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

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.

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.

As a rule, the CEO of Brookfield Asset Management is studiously non-controversial. He rarely appears in public and has little to say to the media. Put-downs? Bravado? “We don’t brag,” he says earnestly. “It always bites you afterwards.”

Instead, Flatt seems to go out of his way to paint Brookfield as boring. “We own 129 office buildings. Some are a little taller, some are a bit shorter,” he says laconically. The strategy? “We’re in the business of buying assets of great quality at less than replacement cost.” The company’s remarkably consistent objective over the years simply has been to earn a 12% to 15% compound annual return per share. “We have no goal to be large or significant,” says Flatt. “If [reaching our objective] meant we should shrink in size, we’d do that.” Even Brookfield’s logo is understated, and its 2009 annual report looks like something thrown together at Kinko’s. Move along, everyone, nothing to see here.

The reality is that this slender 45-year-old executive runs a conglomerate that manages $108-billion worth of real estate, utilities and infrastructure across the planet. In the eight years Flatt has been in charge, Brookfield has emerged as the world’s biggest owner of prime office space—including some of the most prestigious towers on the Manhattan skyline—and its 165 power plants constitute one of the largest hydroelectric portfolios. But what has really impressed observers is how Brookfield weathered the crushing downturn that crippled many of its rivals. Over two years, as its stock plunged by two-thirds along with the markets, the company didn’t panic or go into hype mode. Instead, it quietly added to an already thick cushion of capital. And waited.

…The business landscape is littered with companies that gambled with cheap money and got caught with their shares down and their loans called. Brookfield, meanwhile, has amassed a nearly $10-billion war chest of its own and institutional investors’ cash and has gone hunting. After devouring an Australian port and railway giant and a few real estate portfolios, it’s now tracking perhaps its most succulent prey: General Growth Properties, the second-largest mall operator in the U.S., which adopted the spendthrift ways of its customers, stockpiled a glittering array of trophy properties on credit, and when the markets seized, toppled into bankruptcy. Enter Brookfield, offering up its capital and restructuring expertise in exchange for control of the company.

Whether or not Brookfield secures the deal—the outcome may not be known until this fall —it’s an important chapter for the company, says a close long-time observer who requested anonymity. “This could be a huge new platform for them. Or it could be a huge profit.” Some see it as an unusually risky play for careful Brookfield. But they don’t appreciate its predatory ways.

A Perfect Predator (Business Without Borders)

Be sure to read the entire article. It’s wonderful and details how Flatt has reoriented Brookfield since taking over as CEO.

Brookfield is an interesting business in that much of its revenue stream in that its properties throw off a substantial amount of free cash flow (about $1.5B annually). Some of their properties are more economic sensitive than others – particularly the office buildings and potentially the malls that they would acquire from General Growth Properties. But that would be offset by their infrastructure investments.

For investors hoping to find a savvy team of deal makers who will invest opportunistically in real estate, Brookfield is a good place to start. There aren’t a whole lot of value oriented real estate groups like Brookfield. A lot of the players simply try to buy and sell into bubbles.

Pachner compares Flatt and Brookfield’s approach to investing as similar to the entrepreneurs cited in Michel Villette and Catherine Vuillermot book From Predators to Icons: Exposing the Myth of the Business Hero. This is a good comparison. For the most part, Flatt has been able to steer Brookfield into investing conservatively during bubbles which enables them to build up cash hordes and purchase distressed properties at a discount to their margin of safety when there are few other real competitors.

The most difficult thing about analyzing Brookfield is probably their size. While it helps when they are getting involved in special situations and deals, but it creates difficulty for an analyst attempting to value the company with precision. I think that if you use the intrinsic value estimates that Brookfield provides, along with that average free cash flow figure of $1.5B. You can then get an approximation of what Brookfield is really worth and compare it to its trading price. Ideally you want to obtain a margin of safety and then get the kicker of their investing prowess which should compound intrinsic value.

Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “flation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future…

At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitative considerations. They draw their strength from our regular seven-year forecast. Today this forecast (see Exhibit 1) suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus infl ation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very light on other U.S. stocks. At a time when fixed income is desperately unappealing, this, not surprisingly, results in our accounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wracking as the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a few weeks ago, but then again, prices are 13% cheaper. I regret not having seen the light a few weeks earlier. Running at the same rate of change in attitude as both the market and general opinion is both frustrating and unprofitable. But even as global equities approach reasonable prices, I would err on the side of caution on the margin.

Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is my long-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibrium return. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhaps by a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9% are a little expensive (6% or 7%) but make a respectable filler for a global equity portfolio. Forestry remains, in my opinion, a good diversifier if times turn out well, a brilliant store of value should inflation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.

Summer Essays: Finance and Portfolios (Morningstar)

I’ve posted recently that I am also seeing value in large cap stocks many of which seem to have strong exposure to emerging markets and franchises that should be able to withstand tremors in the global economy. Grantham’s point about deflation is interesting. Unlike with inflation — where certain businesses can simply raise prices, deflation creates a downward pressure that is harder to tackle. I’ve noted in the past that Seth Klarman believes in deflationary environments we should seek a wider margin of safety. So if you used to buy at 60 cents on the dollar, maybe you start buying at 40-50 cents.

Sorry about taking so long with the Red Robin post, I am still getting together the charts/models to present.

Take restaurants for instance. He told me that a restaurant is really just a big box. You come in, order food, eat, and leave. From there, you can gradually build on that model to analyze similar businesses. Like a retailer. Retailers are pretty similar, you walk into a box, buy some clothes, and exit. Clothes replace food in our model. From there, you can take the idea to department stores, which are really like a huge retailers. Instead of selling one type of clothes, they are sourcing from many different manufacturers. But it is mostly the same idea. You come into the box, you make a purchase, you leave.

(I am probably not the best teacher because I’ve taught myself most of how I look at and analyze companies. As a result, I might do things a little differently than the norm. If you disagree or have a different approach with the perspective that I am outlining here, feel free to e-mail me or leave a comment. That way we can improve on this and help out other novice investors who might be interested in looking at restaurants.)

If we accept our box analogy, what are some key factors to look at when analyzing a restaurant business?

1. The Box

(Flickr:forklift)

First there is the box, the actual restaurant building. Sometimes a company might own the underlying real estate – that will be on the balance sheet. If the company is just leasing the location, you still own everything that is actually inside of the restaurant, that will be under property, plant, and equipment. You’re going to incur expenses to rent that location (occupancy costs) or use capital expenditures to purchase new properties and equipment. So you’ll want to look for that on the income and cash flow statement. Some of your equipment is going to degrade each year which will be recorded as depreciation and amortization. Purchasing new restaurants or reinvesting in existing locations will typically be found on the investing section of the statement of cash flows, usually recorded as capital expenditures.

The first thing I do when looking at the box is take a look at if they own the underlying real estate and when they made the purchase. The balance sheet typically employs the cost approach which means asset values are recorded using the price that was paid for them. Then, depreciation might also bring down the recorded value of a building to a level that is actually below its true worth. So you need to watch out for cases like this where the accounting may inaccurately represent the value of the company’s assets.

The individual restaurants have value as well. If you were to sell an established location to a franchisee, the company could fetch a good price because much of the uncertainty that comes from a new restaurant location is gone. So what I do is compare the mix of owned locations to franchised locations and see if there might be any value that could be unlocked by shifting to a more franchise driven model. From a cost perspective, restaurants record a cost on the income statement for “operations” — costs associated with doing repairs, procuring supplies, and the utilities that need to be run for keeping the restaurant open. These would be shifted to a franchisee.

I experienced this first hand with Steak N Shake, a business I purchased at $10 a share which had about $10 of value from their real estate holdings underneath. 80% of the restaurants were company owned (McDonald’s is the opposite with 80% franchised 20% company owned), which meant that management could have sold some locations off to generate cash. As the financial crisis intensified, they used this strategy to make sure they did not breach any debt covenants.

Shifting to a franchise-driven model makes sense because you end up lowering the capital intensity of the business, since you are cutting out the actual costs associated with operating a restaurant. Your efforts become focused on developing new food products, marketing, advertising, and other corporate related expenses. You end up with less expenditures which means more cash for buybacks or dividends and potential for higher returns on invested capital.

2. Food

(Flickr:roboppy)

Then there is the matter of food. Food and labor are your primary expenses in a restaurant. On the balance sheet you will find inventory listed as a current asset. Food is recorded on the balance sheet as inventory, and then you might also have an accounts payable line which records how much is owed to food suppliers. On the income statement, cost of sales gives you the cost of the food and beverages sold at the restaurant.

To prepare the food at the restaurant, you need workers. You’ll see their wages recorded as labor or payroll as an expense on the income statement and accrued payroll on the liabilities section of your balance sheet. Browsing the 10-K of Red Robin Gourmet Burgers (NASDAQ:RRGB), you’ll see that food and labor combined are 60% of restaurant revenues. So there are major costs associated with actually producing the food served in restaurants.

Some sophisticated restaurants will use derivative contracts to hedge the movements in commodity prices, but many smaller restaurants do not. For these smaller restaurants, it is entirely conceivable that on a year-to-year basis, your margins might slightly fluctuate if commodities are particularly volatile.

When I look at restaurants, the food is definitely something that I analyze qualitatively. Food is what brings people into restaurants and it is also transparent to competitors. Wendy’s (NYSE:WEN) was the first nationwide chain to serve meal-sized salads and their major competitors (McDonald’s, Jack in the Box, Burger King) all quickly followed with their own meal-sized salads. So finding a competitive advantage in food is difficult because it is bound to get copied.

Besides the overall unique recipes, food related competitive advantages tend to come from the economies of scale that the business possesses. McDonald’s (NYSE:MCD) once thought about putting shrimp in one of their salads, but they realized that ordering a sufficient quantity of shrimp would have caused a global shortage. That is buying power and it means McDonald’s can achieve cost savings and advantages that give them a leg up against smaller upstarts. This is especially when you look at low margin value menu items.

3. People

(Flickr:newyork808)

We have a rough idea of the box, the food that is sold in the box, but what about the people? The customers are what drives a restaurant’s results. To monitor customer activity, there are a few useful metrics. Most restaurants will provide data on same store sales or comparable store sales which get us an idea of how sales activity has fluctuated on average. You have to compare this data on a YoY basis because seasonal effects such as winter storms or summer vacations might impact the data on a month to month basis. You also need to take into account aberrations or outlier events that may have occurred for the year.

Most restaurants will give you sales data on a monthly basis. As an investor, you really don’t want to get too bogged down by focusing on revenues. We care about the earnings and cash flows. Sometimes restaurant management teams will get too glued to revenues and expand too much, into weak markets. Ultimately, this hurts earnings.

So then why do I mention same store sales? It is a useful metric for seeing how a restaurant is doing. Typically, we are going to be looking at distressed restaurants, where sales have dipped and the company is posting a loss or barely breaking even. I use sales figures to get an idea of whether or not a turnaround is working. If management rolls out a few promotions and new menu items to entice people to return to the restaurant, I’ll see if the effects carry through into the sales figure. Ultimately it is a simple metric that can help tell us a lot about the business.

The way consumers get notified about new menu items is through advertising. You can find annual advertising expenditures in the SG&A line of the income statement. In the footnotes they will break out how much is being used for advertising within the larger SG&A figure. It is useful to monitor how this figure fluctuates, in order to see if SG&A is rising due to salaries or due to ad spending. Then, you can also track how increases in ad spending are translating to same store sales.

Distressed Restaurants

In order for us to find a restaurant that meets our value criteria, something usually has to be wrong about it. There are a few ways restaurants can run into trouble.

A. The Economy

Most restaurants blame the economy or weather, basically factors that they claim are outside of their control for poor performance. There is some legitimacy to the economy argument. If times get hard, people are going to cut back on their spending and trade down. Trading down can mean different things to different people. For one person trading down might mean eating less at Red Robin and more frequently at McDonald’s. For another, it might mean eating less at McDonald’s and eating more at home.

How can a restaurant counter-act the effects of the economy? By bringing value to customers. Usually, you will see restaurants roll out new promotions that are supposed to entice you to come in. McDonald’s is truly awesome at doing this. For example, they rolled out their $1 menu which features certain menu items which have thin to no margins, such as the McDouble. To help balance that out, they are also offering any all soft drinks for only $1. The idea here is that you might opt for one low margin item (McDouble) with higher margin items (soft drinks, french fries) — creating a net benefit. Burger King (NYSE:BKC) did this successfully with their $1 Buck Double paired with their ribs (>$6). Going up the chain, Red Robin is using a strategy where they are selling a bacon cheeseburger for about $7.50. The average cheeseburger on their menu is around $9.50 so it is a price reduction.

B. Debt

The second most common issue I’ve seen with restaurants has to do with debt. Management teams will sometimes keep their eyes so glued to their restaurant count that they become empire builders. They start building out more and more units, even though the cash flows coming in cannot support those types of expenditures. So then they take on debt. Normally, this can work but if the economy goes to negative and the company is not prepared to make the right decisions, the situation can rapidly deteriorate.

When something like that happens, you need to pay careful attention to the balance sheet and conservatively analyze the assets on there to see if they would have potential value if sold. That might allow the company to shed certain assets and amend debt covenants or reduce overall indebtedness. Whenever analyzing in a leveraged company, sit down and research the terms of the debt covenants.

C. Catastrophes

I think the classic catastrophe example in the QSR business is Jack in the Box (NASDAQ:JACK) with the E. coli outbreak in 1993. Four children died and sales plummeted, millions had to be paid out in lawsuits, and their debt rating was cut to junk status. I keep this same example in my mind whenever I invest in a restaurant because it is still a very real risk.

So how do I handicap towards that risk? The best way is to try to do research into what sorts of cleanliness and food safety measures are employed by the company and gauge employee perception around that. You can usually find this out by talking to employees or restaurant industry experts. I’ve found that people are generally pretty willing to help.

For bigger chains, there might be more scrutiny which would lead them to enact a rigorous safety procedures that are uniform across the chain. Some chains have a truly global reach, such was Yum! or McDonald’s which diversifies away from being too tied to any one city.

Homework

If you have a chance, read the latest 10-K from Red Robin and the presentation that they have on their website. With the shareholder activists involved and the quality of their product, Red Robin might be attractive right now. I plan to have a post that goes in more detail on Friday.

WSJ: What are the big risks and opportunities for cable operators right now?

Mr. Malone: Cable has come through technologically in great shape relative to its competitors. The telcos, unless they’re willing to spend a massive amount of capital—like [Verizon Communications Inc.'s] Fios has—have run out of steam in terms of the speed of their Internet capabilities. The real issue I think for cable right now, at least in the U.S., is regulatory.

WSJ: Does Liberty want to invest more in cable?

Mr. Malone: We’ll undoubtedly hold our position [in Time Warner Cable]. And we may choose to increase it if we think cable’s undervalued. That would be a good way to play cable. Just own some more Time Warner Cable.

That would be the only way I could see us playing in cable networks domestically. Internationally, of course, Liberty Global is always in the hunt and has a pretty good pipeline of potential acquisitions. Hopefully we will find some good M&A opportunities, but outside the U.S., in cable.

WSJ: What do you mean?

Mr. Malone: It is entirely feasible that government may choose to open these networks up. They could come in, for instance, and tell cable operators they can’t bundle broadband with video, with telephone, that they’ve got to sell them all a la carte and they can’t do any deep discounting, no exclusionary deals and so on.

And [as they review the Comcast-NBC deal] they can set the pattern that they would later enforce on the industry at large through rule-making.

Malone Is Fired Up By Cable And Ready To Buy (WSJ)

For investors looking to partner up with Malone, there are a few options. Liberty Media Capital (NASDAQ:LCAPA) operates as Malone’s hedge fund. Valuing LCAPA takes some work. The company invests in public and private businesses, which adds complexity. You really want to try to look at it from the perspective of net asset value (NAV) but the problem is that some businesses are extremely difficult to value. This is particularly evident in the company’s ownership of the Atlanta Braves and certain debt/mezzanine investments. Ultimately, I think that this creates opportunity for investors, especially when the markets turn volatile.

Some of Malone’s other holdings are more straightforward to value. Take Starz (NASDAQ:LSTZA). Starz is a premium movie channel that is available to most cable and satellite subscribers. I like this company because it is almost like a tollbooth. Starz basically licenses content from movie studios and then sells it to the cable companies. There’s really no risk of content production costs. A subscriber might elect to go with a plan that gives them HBO, Showtime, and Starz because they are already pre-bundled.

I would value Starz using an EV/EBIT multiple. The company has about $1B in cash with virtually no debt. That brings enterprise value (market cap + debt – cash) down to $1.75B. Using the TTM EBIT figure, we get $330M. That gives us an EV/EBIT of about 5x. To me, that is pretty cheap. Yes, media companies face a good amount of competition, but the tollbooth like nature of the business means it is worth at least 7.5 to 9 times. With the current price around $53, it should fetch a per share valuation of $80 to $95 per share, or a gain of 51% to 80%.

Liberty appears to think the business is undervalued as well:

Share Repurchases

From January 30, 2010 through April 30, 2010, Liberty repurchased 539,970 shares of Series A Liberty Starz common stock at an average cost per share of $47.40 for total cash consideration of $25.6 million. Since the introduction of Liberty Starz on November 19, 2009 through April 30, 2010, Liberty has repurchased 1.1 million shares at an average cost per share of $48.06 for total cash consideration of $53.3 million. These repurchases represent 2.1% of the shares outstanding. Liberty has approximately $446.7 million remaining under its Liberty Starz stock repurchase authorization.

Quarterly Press Release (Liberty Media)

So what might be causing the company to remain undervalued?

1. Starz is a tracking stock, which makes analyzing its financials a bit more complicated. I don’t think many investors are used to dealing with tracking stocks so they might just ignore the company.

2. There seems to be an overall bearish sentiment towards media stocks. Investors might be critical of Starz because as we transition towards consuming more television over the internet, the barriers to entry come down. Starz aggregates content that is created by studios like Disney and some analysts have questioned whether the internet will “cut out the middlemen”. Instead of watching Disney movies on Starz, we will watch them via Disney.com or a video site made in partnership with content creators (such as Hulu.com). So far this has happened with TV programming but not films. Plus, Starz retains the digital airing rights for the content that they license. That is what allows you to watch Starz on Netflix. Over the longer term, I do think there is potential for their business model to be eroded by direct connections to the content creator. I think it will be important to monitor how successful the premium Hulu Plus service is in order to gauge that potential.

3. Investors might be nervous about investing in a business that is so controlled by John Malone. So far though, Malone has been really savvy in the media business and I don’t expect that to cease any time soon. The greater risk might be increased inter-group lending where Starz uses cashflow to provide loans to other Liberty Media units. I think that is probably the greater risk but that it is still pretty limited. The appointment of Chris Albrecht, who used to run HBO indicates that Liberty is serious about making Starz into a competitive pay TV network.

I think that if you are interested in examining the businesses within Malone’s empire, Starz is a good place to start. The business model and structure is simpler than others and the current valuation is pretty attractive.

The billionaire financier, who has been beating the drum that private-equity dollars can save the troubled banking industry, bought a nearly 25% stake for $100 million in Vineland, N.J.-based Sun Bancorp. And, he’s making no secret of the fact that he wants to be involved in consolidating the nearly 120 Garden State banks with deposits of less than $3 billion apiece.

Becoming a mogul in New Jersey banking shouldn’t be too difficult: Ross has a lot of dented merchandise to choose from. Given Ross’s penchant for finding distressed gems, he might look at nine banks in the state that regulators have slapped with enforcement actions that order lenders to meet more stringent capital requirements — or else.

For example, privately-held Amboy Bank, based in Old Bridge with $2 billion of deposits, would jibe well with Ross’ latest acquisition. It is the biggest bank that is being asked by the Federal Reserve Bank of New York and the New Jersey Department of Banking and Insurance to boost capital within the next three years, and could benefit from a well-capitalized partner.

Some smaller names on the list under the watch of regulators include Delanco Federal Savings Bank, BNB Bank, City National Bank, Grand Bank NA, Millennium BCP, First Bank, ISN Bank, and Sterling Bank. The state’s publicly-traded banks have also gotten a lift after the Sun Bancorp deal. Moving higher in morning trading are Lakeland Bancorp, which has about $2.2 billion in deposits; Kearny Financial, with $1.5 billion of deposits; and OceanFirst Financial Corp; with $1.4 billion of deposits.

Wilbur Ross: The King of NJ Banking (WSJ Deal Journal)

I’ve actually spent the last few months analyzing banks in New Jersey and believe that there is indeed some great value to be found over there. New Jersey banks have benefited from largely being unscathed by a lot of the credit issues you saw in other parts of the country. With some of the wealthiest communities in the nation, banks can compete for some high quality deposits.

From speaking to management teams in the region, the consensus is that while they would love to do deals, there aren’t many depressed banks in the region. Deals are going to have to be done at a premium or in the form of a merger of equals. I’m not sure how that will jive with the idea of Ross doing rollups in New Jersey. What we might see are mergers of equals to get some size.

I think that there could be some incentive to do mergers. New Jersey banks face fierce competition for deposits from money center banks. In a number of counties like Bergen, Hudson, Essex, Middelsex, and Union: Bank of America or Wells Fargo leads the pack in deposit market share. More broadly, the largest competitors for deposits tend to be Bank of America, Citibank, Hudson City Savings Bank, JP Morgan Chase Bank, PNC Bank, TD Bank, and Wells Fargo Bank. That puts smaller, regionally/community focused banks at a big disadvantage. They are often left competing with each other for a spot outside of the top 10 in deposits. For a bank, that’s not good. You end up having to market CDs and interest bearing deposits which cut into your NIM. A great bank is able to rely more on savings accounts or low/non-interest deposits.

As a result, there might be some logic for a rolling up banks. It would help ease the competition between New Jersey banks and give the larger money center banks a run for their money. New Jersey is home to a number of mutuals that have excess capital too. Those banks would be very attractive to larger acquirers that are hoping to recapture equity after doing a wave of deals. I’m quite familiar (and bullish) with one of the banks listed in Bruno’s list excerpted above, so I recommend you check it out.

The way I define a special situation is a type of investment that has some sort of transaction (typically a balance sheet event) which unlocks or realizes value. And you can find a lot of complex special situations using the New Highs list. Some will be there because they are getting acquired – so you’ll try to take a merger arbitrage position and hope to earn the spread between the acquisition and current price. You’ll also find companies that are passing through a drug trial our winning a court settlement.

Today we’re going to focus on a court settlement. The situation is Gyrodyne of America (NASDAQ:GYRO). The stock is hitting 52 week highs, but I actually think there is substantial room for appreciation.

Gyro just announced that they won a court settlement from the State of New York. Here’s what happened:

“ST. JAMES, N.Y., June 30, 2010 – Gyrodyne Company of America, Inc. (NASDAQ:GYRO), a Long Island-based real estate investment trust, announced today that the Court of Claims of the State of New York issued an opinion requiring the State to pay to Gyrodyne an additional $98,685,000 for land appropriated in 2005. Under New York’s eminent domain law (the “EDPL”), Gyrodyne is also entitled, subject to EDPL Section 514, to statutory simple interest on the additional amount at a rate not to exceed nine percent (9%) per annum from November 2, 2005, the date of the taking, to the date of payment.

The opinion was issued in connection with Gyrodyne’s claim brought in April 2006 for just compensation for the 245.5 acres of its Flowerfield property in St. James and Stony Brook, New York (the “Property”), taken by the State. The State had paid Gyrodyne $26,315,000 for the Property at the time of the taking, which Gyrodyne elected, under the eminent domain law, to treat as an advance payment while it pursued its claim.

In its opinion, the Court agreed that the State had improperly valued the Property and misapplied the eminent domain law’s requirement that just compensation be determined based upon the highest and best use and the probability that such use could have been achieved. Applying this standard, the Court determined that there was a reasonable probability that the Property would have been rezoned from light industrial use to a planned development district, thereby resulting in the aforementioned award to Gyrodyne.”

Gyrodyne Press Release

I look at situations where a court verdict is announced, a drug trial passes, or a certain earnings target is met as milestones in my investment process. So if I think a stock is undervalued, I will look at whether or not the company meets the milestones that I put up to, check its progress against my thesis. The benefit is that when a company meets its milestones, part of the uncertainty or risk behind your thesis goes away. Gyrodyne is a good case of that.

So let’s look at this on a sum of the parts basis:

$99.0 (settlement)
+ 41.0 (interest payments)
+ 34.0 (book value of real estate)
+ 1.10 (cash & cash equivalents)
- 21.5 (total liabilities)
= 153.6 / 1.29 shares outstanding
= $119 per share.

With the shares currently trading around $73, you get a potential gain of 63%. To me, this is a conservative estimate of liquidation value because the real estate is booked at cost. My guess is that some of it may have appreciated since they acquired it, but would rather not speculate. The company also owns an interest of a bit less than 9% in a Florida development called “The Grove”. Again, I would rather not speculate as to what the value of that interest really is.

Typically, whenever a company has a large cash balance, they tend to be greeted with skepticism. One of the risks companies with high cash balances is the fact that they might squander the cash horde. I think there are two reasons for why I would handicap this as a low possibility:

1. Shareholder Activists

Phil Goldstein of Bulldog Investors owns 17.46% of the stock. Two other partnerships own a combined 15% of the stock (River Road Asset Management, Leap Tide Capital). Phil Goldstein is a notoriously tough activist, he has been pretty big on forcing close-ended funds to liquidate when trading at discounts to NAV. I think there is a good chance Goldstein and the other investors will make sure the money from the court case is used in an accretive manner.

2. Reinvesting

So far, the company has reinvested capital into a series of medical office parks located in New York and Virginia. These acquisitions have worked out pretty well. There are certain start up costs that are incurred which makes reported income not the best figure to represent their economic value.

Instead, if you were to take:

(Rental Income – (Rental Expense – Depreciation)) /
(Real Estate Assets, Net + Accumulated Depreciation) =

(4,834 – (1,943 – 690)) / (34,192 + 3,701) = a yield of 9.4%.

Overall, that is a pretty strong figure and representative of the fact that the management team knows what they are doing. I don’t think they will squander the cash.

3. Taxes

One of the risks to the thesis is the fact that even if the NY State amount is paid out, some of it might have to go to taxes. I think there are a few things to keep in mind. As a REIT, the company typically pays minimal income taxes:

Effective with an election dated May 1, 2006, the Company operates as a real estate investment trust (a “REIT”) for federal and state income tax purposes. As a REIT, the Company is generally not subject to income taxes. The Company is subject to the “built-in gain” rules. Under these rules, taxes may be payable at the time and to the extent that the net unrealized gains on the Company’s assets at the date of conversion to REIT status are recognized in taxable dispositions of such assets in the ten-year period ending April 30, 2016. To maintain its REIT status, the Company is required to distribute at least 90% of its annual REIT taxable income, as defined by the Internal Revenue Code (the “Code”), to its shareholders, among other requirements. As of December 31, 2009, the Company had cash and cash equivalents of $868,786 and a CD for approximately $203,000 maturing in March 2010, thereby having total funds available in 2010 of $1,071,786. The Company anticipates having the capacity to fund normal operating, general and administrative expenses, and its regular debt service requirements.

So far, when receiving settlements, the company has reinvested them in like properties to avoid paying taxes:

The Company initially invested the Advance Payment in short term U.S. Government securities and interest bearing deposits which were valued at $26,184,383 and $238,593, respectively, as of April 30, 2006. Subsequently, the Company invested in hybrid mortgage-backed securities fully guaranteed by agencies of the U.S. Government which are qualified REIT investments. During 2009, the remaining investments in hybrid mortgage backed securities were sold, with the balance of the proceeds applied toward the acquisition of the Fairfax Medical Center – see below.

In accordance with Section 1033 of the Internal Revenue Code, if the Company replaces the condemned property with like kind property within three years (or such extended period if requested and approved by the Internal Revenue Service at its discretion) after April 30, 2006, recognition of the gain for federal and state tax purposes from the disposition of 245.5 acres is deferred until the newly acquired property is disposed of. In June of 2007, June 2008 and March 2009 the Company acquired the Port Jefferson Professional Park, the Cortlandt Medical Center, and the Fairfax Medical Center, respectively. These purchases totaled approximately $28,805,000 and represent the completion of the tax-efficient reinvestment of the condemnation proceeds.

If they could continue to reinvest in such projects, I don’t see there being much likelihood of value destruction. In addition, I think the activist element at the company might push for the company to put itself up for sale. It might be an attractive target for REITs expanding their portfolio of healthcare facilities.

Risks

1. NY State Appeals

It’s possible that the state could try to appeal the verdict. I’m not too sure that they would though. This case has already been tied up for four years and they cannot submit new evidence. I don’t know what kind of legal avenue they could pursue here.

Moreover, as per the current verdict, each year the state does not pay Gyrodyne, 9% accrues. It really is not in their interest to drag this out.

2. Taxes

If the company decides not to reinvest the capital within the given time frame (for the advance payment they had three years), they’d likely have to pay a 15% tax. That would reduce our per share valuation by $16 from $119 to $103. I don’t think this action is likely – just because it is a destruction of shareholder value and there are enough funds with concentrated positions who would not see this as being in their interest.

3. Illiquidity

With only 1.29M shares outstanding, the company trades in small blocks of shares. The lack of liquidity might be problematic for some because it would result in a wider bid/ask spread than usual. It also means that you cannot just place a market order. As a benefit, most larger funds are going to be kept out which creates opportunities for small investors.

Conclusion

Most of my valuation assessment depends on the historical cost figures for certain assets. The fact is, the real estate might be worth a good deal more, especially when you consider the fact that their medical offices are performing well. To get more precision in our analysis, we would need to dive deeper and come up with more developed valuations for each property and the orange grove investment in Florida. So, there might actually be more value in the company’s assets beyond their recorded cost. But right now, I look at that as another aspect of our margin of safety with Gyrodyne.

With shares currently trading around $73 and the potential to make $119 or a 63% return — I see Gyrodyne shares as a bargain because it is trading below liquidation value with a substantial margin of safety.

You don’t really get popular by being bullish on large cap stocks – most people actually look down upon it, especially as a value investor. We are supposed to find these hidden gems that nobody knows about. Everybody and their mother knows about Johnson and Johnson. Still, it and a number of other large caps are trading at valuations that are really attractive right now.

Value investing can go either two ways:

1. Buy an undervalued stock with some kind of catalyst and sell once it reaches your target price.

That approach is much more akin to Benjamin Graham and Warren Buffett from his partnership days.

2. Find a great business with excellent growth potential that is trading at an absurdly low price.

This is the approach Warren Buffett honed in his later years.

To me, either approach works. And for my own portfolio, if I can crank out an annualized return of around 15% over an extended period of time, I’ll be pretty happy. The way I look at undervalued large caps is you can sometimes find them trading at levels that are low enough to make it so your potential for capital loss is minimal. Worst case – you lose nothing. Best case – you have bought into a large cap that still has great overseas growth prospects and a healthy dividend. An investment like that can enable you to buy and hold for years.

So what are some names that have been interesting to me?

Johnson and Johnson

AR’s comment about treasury yields versus the yield on Johnson and Johnson (NYSE:JNJ) reminded me of a chart I saw over at Value Investors Club:

I have updated the original chart to compare the past data with JNJ’s current price and the price it hit during the bottom of the financial crisis. As you can see, the company looks amazingly undervalued — especially when compared to the past. Whenever its forward earnings yield and dividend hit levels like this, it is usually an amazing opportunity for investors.

JNJ is getting some heat right now about a recall from their consumer products division, but the company has a history of being around since the Great Depression. With a minuscule amount of net debt ($6B) and almost $20B in EBITDA, the company is at a really sweet spot. Margins are still healthy at above 25% and a return on equity of around 27.5%.

Yes, sales did decrease for 2009, but it was also during a crisis period described as the worst since the Great Depression. In the longer term, I think there are demographic trends that make the company appealing. With our population expected to grow older, JNJ products should be more in demand. In addition, a substantial amount of revenues come from abroad which means that there will be tailwinds for growth outside of the US.

Walmart

Another one I’ve been looking at is Walmart (NYSE:WMT). A while back after hearing Warren Buffett recommend it, I read Sam Walton’s biography Made in America which details how he started Walmart. I came away for a much higher regard for the company, particularly after learning about their humble beginnings. It is truly amazing that Walmart has been able to grow from its humble beginnings as a rural discount retailer to a global corporation. Along the way, they still have not forgotten their ethos of making sure they bring customers the lowest prices.

Some investors have been skeptical about Walmart, especially after the recent decision to let the Chinese yuan rise. Since Walmart sources most of its goods from Chinese manufacturers, a rising yuan will eat into Walmart’s bottom line as they convert from dollars. Since Walmart buys such a massive amount of goods from China, this could impact margins. I think that this is possible, but I am not too worried.

The fact is, capital is mobile and the folks at Walmart are bright enough to realize that if one country becomes too expensive, they can move elsewhere. That kind of mobility is going to pressure the Chinese to keep their currency down because if they don’t, the prices may hurt their exporters. So far, China does not quite have the kind of domestic demand that is necessary to offset a major reduction in American consumption of their goods.

Walmart has a lot going for it. It is by far, the lowest cost distributor and retailer of basic goods. Part of this comes from its amazing supply chain/distribution system. Walmart was one of the first retailers to figure out that a company-wide computerized inventory system would allow them to stock exactly what people want, when they want them. This translates into better inventory turnover numbers.

Vinod Palika has a report on Walmart (PDF) with plenty of data points that show Walmart’s strength relative to peers. In 2001 Walmart inventory was 51 days, in 2010 it decreased to 40 days. For comparison, at Target inventory was at 58 days in 2001 and is now 56 days in 2010. Walmart’s economies of scale help maintain margins. Take advertising, in 2010 Walmart’s ad budget was only 0.6% of sales, comparatively Target spends 2.15% of sales on their ad budget. The best part? Even though Walmart spends less as a percent, they are still spending more overall – $2.4B versus $1.4B. That means Walmart can outspend Target but keep its margins in tact.

Walmart initially had some hurdles breaking into overseas markets, but so far they have corrected that and if you look you can see some impressive growth there. I think for a business as huge as Walmart, which generates large benefits from its size (bargaining power with suppliers) the company should at least get a forward P/E multiple that is greater than 11x. A 15x multiple on 2011′s EPS would result in a share price of about $66 compared to $49 today.

Kraft

If you study Warren Buffett, you’ll see that some of his best investments occur at a time before a business is about to embark on an upward trend in margin expansion. Basically, what he does is find great businesses that are down in the dumps.

When Roberto Goizueta came to Coca-Cola, the business lagged behind Pepsi. Goizueta applied his background as a chemical engineer to the company, in order to standardize certain processes and add efficiency to the Coca-Cola’s operations. These actions reduced expenses. Then, he he culled low return on invested capital operating units from the business to boost overall profitability. These actions dramatically increased margins and magnified shareholder value: Coca-Cola’s market capitalization increased from $4.3B in 1981 to $152B in 1997. To learn more about how Goizueta did it, be sure to read I’d Like the World to Buy a Coke, his biography.

You might be wondering why I am mentioning Coca-Cola when I’m supposed to be talking about Kraft (NYSE:KFT). Back when Irene Rosenfeld announced the merger with Cadbury, Pershing Square’s Bill Ackman released a report which detailed the potential for margin expansion at Kraft:

Ackman’s thesis appears sound. A merger between Kraft and Cadbury, means there is less competition in the marketplace and the combined company may have the ability to raise prices. That might help increase EBIT margins in 2011 to Ackman’s projected 15%. Plus, I think you really cannot ignore the gains in Kraft’s supply chains that will come from this deal. Most people underestimate just how difficult it is to get consumer goods to shops in developing nations where there might be no paved roads. It’s the kind of investment that takes years to refine, but will pay dividends in the future as we increasingly rely on the developing world for growth.

With leading consumer brands from chocolates to macaroni and cheese, combined with 25% of revenues from developing markets (more than any other North American peer) Ackman’s 15x 2012 EPS ($2.70) multiple appears possible. Ackman provides an upper range of 17x 2012 EPS ($2.90). That gives us a share valuation of $41 to $49 versus today’s $28.30. Plus, you get a 4% dividend.

Kraft is obviously not going to have the same kind of dramatic growth that you saw from Coca-Cola during Goizueta’s time as CEO, but it is an illustrative example of how changes in the business can increase its valuation.

Anheuser-Busch InBev

Another interesting large cap that looks undervalued is Anheuser-Busch InBev (NYSE:BUD). The company, formed by the merger of Anheuser-Busch and Brazil’s InBev looks like another case where through a merger there is a potential for substantial cost savings. Anheuser-Busch is a powerhouse in the beer market. The merger effectively created the largest brewer by market cap, at $77.4B. The company boasts 200 different brands, 13 of which have over $1B in sales. Moreover, BUD occupies the #1 or #2 rank in 25 of its top 31 markets.

BUD trades at basically a 9.6% FCF yield which is great given its side. Free cash flow is expected to increase over the next two years, as Anheuser-Busch InBev is able to reduce costs as the two companies integrate. In contrast, Diageo, a market leader in the beer and spirits area has a FCF yield of 6.2% — even though it is less than half ABInBev’s size. I could see BUD trading at about a 6% yield which would be about $77 per share, 60% higher than today’s prices.

So far BUD seems to be making the right inroads in trying to break into the Chinese market. I think that beer and spirits companies are increasingly going to look at Asia for growth. It wont be an overnight process and so if there is some lag between that Asia growth and US sales growth, you might see some pessimism. One thing I particularly like about BUD is because of its size, it should be able to have better margins because of its size. As in the Walmart case, BUD looks poised to spend more on advertising than its peers at a lower percent of sales. This company should be a bargain as long as the management at BUD are willing to take FCF and use it intelligently by paying down debt and pursuing buybacks.

For anyone interested in learning more about the industry, I suggest checking out Beer Wars, a documentary about the beer business. It contrasts small craft breweries with the majors like Budweiser and Molson Coors. You get to learn a lot about how the major breweries have been able to take advantage of our fragmented legal structure to erect huge barriers to entry in the beer business.

Killing a Large Cap

I’ve outlined short reasons why I would be bullish on these companies. The question you have to ask is why these great companies are trading at such low prices. I think there are a few factors. More broadly, into and during the financial crisis, money poured into these stocks as they were seen as safe havens. Some held up and others only had slight price declines relative to the market. When things started to turn, money exited and went into the stocks that got clobbered. So there might be less money in some of these large cap blue chip stocks than others.

Secondly, when you start hearing worries about global growth some of these stocks get affected. Many of them are large enough to provide the liquidity necessary to allow large macro funds to exit in and out. So they might be more susceptible to day-to-day volatility than smaller, less noticed stocks.

Then there is sell side pessimism. Large cap stocks are particularly vulnerable to sell side pessimism. They tend to attract the masses who sell whenever they hear an analyst downgrade a company. Most sell side calls are for the medium term, so whenever there there is some temporary panic the sell side erupts. Such reports tend to discount the longer term potential earnings power behind some of these businesses.

During the financial crisis some analysts claimed people would stop drinking Coca-Cola because of the deteriorating economic situation. Or with Kraft, some analysts feared that private labels made by supermarkets would undercut Kraft’s products. But, the fact is, you can make a bear case for almost any investment. Most people I know kept chugging cans of Coke, even during the March 2009 bottom. People still ate Kraft Mac ‘n Cheese. But none of these companies are a perfect hedge, they almost all hit 52 week lows during the crisis. At the same time, their longer term prospects were much better than the broader market. If you are willing to wait years I’d expect these companies to do quite well. They should at least be able to preserve your capital — especially at the P/Es we see today. That is a critical factor you need to look for in equities given the concerns about inflation.

More Depth

Now, I’ve outlined reasons for why some of the above companies look undervalued and have sustainable competitive advantages. That’s not enough to warrant an investment though — more research needs to be done. Over the next coming weeks I plan to look at a few of them in more depth in terms of analyzing financials and putting together models. If I get some indication of what company readers would be interested in (either by comments or e-mail) I’ll start there first. They can even be large caps not explored in this post. I’ve also started looking at: MasterCard (NYSE:MA) – at 17x EPS for basically an oligopoly, it looks really appealing, Monsanto (NYSE:MON) – their seeds and pesticides are going to be needed by the rest of the world’s farmers, and even some foreign telecoms.

For those of you happy to do your own reading, one of the neat things I noticed is certain big companies have very generous annual report policies. I was able to get 5 years worth of 10Ks mailed to me within a couple days from JNJ and McDonalds.

Some people fret about whether or not they can get an edge when looking at companies that are so large. I think with these blue chip companies, you’re edge is going to come from your discipline. Being willing to ignore downgrade calls and buy when most people are selling. If you can do that, you might be able to own part of a growing business at a price that is low enough to provide you with a satisfactory margin of safety.