run by Michael Smith, who is also the chairman of the company formerly known as KHD Humboldt Wedag and is now called Terra Nova Royalty Corporation (NYSE:TTT).

MFC was spun out of KHD in January 2006, and had negligible book value at the time of its spin-off. The stock trades for $9 and change, and has a market cap of approximately $200 million. In the last four years, MFC has averaged over $40 million in net income and over $50 million in free cash flow. Here’s the book value per-share at the year-end each of the last four years, starting basically from zero at January 2006 (note that the book value per share figures are adjusted for a 9% stock dividend issued in late December 2009):

December 31, 2006 $2.43
December 31, 2007 $4.39
December 31, 2008 $5.71
December 31, 2009 $9.72

Going back further, prior to folding MFC into KHD, Michael Smith ran the company (then called MFC Bancorp) from 1984 to 1995, and during that stretch he grew book value from $1.49 per share to $17.09 per share, which is a pretty impressive performance. Overall, we think that MFC is a very intriguing investment at a discount to book value given the impressive track record.

The downside to an investment in MFC is that there is never really any way to know what Michael Smith is up to. Smith’s policy is to report financial results every six months, and only issues press releases when a material development occurs. In addition, the company’s disclosures are not as highly detailed as one might like regarding its merchant banking and direct investment activities. Nevertheless, the performance of the company speaks for itself, and MFC has an extremely strong and liquid balance sheet and uses very little leverage in its activities, making the historical performance that much more impressive. A couple months ago, MFC took over a majority interest in a micro-cap Canadian listed company called Canoro Resources (CVE:CNS), which has some very interesting oil and gas assets in India. As I mentioned, MFC is a small position for us, but I like having it in the portfolio.

Zeke, thank you for taking the time to interview with Street Capitalist

A couple of days ago I saw this message on Twitter about Global Cash Access Holdings (NYSE:GCA):

That piqued my interest. I’ve had some success in the past with investing in companies after they lose a major customer. In this case, Harrah’s made up 14% of revenues. So, I decided to hop on the conference call and read through the latest 10-K to get an idea of the business and where it stands after losing Harrah’s.

Here’s how GCA describes their business:

Global Cash Access Holdings, Inc. (Holdings) is a global provider of cash access and data intelligence services and solutions to the gaming industry. The Company’s services and solutions provide gaming establishment patrons access to cash through a variety of methods, including automated teller machine (ATM) cash withdrawals, credit card cash access transactions, point-of-sale (POS) debit card transactions, check verification and warranty services and money transfers. The Company operates ATMs at certain customer gaming establishments, where the gaming establishment provides the cash required for the ATM operational needs.

These are some of my notes from the call:

-no detail yet on the Harrah’s cancellation. Less than 14% of revenues, not above avg margins. No material impact on 2010 results.
-Still have strong cash flows
-Gaming customers are under enormous pressure
-no debt covenants triggered by loss of Harrah’s.
-no debt covenants triggered by loss of Harrah’s. No disclosure on other contract times (e.g. with MGM and others)
-buyback authorization kept in place.

A number of analysts expressed their frustration at the management team’s lack of willingness to discuss current market conditions. Their frustration is understandable. One of the common questions that I’ll ask an executive at a business I am looking to invest in is what they are seeing in their market. You do this for two reasons: One, to get a feel for how they are thinking about the business at that moment in time. Two, to check their views versus a direct competitor. I love to do this because you can see what the similarities and differences are in their statements. That way you can check to see if one company is exaggerating or overly optimistic. GCA said that they couldn’t really discuss because they were still in contract negotiations with customers and those are confidential. That might be understandable, but I still felt that they could have provided us with some color.

Doing more reading about GCA, I learned that when the company went public in 2006 they worked hard to sign a big name customer. In the end, they managed to sign MGM but the casino really onerous — the contract was basically break even for GCA. That MGM contract is up for negotiation this year and it was one of the reasons for an earlier sell off in the stock. Losing Harrah’s is another blow to GCA’s business.

GCA’s competition basically consists of GPN (10% of the market) and then a few start ups. Right now, the Vegas casino operators are really hurting and there’s a good deal of pressure for them to cut costs. I think that it is likely that either Harrah’s plans to take GCA’s business on themselves or chose to contract it out to GPN or another start up. Just as GCA signed a break even contract with MGM, many of these other cash processing businesses might be willing to do the same. I am sure that their thought process is that they can sign one of these major casinos at break even during the trough period and then 3 years later, renegotiate at higher rates. To me, this exposes one of the flaws in GCA’s business model. It lacks a substantial competitive advantage and is at the mercy of casino operators.

Now we don’t know what kind of margin the Harrah’s contract had, but on the conference call the CEO said it was at average to below average margins. On the one hand, this means when modeling for the reduction we can probably reduce revenues by 15% and then apply the previous EBIT margin. But that is thinking backwards when we need to look forwards. The greater threat is margin compression. On the call, the CEO said that in any given year about 1/3rd of contracts are up for negotiation. After seeing Harrah’s leave, I think casino operators might threaten to also leave unless given contracts that provide GCA with substantially lower margins. In this case, your dumbest competitor is also your most deadly competitor.

The other issue I see with GCA is their financing situation. In 2-3 years the company has $272.5M in cash obligations due. Here’s their financing agreement with Bank of America:

Treasury Services Agreement. We obtain currency to meet the normal operating requirements of our domestic ATMs pursuant to the Treasury Services Agreement. Under this agreement, all currency supplied by Bank of America remains the sole property of Bank of America at all times until it is dispensed, at which time Bank of America obtains an interest in the corresponding settlement receivable. Because the cash supplied to us under the Treasury Services Agreement is never an asset of ours, supplied cash is not reflected on our balance sheet. At December 31, 2009, the total currency obtained from Bank of America pursuant to this agreement was $428.3 million. Because Bank of America obtains an interest in our settlement receivables, there is no liability corresponding to the supplied cash reflected on our balance sheet. The fees that we pay to Bank of America for cash usage pursuant to the Treasury Services Agreement are reflected as interest expense in our financial statements for the following reasons:

-the Treasury Services Agreement operates in a fashion similar to a revolving line of credit, in that amounts are drawn and repaid on a daily basis;

-the resource being procured by the Company under the terms of the Treasury Services Agreement is a financial resource and in the absence of such an arrangement, the Company would be required to obtain sufficient alternative financing either on balance sheet or off balance sheet in order to meet its financial obligations;

-the fees of the Treasury Services Agreement are assessed on the outstanding balance during the applicable period and include a base rate which is tied to LIBOR and a spread, similar to a credit spread, of 25 basis points; and

-the fees incurred by the Company under the Treasury Services Agreement are a function of both the prevailing rate of LIBOR as dictated by the capital markets and the average outstanding balance during the applicable period as previously noted. The fees do not vary with revenue or any other underlying driver of revenue such as transaction count or dollars processed as is the case with all costs classified as cost of revenue such as interchange expense, and processing fees.

My issue is that GCA is a company you might have to hold onto for years if their customers start squeezing their margins. The danger of holding it for so long is that interest rates are likely to rise in a few years. So not only would GCA face difficulties getting good prices out of their customers, but they would also have to pay out higher rates to their bankers.

To me, that potential for margin compression creates complications for the company with so much cash being due in just 2-3 years. Now, it is entirely possible that GCA could amend their credit agreements to get terms that are more favorable, especially if the trough market for casino operators persists. But I don’t want to depend on debt negotiations for an investment to work. The other thing that could work in GCA’s favor is if the profits for casino operators return to pre-financial crisis levels. That’s entirely another good possibility and it is something that might be worth watching for — especially when management releases some guidance with more clarity on the state of their market.

For now though, I am putting GCA in the too hard pile. For a different perspective, look to the Inelegant Investor blog for a bull-case on GCA.

Bill Miller has an article over at Morningstar where he argues that large cap stocks are more undervalued than ever:

A few weeks ago I sent a little note to our staff about Exxon Mobil. It pointed out that Exxon Mobil was on the 52 week low list, and was actually lower than it was during the depths of the panic in the fall of 2008. It had (and still has) a yield greater than the 10 year treasury, trades at a multiple well below the market, has returns on capital above the market, has grown the dividend over 9% per year the past 5 years, and uses its prodigious free cash flow to shrink its shares outstanding by between 300 and 400 million shares per year. If it keeps this up for the next 15 years, it will be just about out of shares. Yet it languishes at 5 year lows. When it was last trading here in 2005 oil was $50 a barrel. The math is fairly simple: a sum of the dividend yield, growth rate and share shrink could represent an attractive annual return even if the valuation stays the same, and the valuation is among the lowest the company has traded at in years. Cash returns zero, the 5 year treasury is now trading at one of the lowest yields in history, the 10 year yields 2.93% and that yield will not go up. Yet what do people want: treasuries. What do they not want: Exxon Mobil and most other large capitalization U.S. stocks with similar characteristics.

Exxon Mobil is the largest company in the U.S. equity market, and one of the highest quality companies in the world, yet no one seems to care. When I mentioned this to a hedge fund manager a few weeks ago, he said that the oil stocks have underperformed this year, that the oil spill had cast a pall over all energy equities, that regulations on energy companies were going to increase, that subsidies may decrease as governments seek more revenue, and that the Congress is now going to take up a new energy bill, which is why Exxon Mobil is not attractive. Well the math is the math, no matter what the near term sentiment. I then asked him about Kimberly Clark, with a 4% yield, an 8% dividend growth rate, buys back shares, etc. So is Congress going after diapers and Kleenex next?

Bill Miller: Large Cap Stocks Represent a Once in a Lifetime Opportunity

To me, I never understood the fervor around buying BP (NYSE:BP) when you could purchase Exxon (NYSE:XOM).

Exxon Margins

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BP Margins

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Exxon is consistently more profitable than BP and is without all of the headline risk associated with BP’s oil spill. Yes, the likelihood of increased restrictions on drilling in the gulf is high – but Exxon has operations globally and I think they’ll be better suited to cope with the increased regulations. To me, it is at least the better buy when compared to BP.

The other one worth watching is Johnson and Johnson (NYSE:JNJ). So far, JNJ has hit new 52 week lows on concerns over product recalls. JNJ has had some experience with these before and I don’t see them crippling the company. The Financial Times’ Lex column has a great article on the company:

The three negative storylines for US drug companies this year are the weak euro, Obamacare and patent cliffs. J&J, with its strong medical devices and consumer product franchises and relatively attractive drug pipeline, should face a far smoother ride than pure large-capitalisation pharmaceuticals manufacturers. This justifies a premium not only to the likes of Merck, Pfizer and Eli Lilly, which face the most daunting gaps in future revenue, but also Abbott Laboratories and Bristol-Myers Squibb.

J&J’s product recalls are no small matter, having cut its US consumer revenue by more than 14 per cent in the last quarter, but this is more than amply reflected in its 2010 valuation. All else being equal, a recovery in sales should flatter its results starting early next year. Likewise, the drag on the quarter of its sales that come from Europe should fade from its dollar results by next year barring serious continued weakness in the euro, whose average exchange rate was 6 per cent lower last quarter compared with the year-ago period. Its US peers are similarly exposed to Europe.

At just 12 times prospective earnings and with prodigious cash flow enabling it simultaneously to keep up its pace of small acquisitions while still repurchasing shares, the market may soon realise that its diagnosis of J&J was overly dire.

Johnson & Johnson (FT Lex)

Previously, I’ve mentioned that this is usually a good place to buy the stock. This chart is a little outdated since the stock has hit new lows, but you get the idea.

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The real question that investors wrestle with is how to implement large caps into their portfolio. These aren’t companies that are going to double or triple. One thing I’ve thought about is using these stocks as placeholder investments. At current prices they appear better than holding cash because of their current valuation and dividends.

Another way to do it would be with a heavy allocation to large cap blue chips and then a smaller allocation to cigar butt companies that are trading at really high >20% free cash flow yields. You’re trying to use quality companies to help put a floor on your portfolio and then using cheap low quality companies to increase your upside. Sort of a value investor’s approach to the portfolio strategy prescribed by Nassim Taleb in the Black Swan — where he advocated doing 90% cash and 10% in out of the money options or high risk (technology, biotech) stocks.