FORTUNE -- Today, a large Berkshire Hathaway mystery lifted when a Greenwich, Conn., hedge fund, Castle Point Capital Management, quietly advised its investors that the fund's managing partner, Todd Anthony Combs, would leave to join Berkshire at the end of the year.
Behind that simple fact is a big story: Combs, a mere 39, will with this move become the leading contender to eventually succeed Warren Buffett as manager of Berkshire's billions in investments.
The word "investment" is key to that last sentence. As chairman of Berkshire, Buffett has two jobs: He runs the business as CEO, and he manages Berkshire's huge investments in securities. It is the investment job for which Combs is the leading contender.
Buffett's hiring of Combs at least partially satisfies a commitment Buffett made to Berkshire's shareholders more than threes year ago in his 2007 annual letter, published in March that year. Buffett said were he to die "tonight," the company would have three outstanding candidates in the CEO half of his job. On the investment side, however he conceded that good candidates were not lined up in the wings.
http://money.cnn.com/2010/10/25/news/todd_combs_berkshire.fortune/index.htm
Monday, October 25, 2010
Sunday, October 17, 2010
Bought Shanda interactive Entertainment - SNDA @ $40.20
Shanda Entertainment is one of the largest operators of online games in China through Shanda Games. In 2009 it spun off Shanda Games for $1B in an IPO. This is capitalizing on china’s exploding online gaming market. As part of its growth strategy, the company in 2009 acquired 51% of ringtone provider Hurray! Holding Co. -- later renamed Ku6 Media Co. -- in a deal valued at $46.2 million. Then, in 2010 Shanda and Ku6 completed an asset swap: Ku6 acquired 75% an online audio business of Shanda in exchange for about 415 million newly issued shares of Ku6, while Shanda acquired Ku6's recorded music and wireless value-added services businesses for some $37 million in cash. The deal is part of Shanda's use of proceeds from the 2009 spinoff and IPO of its games unit.
Shanda has unique model. It includes a venture capital fund that invests in fledgling independent game studios, and taps the full potential of promising new games by leveraging the firm's management expertise and gaming platform. This strategy can be particularly effective in expanding and refreshing the game portfolio, to keep its large gamer community "hooked" to the Shanda platform. Currently, the company offers 33 multiplayer and casual games on its website, with another 28 games in the pipeline.
Shanda is also into online literature, online video and other media related businesses.
Competitors: The main competitors are Tencent and NetEase. Currently there is talk that Shanda is lagging behind the competitors as Shanda is dependent on few aging games for the bulk of the revenue.
What can go wrong with this stock?
- Mismanagement of cash due to bad acquisitions. Currently we have not seen anything like that
- If Chinese market crashes, the stock price might temporarily gets depressed but we have strong downward protection with $25 cash
- Accounting Fraud is one other biggest concern for us. We have seen more of that in smaller Chinese companies but not in large companies
Why do you invest in technology stocks and it is not deep value investing ?
- We do not go with conventional definition of deep value. We have strong downside protection with more than $20/share cash. Currently the stock price is close to $40.
- In technology and some businesses, sometimes the future is not very clear but we know that they have valuable digital assets. Even if you put $0 value for all those assets, still it damn cheap selling for less than 4 times EV/EBITDA. The value of online games is just $42.
- Shanda Literature and online video has the potential to be huge. They recently came up with Chinese version of kindle. They also get their revenue from ring tones
(Recent Excerpts from an interview from Mason Hawkins on Shanda Entertainment. Very respected Value investor. Thanks Value investor insight)
We wouldn’t expect a company with “Chinese” and “Internet” in its business description to have a value-priced stock. Why do you consider that the case with Shanda Interactive?
- KS: Shanda Interactive is a leading online entertainment media company in China, basically providing the platform for players of online games created by its publicly traded and 70%-owned subsidiary, Shanda Games. They run more than 30 online games, the blockbuster being Legend of Mir II, a multi-player online role-playing game akin to Activision Blizzard’s World of Warcraft. The business model varies, but for the most part the network’s 100 million registered users can start playing any given game for free, but they then pay to upgrade their capabilities or powers to advance further into the game. Shanda’s stock got hit earlier this year after they tweaked Legend of Mir II so that it was easier to just buy new powers than have to earn them, which turned some hardcore players off. Usage went down and they had to revise earnings expectations, which sent the stock in January from almost $60 to less than $40. We saw that as a temporary problem they will work through, so that gave us an excellent buying opportunity. On a consolidated basis, Shanda Interactive has cash on its balance sheet worth 65% of its current market cap, so obviously whether value is created or destroyed going forward has a lot to do with how they spend that cash. We like that the CEO, Tianqiao Chen, owns more than 40% of the company and has his entire net worth invested in it. He also has a clear eye on increasing shareholder value and has spent more money in the past two years on share repurchases than on anything else by far. At one point he issued convertible debt with a strike price of $35 and used the proceeds to buy back stock at an average of $28 per share
How cheap do you consider the shares today, at a recent price of $40.90?
- KS: The current market value is around $2.7 billion and they have nearly $1.9 billion in net cash, so the enterprise value is only about $800 million. We estimate the company will make $270 million in free cash flow over the next twelve months, so the multiple of that on an EV basis is only about 3x. That makes no sense to us for a company with 35%-plus operating margins, an attractive network effect, a sticky revenue model, and still-vibrant growth prospects in an underpenetrated market. We value Shanda Games on its own at $11.25 per share [versus a current market price of around $5.80], which assumes a 7x multiple of free cash flow (after cash) for a business that should grow at least at a low-teens rate. That valuation translates into roughly $42 per share in Shanda Interactive value. There’s another $20 per share in cash
- at the holding company level. On top of that is the “rent” Shanda Interactive receives from Shanda Games for access to
- its online network – at 17x free cash flow, that’s worth another $10 per share. That brings our intrinsic value estimate for the holding company to more than $70 per share. If we’re right about management investing the cash wisely, that could easily turn out to be conservative.
Shanda has unique model. It includes a venture capital fund that invests in fledgling independent game studios, and taps the full potential of promising new games by leveraging the firm's management expertise and gaming platform. This strategy can be particularly effective in expanding and refreshing the game portfolio, to keep its large gamer community "hooked" to the Shanda platform. Currently, the company offers 33 multiplayer and casual games on its website, with another 28 games in the pipeline.
Shanda is also into online literature, online video and other media related businesses.
Competitors: The main competitors are Tencent and NetEase. Currently there is talk that Shanda is lagging behind the competitors as Shanda is dependent on few aging games for the bulk of the revenue.
What can go wrong with this stock?
- Mismanagement of cash due to bad acquisitions. Currently we have not seen anything like that
- If Chinese market crashes, the stock price might temporarily gets depressed but we have strong downward protection with $25 cash
- Accounting Fraud is one other biggest concern for us. We have seen more of that in smaller Chinese companies but not in large companies
Why do you invest in technology stocks and it is not deep value investing ?
- We do not go with conventional definition of deep value. We have strong downside protection with more than $20/share cash. Currently the stock price is close to $40.
- In technology and some businesses, sometimes the future is not very clear but we know that they have valuable digital assets. Even if you put $0 value for all those assets, still it damn cheap selling for less than 4 times EV/EBITDA. The value of online games is just $42.
- Shanda Literature and online video has the potential to be huge. They recently came up with Chinese version of kindle. They also get their revenue from ring tones
(Recent Excerpts from an interview from Mason Hawkins on Shanda Entertainment. Very respected Value investor. Thanks Value investor insight)
We wouldn’t expect a company with “Chinese” and “Internet” in its business description to have a value-priced stock. Why do you consider that the case with Shanda Interactive?
- KS: Shanda Interactive is a leading online entertainment media company in China, basically providing the platform for players of online games created by its publicly traded and 70%-owned subsidiary, Shanda Games. They run more than 30 online games, the blockbuster being Legend of Mir II, a multi-player online role-playing game akin to Activision Blizzard’s World of Warcraft. The business model varies, but for the most part the network’s 100 million registered users can start playing any given game for free, but they then pay to upgrade their capabilities or powers to advance further into the game. Shanda’s stock got hit earlier this year after they tweaked Legend of Mir II so that it was easier to just buy new powers than have to earn them, which turned some hardcore players off. Usage went down and they had to revise earnings expectations, which sent the stock in January from almost $60 to less than $40. We saw that as a temporary problem they will work through, so that gave us an excellent buying opportunity. On a consolidated basis, Shanda Interactive has cash on its balance sheet worth 65% of its current market cap, so obviously whether value is created or destroyed going forward has a lot to do with how they spend that cash. We like that the CEO, Tianqiao Chen, owns more than 40% of the company and has his entire net worth invested in it. He also has a clear eye on increasing shareholder value and has spent more money in the past two years on share repurchases than on anything else by far. At one point he issued convertible debt with a strike price of $35 and used the proceeds to buy back stock at an average of $28 per share
How cheap do you consider the shares today, at a recent price of $40.90?
- KS: The current market value is around $2.7 billion and they have nearly $1.9 billion in net cash, so the enterprise value is only about $800 million. We estimate the company will make $270 million in free cash flow over the next twelve months, so the multiple of that on an EV basis is only about 3x. That makes no sense to us for a company with 35%-plus operating margins, an attractive network effect, a sticky revenue model, and still-vibrant growth prospects in an underpenetrated market. We value Shanda Games on its own at $11.25 per share [versus a current market price of around $5.80], which assumes a 7x multiple of free cash flow (after cash) for a business that should grow at least at a low-teens rate. That valuation translates into roughly $42 per share in Shanda Interactive value. There’s another $20 per share in cash
- at the holding company level. On top of that is the “rent” Shanda Interactive receives from Shanda Games for access to
- its online network – at 17x free cash flow, that’s worth another $10 per share. That brings our intrinsic value estimate for the holding company to more than $70 per share. If we’re right about management investing the cash wisely, that could easily turn out to be conservative.
Saturday, October 16, 2010
Scary stuff about China and Japan bubble
One of the very good interviews I read about China and Japan. I need to validate this info with my friends in China and Japan. Very logical interview, though I do not agree few points but still very interesting info. Thanks Contrarian Edge
An interview with Vitaliy Katsenelson, Chief Investment Officer, Investment Management Associates, Inc., and author of Active Value Investing. Profiled in Barron’s in September 2009, Vitaliy, who was born in Murmansk, Russia, and moved to the U.S. in 1991, from 2007 to 2007 was an adjunct faculty member at the University of Colorado at Denver’s Graduate School of Business.
TCR: What our readers are looking for is a better sense of China and Japan, both of which are very important in the context of the global economy. As we have to start somewhere, let’s start with China.
Today the conventional wisdom is that somehow the Chinese economy is better managed than its competitors, very similar to how people viewed Japan in the 1970s and 1980s. Back then people were absolutely convinced that Japan was the superior country with superior policies and that its economy was unstoppable. We all know how that ended.
So, let’s start there. Is China’s system better than everyone else’s? Is it really possible the Chinese economy can keep steamrolling along?
VK: A few months ago, I watched a movie about Ayn Rand and it talked about how Americans in the 1930s looked at the Soviet Union’s flavor of managed economy as being superior to the American version of capitalism. At the time America was just coming out of the Great Depression, so that view made a lot of sense. So in the short run, and especially after the ugly side of creative destruction has paid us a visit, the grass of managed economy may look greener.
So when we look at China, the conventional wisdom says that the government is very, very smart, and therefore they can do a very good job in steering the economy in the right way. Chinese government may have the best intentions, its leaders may have IQs of 250 each on a bad day, but it is impossible to centrally manage an economy of China’s size.
I am a big believer that in the boxing match between a visible and an invisible hand, though the invisible hand may lose a few rounds, it will win the match every time. Last century we had the most amazing economic experiment take place when after World War II, Germany was split into two countries with different economic and political systems. But they were the same people, with the same language and culture, separated by a wall. We know how that story ended.
Of course, for a time, having government control over the levers of the economy can have advantages. For example, by taking prompt action, the Chinese government was able to pull the economy out of the recession remarkably fast, basically by fire-housing the stimulus package that was equivalent to 12% GDP. That’s the advantage. The only problem is that these kinds of short-term advantages come with long-term, painful consequences.
For example, when you have a huge government presence in the economy, you also have a huge bureaucracy, and bureaucracy brings corruption. This is one of the reasons why China is rated so poorly on Transparency International’s annual corruption rating. Corruption breeds misallocation of capital, because the capital flows not to the best use, but it basically flows to whatever the political connection or whatever the bribe is directed to.
In addition, when you have a government-managed economy, it creates excesses. China has huge excesses in the industrial sector, as well as in commercial and residential real estate. We see plenty of evidence of these excesses, but they are likely to be much greater than we can measure today as they are covered up by robust economic growth. The true magnitude of these excesses will come to the surface once the economy slows down.
TCR: In essence, you’ve got a relatively small group of individuals who are making big decisions about China’s economy and where production should be, in what sectors, etc. If history is any guide, that really can’t last, yet many people seem to think it can. That said, China’s economy has certainly done remarkably well in the global economic crisis. In fact, according to their government, their GDP is almost back to where it was pre-crash. Why?
VK: Sure, the growth you see today in China is there, but it’s not a sustainable growth. It’s not a growth that you’ll see a few years from now. That is an important point for readers to understand.
TCR: Why is it not sustainable?
VK: Because the growth is being induced by government spending, by a misallocation of capital.
I’ll give you an example. The vacancy rate on commercial real estate in China is fairly high, but they still keep on building new office buildings because they think they will always grow. So therefore as long as they keep building, that activity will be registered as growth, until they stop. And when they do stop, they’ll drown in overcapacity, and they won’t be building new skyscrapers for a very long time.
TCR: We read that note you sent about the South China Mall, which is pretty stunning. It’s the second largest mall in the world but is mostly empty.
VK: That’s right. But as outrageous an example as the South China Mall is, there’s an even more outrageous example – namely that the Chinese built an entire city, Ordos, in Inner Mongolia for 1.5 million residents and it is completely empty. These are classic examples of the sort of excesses going on in China.
TCR: The equivalent of building bridges to nowhere, but on a very large – Chinese – scale.
VK: Exactly. There are no shortcuts to greatness. As long as they keep building new bridges, the economic numbers will register that there is growth, but at some point the piper will have to be paid, and these projects have a negative return on capital.
TCR: It seems the Chinese are following the script Japan used to dig itself out of its postwar doldrums, deliberately keeping their currency low in order to build an economy on the back of low-cost manufacturing. But that game inevitably has to end – already we see more and more things being made in Indonesia, Pakistan, India, and so forth. If China loses the manufacturing core of their economy, won’t they be in big trouble?
VK: Well, once you move manufacturing to other countries, it’s very difficult to get it back. So you could probably argue that China will maintain its manufacturing advantage for a while.
The problem with China is pretty much same as with any bubble. Though it may have had a solid foundation under it, it is simply a good thing taken too far. If you look at the railroad bubble in the United States, the country did need railroads, but we built too many.
The same thing happened with the technology bubble in 1998. The Internet was transformative to our economy, no question about it. But, again, it was taken too far.
There are some other countries that are lower-cost producers than China, but they probably can’t do it on the same scale that China can. But my point is that China is just a good thing taken too far, and if you add government involvement and corruption into the mix, you will get a bubble that is taken a lot further than you would normally expect.
One way of thinking about it is that the actions taken by the Chinese government, especially after the recent global recession, have basically supersized the bubble that was already forming.
TCR: Their government is sort of a holdover from a largely bygone era when many nations were communists, so isn’t it true that they need to maintain some fairly strong forward momentum, otherwise they could run into some political problems? Is that why they were so quick to unleash the massive stimulus or encourage their banks to lend an amazing amount of money? You have a chart showing those loans amounted to 29% of GDP in 2009. What kind of quality of lending can that be?
VK: Let’s try to understand why the Chinese government did the things they did. As everyone knows, the Chinese economy grew at a very high rate for a long period of time. When the global economy slowed down, their economy slowed down as well (though official numbers did not show it). The Chinese government is extremely concerned about the economy slowing down because that is likely to lead to political unrest. A lot of that potential friction comes because a lot of people moved from villages to the cities. China has an almost nonexistent social safety net system. So people who lose jobs don’t complain, they riot.
So, yes, the Chinese government is afraid of political unrest, and therefore they quickly released a tremendous amount of stimulus into the economy, then followed it up with encouraging bank loans equal to 29% of GDP in 2009, a huge increase. When you infuse this much debt into an economy, it’s impossible to have good capital allocation decisions. While the economy is growing, the bad debt won’t be so apparent, but it certainly will be when the economic growth slows.
A good analogy might be that when you analyze a credit card company that is growing very, very fast, and that has opened new accounts, you don’t see the bad debt because that debt is covered up by new loans. The true nature of the past lending decisions only becomes obvious when the company’s growth falls off.
One way to think about the Chinese economy is by comparing it to the bus in the movie Speed with Keanu Reeves and Dennis Hopper. In the movie, a bus was wired with explosives that would blow up if the bus’s speed dropped below 50 miles an hour.
Since China is manufacturer to the world, that manufacturing business comes with a lot of fixed costs. Factories, equipment need financing, and they are mainly financed by debt – another fixed cost. The high level of fixed costs doesn’t afford China an economic slowdown, but when it happens, the consequences will be dire. High fixed costs are great when revenues are rising as income grows at a faster rate than sales. But they are devastating to profitability when sales decline: costs decline at a slower rate than sales and you start losing money, fast.
TCR: Interestingly, there’s clearly a slowdown in the U.S. and Europe, China’s two biggest markets, so you would assume that China’s export industries would have suffered a fairly sharp decline since the go-go days before the crash. That has to be putting pressure on their growth. How important to the Chinese is it that the U.S. and the European economies recover and Western consumers get back into the game?
VK: I think a return of U.S. and European consumers is extremely important to the health of the Chinese economy. Some analysts think China’s internal demands can overcome the demand decline from U.S. and European consumers, and I think it is possible in the long run. But in the short run, I don’t think that’s possible. Let me explain the reasons for that.
Chinese consumers represent one-third of a 5-trillion-dollar economy. If you look at the size of the U.S. and European Union together, they are equal to a 30-trillion-dollar economy, and the consumers there constitute about two-thirds of those economies.
So on the one hand, you have U.S. and European consumers representing 20 trillion dollars in purchases, versus Chinese consumers at about 2 trillion dollars. In other words, U.S. and European consumers are 10 times the size of the Chinese consumers. As a result, a very small change in consumption in the U.S. and Europe has to be overcompensated by a huge increase in consumption in China, and that is going to be very difficult to do, especially considering that the Chinese currency is kept at artificially low levels. That, of course, diminishes the purchasing power of the Chinese consumer. Over time the Chinese consumer will play a larger role in the economy, but it’s going to take a decade, not months – not even a few years.
TCR: You’re pretty bearish on the outlook for China; do you have a theory about what might trip them up? What’s the thing that readers should be watching for that would suggest things are starting to unravel?
VK: It’s very difficult to know exactly what’s going to be the straw that breaks the camel’s back. It could be a slowdown in the Japanese economy, or a double-dip in the U.S., or some other factors that are not apparent to us today. It could be just the simple fact that the Chinese government is trying to put the brakes on the economy and mistakenly does too much.
I don’t trust government-reported statistics, thus I’d watch numbers that the Chinese government is less likely to fudge: electricity consumption, which was down during the global recession, same-store sales of American fast food restaurants in China, tonnage of goods shipped through railroads, and, though they may lag, sales by American and European companies in China.
TCR: If you look at inputs like copper imports and even copper stocks in Shanghai, by all appearances China is at least pretending that it’s business as usual. In fact, I think in August they imported 22% more refined copper than they did the year before. But if this is just to build bridges to nowhere, then it supports the idea that this is not going to be sustainable.
VK: That’s right. That is the problem with looking at this kind of data, because a lot of it is going to building things that have a negative return on capital. Therefore, you look at the data and the data does not really tell you that much – until it does. Because, basically, it’s the government’s involvement that is driving a lot of the demand.
You can make the same argument that the U.S. economy was doing great in 2004, 2005, 2006, despite the obvious problems in real estate and its financial system. Likewise, a lot of people said great things about what was going on in Japan in the late ‘80s. Of course, the U.S., and Japan before it, were experiencing huge real estate bubbles that few saw as being a problem, until they were.
There was an article in the Wall Street Journal a couple of weeks ago talking about a Chinese state-owned enterprise that operated salt mines, but now it’s building office parks. Those are kind of the signs you start seeing in an economy in the late stages of a bubble, where a state-owned enterprise starts building real estate projects because it’s almost like you can’t lose money doing this. But one thing that makes predicting the end of this bubble very difficult is the amount of firepower the Chinese government has. The government can drive this bubble further than a rational observer would expect.
TCR: Because they’ve got so much in the way of reserves?
VK: Because they have a significant influence over the economy. Chinese government can force banks to lend and can force companies to borrow and spend (or build).
TCR: On the topic of real estate, I was speaking to a very well-off Chinese friend recently who had bought a very expensive apartment in Beijing. When I asked him about buying at bubble prices, he commented that it really didn’t matter. The money was almost irrelevant, given the status that came from having an apartment in that particular part of town. He said it was very good for his business and that he didn’t really plan on using it very much. It was an interesting perspective, how he saw real estate.
VK: In the same way that everyone in the United States decided they “must” own a house, this belief was reinforced by continuously rising house prices. You can see how big a problem this became in big cities such as Beijing and Shanghai where the affordability ratio is horrible, so the property-value-to-income ratio in Beijing is pushing 15. In Shanghai it is over 12. If you look at the national average, it is over eight times.
TCR: Can you explain that ratio to our readers?
VK: You get the ratio by taking the property value and dividing it by annual disposable income.
Basically, if you spent all your money, after you paid your taxes, just to pay off the mortgage, it would take you 14 years – which means you didn’t pay for food, electricity, etc.
This ratio is important because it helps put the scale of the Chinese real estate bubble in its proper context. In Tokyo, at the peak of the massive Japanese bubble, the ratio stood at nine times. In Beijing it’s already 14 times. In Shanghai it’s over 12 times. The national average for China is pushing 8.2 times right now. So housing affordability is very, very low, and the housing prices are extremely high.
Here is another interesting piece of data: property investment in China in 2009 was 10% of GDP, up from 8% in 2007. In Japan, at the peak of its bubble, it did not exceed 9%; in the U.S. it never exceeded 6%.
A recent study found that 64.5 million apartments basically don’t use electricity because they are empty. Chinese people buy those condos, and they don’t rent them. Similar to new cars in the U.S. when taken off the lot, in China an apartment is worth less once rented out. So they just keep them unoccupied with the hope to flip them, and you know how that story ends.
TCR: Yes, after Japan’s real estate bubble collapsed, prices in the major cities fell by about two-thirds and have rebounded only very little from the post-crash lows.
If a lot of Chinese lost a lot of money in real estate, one has to assume they’re going to be very unhappy. I recall a conversation with another Chinese man who lives in the States half a year and in Beijing half the year. When I asked him about the real estate bubble in China, his comment was, “Well, the government would never let it fall,” and he said the same thing was true of their stock market. To put it mildly, he had an inordinate amount of faith in the Chinese government’s ability to prop up bubbles.
VK: As you can tell from my accent, I was born in Russia and spent half of my life in Soviet Russia. From my direct experience, the Russian propaganda machine was very, very powerful, and so many people believed how smart the leaders were and that they could do nothing wrong.
China is not that much different from Russia in that respect. Due to the government’s control of the media, the average citizen has been brainwashed into thinking of the government with respect. They has led to an unconditional belief that the Chinese government walks on water, that the laws of economics are somehow suspended when they touch things (except they also did a fine job convincing not just their own citizens but the West as well). Sure, they have a greater control of the economy, but at the long-term cost we talked about earlier. That’s point number one.
Point number two can be understood by asking why people are buying those apartments, why are they buying this real estate? In part it is because if they put money in the bank – where the government basically sets the rates on savings accounts and the checking deposits – they are getting very little interest on their savings. Therefore they look at real estate as basically a form of savings.
Some analysts will argue that it can’t be a bubble because of the lack of leverage, given that in China you have to put 30%-40% down when you buy an apartment. It is a large down payment. But think about how much wealth will be destroyed when real estate prices decline – and that in itself could trigger a serious crisis in China because it would destroy a lot of wealth, and that could lead to political unrest. So that would be very important psychologically and for the political stability of the Chinese economy.
TCR: What would typically trigger the end of this real estate bubble?
VK: To some degree, a real estate bubble is like a Ponzi scheme. As long as there is an incremental buyer, prices keep going up, but at some point everybody who wants to buy a house has bought a house, so when an incremental buyer is not there, the prices start declining and then it becomes self-feeding. It’s very difficult to time the end, but there is always an end.
TCR: What about commercial real estate?
VK: If you look at commercial real estate, it’s often one subsidiary that is borrowing money from another subsidiary to put a down payment to build or buy a building. And a lot of times land is used as collateral. As land prices decline, so the loan-to-value ratio can jump through the roof very quickly when real estate prices collapse.
TCR: Talk a little about the renminbi. The Chinese government has been making noises about possibly allowing it to rise against the dollar, but from a practical standpoint, can they actually afford to let that happen?
VK: They could let it rise on a very gradual basis, but they absolutely cannot allow it to rise very rapidly because that would quickly diminish the value of the foreign reserves. But there is a conundrum. When the Chinese economy bursts, there is a very good chance the renminbi will actually depreciate, because you are going to have a flight of capital leaving China. So right now you may argue that China’s currency is too cheap, but during the crisis it’s probably going to get cheaper.
TCR: What’s your general sense about how much longer they can keep the game going before they collapse? And is collapse the right word?
VK: I really don’t know. In the case of Japan, their government basically ran out of chips. I think the Chinese government still has enough chips to keep the bubble going awhile longer. These bubbles usually last longer than the reputation of the person who predicts their demise.
TCR: Do you think it will occur within a decade?
VK: I think so, yes. GMO became famous for predicting the Japanese bubble collapse, but they started predicting it in 1986, so they were “wrong” for a while because it actually burst in 1989-1990. The point being, these bubbles typically last longer than you would expect, but it’s going to burst.
TCR: Let’s talk for a minute about some of the potential implications of a bursting Chinese bubble. There are some fairly obvious ones, like Chinese real estate, but there are a lot of somewhat less obvious consequences, for example the hit this would cause to the Australian economy because its export sector depends heavily on China.
VK: China has been responsible for a very large portion, if not all, of incremental demand for commodities in recent years. If you’re talking about copper, about oil, or pretty much all the industrial commodities, China was responsible for a very large portion of the demand. When the economy slows down and the bubble bursts, then the demand for those commodities will decline dramatically.
It’s going to impact economies that benefitted tremendously from China’s ascent, so Australia will be impacted, Russia will be impacted because oil prices will decline and Russia is basically a commodity-driven nation. Brazil will be impacted. Any economy you can think of that benefitted from China’s ascent will get hurt from its descent as well.
Let me clarify this. I’m not saying that China will cease to exist or that it’s going back to the stone-age – I’m saying there is a bubble and it’s going to burst. It’s going to go through readjustments.
TCR: But it will be a serious crisis.
VK: The bubble burst will have significant consequences.
TCR: So you’d be cautious on sort of base commodities.
VK: Yes. But also think about industrial goods. Getting commodities out of the ground, building empty shopping malls, ghost towns, and bridges to nowhere requires a lot of equipment. Industrial goods companies benefitted tremendously from Chinese demand. In the past, those were very cyclical companies, and it seems like this time they almost didn’t have a normal cycle. They declined but then came back very fast because the demand came back very fast, and a lot of that demand came from China.
TCR: And what would you invest in, are there any opportunities you see?
VK: Unless you short stocks, it’s very difficult to see an opportunity in a Chinese downturn. As a portfolio manager, I look at it as a risk, and I say, all right, what can I do to immunize my portfolio from that risk. I have very little exposure to commodities and industrial stocks, and very little exposure to countries that will get hurt from China’s bursting bubble – the countries we mentioned, like Australia, Brazil, Russia, etc.
TCR: Canada would have to be on that list.
VK: Yes, very true.
TCR: Let’s talk briefly about Japan. Bud Conrad, our chief economist, has done a lot of looking at Japan and concludes that it’s basically past the point of no return. What are your general thoughts on the implications of that country tipping back into a serious crisis? After all, it’s a very big economy, and so that would have to have a big impact on the world.
VK: Japan’s story is very simple. The economy slowed down in the 1990s. To keep the economy growing, the government lowered taxes and increased government spending, sending budget deficits up. In order to finance those deficits, the amount of government debt has tripled.
The only reason they were able to finance that debt was because over 90% of the government debt was purchased internally; therefore, thanks to Japanese interest rates declining from 7.5% to 1.4%, the government was able to dramatically increase the amount of debt without the total borrowing costs going up.
Today, Japan is one of the most indebted nations in the developed world, and its population demographics are horrible because every fourth Japanese is over 65 years old. There’s no immigration into Japan, and the population is aging rapidly, and the savings rate went from the middle teens to quickly approaching zero.
TCR: So there is less demand for Japanese government bonds.
VK: Yes, exactly. With the demand for Japanese bonds declining, they are going to have to start shopping their debt outside of Japan, and the second they do, they’ll realize that no rational buyer would buy Japanese debt yielding 1.4% when they can buy U.S. debt or German debt with yields double that.
So the Japanese are going to have to start paying high interest rates, and they can’t afford that, because one-quarter of the tax revenues already goes to servicing their debt. If their interest rates were to double to just 2.8%, it basically wipes out the funding for the country’s Departments of Defense and Education. So this is a situation where they go from deflation to hyperinflation, because they’re going to have to start printing money to be able to keep paying off their debt, so this is the case where they are going just from one extreme to another.
TCR: Their economy has been hugely helped by their trade surplus, but their trade surplus has been going down steadily, in no small part because China has been stealing market share.
VK: Exactly. A lot of manufacturing went to China from Japan, so that hurt the economy too.
So when you ask me about what could trigger Chinese problems, well, you know, Japan is still a big trading partner for China, so Japan’s decline would impact China as well, and vice versa.
TCR: We have heard a lot about Japanese demographics. That seems to be an intractable problem.
VK: Recently I heard that the Japanese were considering trying to solve their demographic problems by allowing immigration from China to Japan. I almost fell off my chair when I heard that, because there is a lot of animosity between the two countries. They love each other as much as Armenians love Turks, so it’s very difficult for me to see that happening just because of the cultural issues going on.
TCR: And it seems that the tensions are actually getting much worse.
VK: Too true. But the key point is that Japan is past the point of no return. It’s like the Titanic has already hit the iceberg and you know it’s going to sink, you just don’t know just how long it will take to go down. That’s basically what is taking place in Japan.
TCR: Sticking with that metaphor, it seems like people need to begin donning life jackets and edging toward the nearest lifeboat.
So we’ve got some serious issues with Asia, which obviously will have some global implications. How does this tie back to the U.S.? Our take has been that – at least on a short-term basis – when things start to come unglued, it will benefit the U.S. as a purported “safe harbor,” but then people will begin to realize that if two out of three of the world’s biggest economies can fall, so can the U.S.
VK: In the short run, it may benefit the U.S. dollar because the value of currencies is relative, right? As my friend Barry Pasikov says – the U.S. dollar is valedictorian in summer school. So if people are afraid of Japan, afraid of China, they would be running towards the U.S. currency. By the way, the Japanese currency made a 15-year high recently suggesting what could be the trade of the decade.
I’m a value investor, so I generally don’t spend much time on currencies, but I think this is a case where shorting Japanese yen makes a lot of sense.
http://contrarianedge.com/2010/10/14/shadow-over-asia/
An interview with Vitaliy Katsenelson, Chief Investment Officer, Investment Management Associates, Inc., and author of Active Value Investing. Profiled in Barron’s in September 2009, Vitaliy, who was born in Murmansk, Russia, and moved to the U.S. in 1991, from 2007 to 2007 was an adjunct faculty member at the University of Colorado at Denver’s Graduate School of Business.
TCR: What our readers are looking for is a better sense of China and Japan, both of which are very important in the context of the global economy. As we have to start somewhere, let’s start with China.
Today the conventional wisdom is that somehow the Chinese economy is better managed than its competitors, very similar to how people viewed Japan in the 1970s and 1980s. Back then people were absolutely convinced that Japan was the superior country with superior policies and that its economy was unstoppable. We all know how that ended.
So, let’s start there. Is China’s system better than everyone else’s? Is it really possible the Chinese economy can keep steamrolling along?
VK: A few months ago, I watched a movie about Ayn Rand and it talked about how Americans in the 1930s looked at the Soviet Union’s flavor of managed economy as being superior to the American version of capitalism. At the time America was just coming out of the Great Depression, so that view made a lot of sense. So in the short run, and especially after the ugly side of creative destruction has paid us a visit, the grass of managed economy may look greener.
So when we look at China, the conventional wisdom says that the government is very, very smart, and therefore they can do a very good job in steering the economy in the right way. Chinese government may have the best intentions, its leaders may have IQs of 250 each on a bad day, but it is impossible to centrally manage an economy of China’s size.
I am a big believer that in the boxing match between a visible and an invisible hand, though the invisible hand may lose a few rounds, it will win the match every time. Last century we had the most amazing economic experiment take place when after World War II, Germany was split into two countries with different economic and political systems. But they were the same people, with the same language and culture, separated by a wall. We know how that story ended.
Of course, for a time, having government control over the levers of the economy can have advantages. For example, by taking prompt action, the Chinese government was able to pull the economy out of the recession remarkably fast, basically by fire-housing the stimulus package that was equivalent to 12% GDP. That’s the advantage. The only problem is that these kinds of short-term advantages come with long-term, painful consequences.
For example, when you have a huge government presence in the economy, you also have a huge bureaucracy, and bureaucracy brings corruption. This is one of the reasons why China is rated so poorly on Transparency International’s annual corruption rating. Corruption breeds misallocation of capital, because the capital flows not to the best use, but it basically flows to whatever the political connection or whatever the bribe is directed to.
In addition, when you have a government-managed economy, it creates excesses. China has huge excesses in the industrial sector, as well as in commercial and residential real estate. We see plenty of evidence of these excesses, but they are likely to be much greater than we can measure today as they are covered up by robust economic growth. The true magnitude of these excesses will come to the surface once the economy slows down.
TCR: In essence, you’ve got a relatively small group of individuals who are making big decisions about China’s economy and where production should be, in what sectors, etc. If history is any guide, that really can’t last, yet many people seem to think it can. That said, China’s economy has certainly done remarkably well in the global economic crisis. In fact, according to their government, their GDP is almost back to where it was pre-crash. Why?
VK: Sure, the growth you see today in China is there, but it’s not a sustainable growth. It’s not a growth that you’ll see a few years from now. That is an important point for readers to understand.
TCR: Why is it not sustainable?
VK: Because the growth is being induced by government spending, by a misallocation of capital.
I’ll give you an example. The vacancy rate on commercial real estate in China is fairly high, but they still keep on building new office buildings because they think they will always grow. So therefore as long as they keep building, that activity will be registered as growth, until they stop. And when they do stop, they’ll drown in overcapacity, and they won’t be building new skyscrapers for a very long time.
TCR: We read that note you sent about the South China Mall, which is pretty stunning. It’s the second largest mall in the world but is mostly empty.
VK: That’s right. But as outrageous an example as the South China Mall is, there’s an even more outrageous example – namely that the Chinese built an entire city, Ordos, in Inner Mongolia for 1.5 million residents and it is completely empty. These are classic examples of the sort of excesses going on in China.
TCR: The equivalent of building bridges to nowhere, but on a very large – Chinese – scale.
VK: Exactly. There are no shortcuts to greatness. As long as they keep building new bridges, the economic numbers will register that there is growth, but at some point the piper will have to be paid, and these projects have a negative return on capital.
TCR: It seems the Chinese are following the script Japan used to dig itself out of its postwar doldrums, deliberately keeping their currency low in order to build an economy on the back of low-cost manufacturing. But that game inevitably has to end – already we see more and more things being made in Indonesia, Pakistan, India, and so forth. If China loses the manufacturing core of their economy, won’t they be in big trouble?
VK: Well, once you move manufacturing to other countries, it’s very difficult to get it back. So you could probably argue that China will maintain its manufacturing advantage for a while.
The problem with China is pretty much same as with any bubble. Though it may have had a solid foundation under it, it is simply a good thing taken too far. If you look at the railroad bubble in the United States, the country did need railroads, but we built too many.
The same thing happened with the technology bubble in 1998. The Internet was transformative to our economy, no question about it. But, again, it was taken too far.
There are some other countries that are lower-cost producers than China, but they probably can’t do it on the same scale that China can. But my point is that China is just a good thing taken too far, and if you add government involvement and corruption into the mix, you will get a bubble that is taken a lot further than you would normally expect.
One way of thinking about it is that the actions taken by the Chinese government, especially after the recent global recession, have basically supersized the bubble that was already forming.
TCR: Their government is sort of a holdover from a largely bygone era when many nations were communists, so isn’t it true that they need to maintain some fairly strong forward momentum, otherwise they could run into some political problems? Is that why they were so quick to unleash the massive stimulus or encourage their banks to lend an amazing amount of money? You have a chart showing those loans amounted to 29% of GDP in 2009. What kind of quality of lending can that be?
VK: Let’s try to understand why the Chinese government did the things they did. As everyone knows, the Chinese economy grew at a very high rate for a long period of time. When the global economy slowed down, their economy slowed down as well (though official numbers did not show it). The Chinese government is extremely concerned about the economy slowing down because that is likely to lead to political unrest. A lot of that potential friction comes because a lot of people moved from villages to the cities. China has an almost nonexistent social safety net system. So people who lose jobs don’t complain, they riot.
So, yes, the Chinese government is afraid of political unrest, and therefore they quickly released a tremendous amount of stimulus into the economy, then followed it up with encouraging bank loans equal to 29% of GDP in 2009, a huge increase. When you infuse this much debt into an economy, it’s impossible to have good capital allocation decisions. While the economy is growing, the bad debt won’t be so apparent, but it certainly will be when the economic growth slows.
A good analogy might be that when you analyze a credit card company that is growing very, very fast, and that has opened new accounts, you don’t see the bad debt because that debt is covered up by new loans. The true nature of the past lending decisions only becomes obvious when the company’s growth falls off.
One way to think about the Chinese economy is by comparing it to the bus in the movie Speed with Keanu Reeves and Dennis Hopper. In the movie, a bus was wired with explosives that would blow up if the bus’s speed dropped below 50 miles an hour.
Since China is manufacturer to the world, that manufacturing business comes with a lot of fixed costs. Factories, equipment need financing, and they are mainly financed by debt – another fixed cost. The high level of fixed costs doesn’t afford China an economic slowdown, but when it happens, the consequences will be dire. High fixed costs are great when revenues are rising as income grows at a faster rate than sales. But they are devastating to profitability when sales decline: costs decline at a slower rate than sales and you start losing money, fast.
TCR: Interestingly, there’s clearly a slowdown in the U.S. and Europe, China’s two biggest markets, so you would assume that China’s export industries would have suffered a fairly sharp decline since the go-go days before the crash. That has to be putting pressure on their growth. How important to the Chinese is it that the U.S. and the European economies recover and Western consumers get back into the game?
VK: I think a return of U.S. and European consumers is extremely important to the health of the Chinese economy. Some analysts think China’s internal demands can overcome the demand decline from U.S. and European consumers, and I think it is possible in the long run. But in the short run, I don’t think that’s possible. Let me explain the reasons for that.
Chinese consumers represent one-third of a 5-trillion-dollar economy. If you look at the size of the U.S. and European Union together, they are equal to a 30-trillion-dollar economy, and the consumers there constitute about two-thirds of those economies.
So on the one hand, you have U.S. and European consumers representing 20 trillion dollars in purchases, versus Chinese consumers at about 2 trillion dollars. In other words, U.S. and European consumers are 10 times the size of the Chinese consumers. As a result, a very small change in consumption in the U.S. and Europe has to be overcompensated by a huge increase in consumption in China, and that is going to be very difficult to do, especially considering that the Chinese currency is kept at artificially low levels. That, of course, diminishes the purchasing power of the Chinese consumer. Over time the Chinese consumer will play a larger role in the economy, but it’s going to take a decade, not months – not even a few years.
TCR: You’re pretty bearish on the outlook for China; do you have a theory about what might trip them up? What’s the thing that readers should be watching for that would suggest things are starting to unravel?
VK: It’s very difficult to know exactly what’s going to be the straw that breaks the camel’s back. It could be a slowdown in the Japanese economy, or a double-dip in the U.S., or some other factors that are not apparent to us today. It could be just the simple fact that the Chinese government is trying to put the brakes on the economy and mistakenly does too much.
I don’t trust government-reported statistics, thus I’d watch numbers that the Chinese government is less likely to fudge: electricity consumption, which was down during the global recession, same-store sales of American fast food restaurants in China, tonnage of goods shipped through railroads, and, though they may lag, sales by American and European companies in China.
TCR: If you look at inputs like copper imports and even copper stocks in Shanghai, by all appearances China is at least pretending that it’s business as usual. In fact, I think in August they imported 22% more refined copper than they did the year before. But if this is just to build bridges to nowhere, then it supports the idea that this is not going to be sustainable.
VK: That’s right. That is the problem with looking at this kind of data, because a lot of it is going to building things that have a negative return on capital. Therefore, you look at the data and the data does not really tell you that much – until it does. Because, basically, it’s the government’s involvement that is driving a lot of the demand.
You can make the same argument that the U.S. economy was doing great in 2004, 2005, 2006, despite the obvious problems in real estate and its financial system. Likewise, a lot of people said great things about what was going on in Japan in the late ‘80s. Of course, the U.S., and Japan before it, were experiencing huge real estate bubbles that few saw as being a problem, until they were.
There was an article in the Wall Street Journal a couple of weeks ago talking about a Chinese state-owned enterprise that operated salt mines, but now it’s building office parks. Those are kind of the signs you start seeing in an economy in the late stages of a bubble, where a state-owned enterprise starts building real estate projects because it’s almost like you can’t lose money doing this. But one thing that makes predicting the end of this bubble very difficult is the amount of firepower the Chinese government has. The government can drive this bubble further than a rational observer would expect.
TCR: Because they’ve got so much in the way of reserves?
VK: Because they have a significant influence over the economy. Chinese government can force banks to lend and can force companies to borrow and spend (or build).
TCR: On the topic of real estate, I was speaking to a very well-off Chinese friend recently who had bought a very expensive apartment in Beijing. When I asked him about buying at bubble prices, he commented that it really didn’t matter. The money was almost irrelevant, given the status that came from having an apartment in that particular part of town. He said it was very good for his business and that he didn’t really plan on using it very much. It was an interesting perspective, how he saw real estate.
VK: In the same way that everyone in the United States decided they “must” own a house, this belief was reinforced by continuously rising house prices. You can see how big a problem this became in big cities such as Beijing and Shanghai where the affordability ratio is horrible, so the property-value-to-income ratio in Beijing is pushing 15. In Shanghai it is over 12. If you look at the national average, it is over eight times.
TCR: Can you explain that ratio to our readers?
VK: You get the ratio by taking the property value and dividing it by annual disposable income.
Basically, if you spent all your money, after you paid your taxes, just to pay off the mortgage, it would take you 14 years – which means you didn’t pay for food, electricity, etc.
This ratio is important because it helps put the scale of the Chinese real estate bubble in its proper context. In Tokyo, at the peak of the massive Japanese bubble, the ratio stood at nine times. In Beijing it’s already 14 times. In Shanghai it’s over 12 times. The national average for China is pushing 8.2 times right now. So housing affordability is very, very low, and the housing prices are extremely high.
Here is another interesting piece of data: property investment in China in 2009 was 10% of GDP, up from 8% in 2007. In Japan, at the peak of its bubble, it did not exceed 9%; in the U.S. it never exceeded 6%.
A recent study found that 64.5 million apartments basically don’t use electricity because they are empty. Chinese people buy those condos, and they don’t rent them. Similar to new cars in the U.S. when taken off the lot, in China an apartment is worth less once rented out. So they just keep them unoccupied with the hope to flip them, and you know how that story ends.
TCR: Yes, after Japan’s real estate bubble collapsed, prices in the major cities fell by about two-thirds and have rebounded only very little from the post-crash lows.
If a lot of Chinese lost a lot of money in real estate, one has to assume they’re going to be very unhappy. I recall a conversation with another Chinese man who lives in the States half a year and in Beijing half the year. When I asked him about the real estate bubble in China, his comment was, “Well, the government would never let it fall,” and he said the same thing was true of their stock market. To put it mildly, he had an inordinate amount of faith in the Chinese government’s ability to prop up bubbles.
VK: As you can tell from my accent, I was born in Russia and spent half of my life in Soviet Russia. From my direct experience, the Russian propaganda machine was very, very powerful, and so many people believed how smart the leaders were and that they could do nothing wrong.
China is not that much different from Russia in that respect. Due to the government’s control of the media, the average citizen has been brainwashed into thinking of the government with respect. They has led to an unconditional belief that the Chinese government walks on water, that the laws of economics are somehow suspended when they touch things (except they also did a fine job convincing not just their own citizens but the West as well). Sure, they have a greater control of the economy, but at the long-term cost we talked about earlier. That’s point number one.
Point number two can be understood by asking why people are buying those apartments, why are they buying this real estate? In part it is because if they put money in the bank – where the government basically sets the rates on savings accounts and the checking deposits – they are getting very little interest on their savings. Therefore they look at real estate as basically a form of savings.
Some analysts will argue that it can’t be a bubble because of the lack of leverage, given that in China you have to put 30%-40% down when you buy an apartment. It is a large down payment. But think about how much wealth will be destroyed when real estate prices decline – and that in itself could trigger a serious crisis in China because it would destroy a lot of wealth, and that could lead to political unrest. So that would be very important psychologically and for the political stability of the Chinese economy.
TCR: What would typically trigger the end of this real estate bubble?
VK: To some degree, a real estate bubble is like a Ponzi scheme. As long as there is an incremental buyer, prices keep going up, but at some point everybody who wants to buy a house has bought a house, so when an incremental buyer is not there, the prices start declining and then it becomes self-feeding. It’s very difficult to time the end, but there is always an end.
TCR: What about commercial real estate?
VK: If you look at commercial real estate, it’s often one subsidiary that is borrowing money from another subsidiary to put a down payment to build or buy a building. And a lot of times land is used as collateral. As land prices decline, so the loan-to-value ratio can jump through the roof very quickly when real estate prices collapse.
TCR: Talk a little about the renminbi. The Chinese government has been making noises about possibly allowing it to rise against the dollar, but from a practical standpoint, can they actually afford to let that happen?
VK: They could let it rise on a very gradual basis, but they absolutely cannot allow it to rise very rapidly because that would quickly diminish the value of the foreign reserves. But there is a conundrum. When the Chinese economy bursts, there is a very good chance the renminbi will actually depreciate, because you are going to have a flight of capital leaving China. So right now you may argue that China’s currency is too cheap, but during the crisis it’s probably going to get cheaper.
TCR: What’s your general sense about how much longer they can keep the game going before they collapse? And is collapse the right word?
VK: I really don’t know. In the case of Japan, their government basically ran out of chips. I think the Chinese government still has enough chips to keep the bubble going awhile longer. These bubbles usually last longer than the reputation of the person who predicts their demise.
TCR: Do you think it will occur within a decade?
VK: I think so, yes. GMO became famous for predicting the Japanese bubble collapse, but they started predicting it in 1986, so they were “wrong” for a while because it actually burst in 1989-1990. The point being, these bubbles typically last longer than you would expect, but it’s going to burst.
TCR: Let’s talk for a minute about some of the potential implications of a bursting Chinese bubble. There are some fairly obvious ones, like Chinese real estate, but there are a lot of somewhat less obvious consequences, for example the hit this would cause to the Australian economy because its export sector depends heavily on China.
VK: China has been responsible for a very large portion, if not all, of incremental demand for commodities in recent years. If you’re talking about copper, about oil, or pretty much all the industrial commodities, China was responsible for a very large portion of the demand. When the economy slows down and the bubble bursts, then the demand for those commodities will decline dramatically.
It’s going to impact economies that benefitted tremendously from China’s ascent, so Australia will be impacted, Russia will be impacted because oil prices will decline and Russia is basically a commodity-driven nation. Brazil will be impacted. Any economy you can think of that benefitted from China’s ascent will get hurt from its descent as well.
Let me clarify this. I’m not saying that China will cease to exist or that it’s going back to the stone-age – I’m saying there is a bubble and it’s going to burst. It’s going to go through readjustments.
TCR: But it will be a serious crisis.
VK: The bubble burst will have significant consequences.
TCR: So you’d be cautious on sort of base commodities.
VK: Yes. But also think about industrial goods. Getting commodities out of the ground, building empty shopping malls, ghost towns, and bridges to nowhere requires a lot of equipment. Industrial goods companies benefitted tremendously from Chinese demand. In the past, those were very cyclical companies, and it seems like this time they almost didn’t have a normal cycle. They declined but then came back very fast because the demand came back very fast, and a lot of that demand came from China.
TCR: And what would you invest in, are there any opportunities you see?
VK: Unless you short stocks, it’s very difficult to see an opportunity in a Chinese downturn. As a portfolio manager, I look at it as a risk, and I say, all right, what can I do to immunize my portfolio from that risk. I have very little exposure to commodities and industrial stocks, and very little exposure to countries that will get hurt from China’s bursting bubble – the countries we mentioned, like Australia, Brazil, Russia, etc.
TCR: Canada would have to be on that list.
VK: Yes, very true.
TCR: Let’s talk briefly about Japan. Bud Conrad, our chief economist, has done a lot of looking at Japan and concludes that it’s basically past the point of no return. What are your general thoughts on the implications of that country tipping back into a serious crisis? After all, it’s a very big economy, and so that would have to have a big impact on the world.
VK: Japan’s story is very simple. The economy slowed down in the 1990s. To keep the economy growing, the government lowered taxes and increased government spending, sending budget deficits up. In order to finance those deficits, the amount of government debt has tripled.
The only reason they were able to finance that debt was because over 90% of the government debt was purchased internally; therefore, thanks to Japanese interest rates declining from 7.5% to 1.4%, the government was able to dramatically increase the amount of debt without the total borrowing costs going up.
Today, Japan is one of the most indebted nations in the developed world, and its population demographics are horrible because every fourth Japanese is over 65 years old. There’s no immigration into Japan, and the population is aging rapidly, and the savings rate went from the middle teens to quickly approaching zero.
TCR: So there is less demand for Japanese government bonds.
VK: Yes, exactly. With the demand for Japanese bonds declining, they are going to have to start shopping their debt outside of Japan, and the second they do, they’ll realize that no rational buyer would buy Japanese debt yielding 1.4% when they can buy U.S. debt or German debt with yields double that.
So the Japanese are going to have to start paying high interest rates, and they can’t afford that, because one-quarter of the tax revenues already goes to servicing their debt. If their interest rates were to double to just 2.8%, it basically wipes out the funding for the country’s Departments of Defense and Education. So this is a situation where they go from deflation to hyperinflation, because they’re going to have to start printing money to be able to keep paying off their debt, so this is the case where they are going just from one extreme to another.
TCR: Their economy has been hugely helped by their trade surplus, but their trade surplus has been going down steadily, in no small part because China has been stealing market share.
VK: Exactly. A lot of manufacturing went to China from Japan, so that hurt the economy too.
So when you ask me about what could trigger Chinese problems, well, you know, Japan is still a big trading partner for China, so Japan’s decline would impact China as well, and vice versa.
TCR: We have heard a lot about Japanese demographics. That seems to be an intractable problem.
VK: Recently I heard that the Japanese were considering trying to solve their demographic problems by allowing immigration from China to Japan. I almost fell off my chair when I heard that, because there is a lot of animosity between the two countries. They love each other as much as Armenians love Turks, so it’s very difficult for me to see that happening just because of the cultural issues going on.
TCR: And it seems that the tensions are actually getting much worse.
VK: Too true. But the key point is that Japan is past the point of no return. It’s like the Titanic has already hit the iceberg and you know it’s going to sink, you just don’t know just how long it will take to go down. That’s basically what is taking place in Japan.
TCR: Sticking with that metaphor, it seems like people need to begin donning life jackets and edging toward the nearest lifeboat.
So we’ve got some serious issues with Asia, which obviously will have some global implications. How does this tie back to the U.S.? Our take has been that – at least on a short-term basis – when things start to come unglued, it will benefit the U.S. as a purported “safe harbor,” but then people will begin to realize that if two out of three of the world’s biggest economies can fall, so can the U.S.
VK: In the short run, it may benefit the U.S. dollar because the value of currencies is relative, right? As my friend Barry Pasikov says – the U.S. dollar is valedictorian in summer school. So if people are afraid of Japan, afraid of China, they would be running towards the U.S. currency. By the way, the Japanese currency made a 15-year high recently suggesting what could be the trade of the decade.
I’m a value investor, so I generally don’t spend much time on currencies, but I think this is a case where shorting Japanese yen makes a lot of sense.
http://contrarianedge.com/2010/10/14/shadow-over-asia/
Tuesday, October 5, 2010
Picked up some Visteon@57
I have picked up Visteon today at 57. I think this is no brainer. If you want to read the detailed analysis, please read it here. The entire credit goes to Ryan from Cushman Capital. Excellent Analysis.
Brief Business Description:
Visteon Corporation is a global Tier 1 supplier of automotive products to original equipment manufacturers (OEM’s). Visteon is a market leader in each of its three core product groups: climate, electronics, and interior systems. Visteon is geographically diversified and is not overly reliant on any one particular OEM. The company’s three largest customers are Ford, Hyundai/Kia, and Nissan/Renault (which make up 29%, 27%, and 9% of the company’s revenues respectively).
Opportunity Overview:
Visteon’s shares are currently trading on a “when issued” basis at roughly 3x 2011 EBITDA, and after backing out the company’s significant ownership in high growth subsidiaries, we believe the core Visteon business trades for roughly 1.5x EBITDA. Given Visteon’s multiple internal and external catalyst’s, highly attractive absolute valuation and the outsized spread between the company’s “when issued” shares and the already depressed valuation’s of its global competitors, we think that the stars are aligning for bargain hunting investors to generate spectacular returns of 30%+ in a short period of time with relatively low risk. Keep in mind that this isn’t “your father’s” Visteon, as the company will exit bankruptcy permanently improved and completely transformed, offering investor’s both a 1) quick, high-return, relatively risk-free arbitrage and/or 2) an inexpensive way to play any upturn in - or at least the stabilization of – global auto sales and economic activity in general.
The idea here is simple. As Visteon exits chapter 11, the near to medium-term upside will likely be driven by a combination of 1) a couple of imminent, high probability catalyst’s that should force the market to assign this company with a much more appropriate valuation on an absolute basis and relative to its peers and 2) various operational and financial enhancements that the company recently undertook while in bankruptcy should continue to yield visible and increasingly positive operating results for the foreseeable future.
Our expectation is that the initial roughly 30%+ will come almost instantaneously (within a month or so) as 1) the stock begins to trade regular way 2) equity analysts initiate coverage and 3) various institutional and index funds that have been unable to purchase the stock up until this point (due to restrictions on purchasing company’s in Ch. 11), begin buying in droves. Notably, the return assumption above assumes that upon re-emergence the company trade’s at an incredibly non-demanding multiple of 3.75x EBITDA or, to put it another way, in line with the cheapest automotive suppliers within the industry as a whole. Keep in mind that we think this estimate is very (almost unjustifiably) conservative given that on average Visteon’s peers tend to be considerably more levered, and typically possess both lower EBITDA margins as well as less attractive long-term growth prospects.
http://www.sumzero.com/postings/3190/guest_view
Brief Business Description:
Visteon Corporation is a global Tier 1 supplier of automotive products to original equipment manufacturers (OEM’s). Visteon is a market leader in each of its three core product groups: climate, electronics, and interior systems. Visteon is geographically diversified and is not overly reliant on any one particular OEM. The company’s three largest customers are Ford, Hyundai/Kia, and Nissan/Renault (which make up 29%, 27%, and 9% of the company’s revenues respectively).
Opportunity Overview:
Visteon’s shares are currently trading on a “when issued” basis at roughly 3x 2011 EBITDA, and after backing out the company’s significant ownership in high growth subsidiaries, we believe the core Visteon business trades for roughly 1.5x EBITDA. Given Visteon’s multiple internal and external catalyst’s, highly attractive absolute valuation and the outsized spread between the company’s “when issued” shares and the already depressed valuation’s of its global competitors, we think that the stars are aligning for bargain hunting investors to generate spectacular returns of 30%+ in a short period of time with relatively low risk. Keep in mind that this isn’t “your father’s” Visteon, as the company will exit bankruptcy permanently improved and completely transformed, offering investor’s both a 1) quick, high-return, relatively risk-free arbitrage and/or 2) an inexpensive way to play any upturn in - or at least the stabilization of – global auto sales and economic activity in general.
The idea here is simple. As Visteon exits chapter 11, the near to medium-term upside will likely be driven by a combination of 1) a couple of imminent, high probability catalyst’s that should force the market to assign this company with a much more appropriate valuation on an absolute basis and relative to its peers and 2) various operational and financial enhancements that the company recently undertook while in bankruptcy should continue to yield visible and increasingly positive operating results for the foreseeable future.
Our expectation is that the initial roughly 30%+ will come almost instantaneously (within a month or so) as 1) the stock begins to trade regular way 2) equity analysts initiate coverage and 3) various institutional and index funds that have been unable to purchase the stock up until this point (due to restrictions on purchasing company’s in Ch. 11), begin buying in droves. Notably, the return assumption above assumes that upon re-emergence the company trade’s at an incredibly non-demanding multiple of 3.75x EBITDA or, to put it another way, in line with the cheapest automotive suppliers within the industry as a whole. Keep in mind that we think this estimate is very (almost unjustifiably) conservative given that on average Visteon’s peers tend to be considerably more levered, and typically possess both lower EBITDA margins as well as less attractive long-term growth prospects.
http://www.sumzero.com/postings/3190/guest_view
Monday, October 4, 2010
Arbitrage Spreads
Reuters has excellent website which provides you arbitrage spreads. Based on Seth Klarmans interview, there are a lot more values in spin off's, post BK and merger arbitrage. My quest for learning has only increased. I will continue to post any possible links to these items.
http://www.reuters.com/finance/deals/arbitrageSpreads
http://www.reuters.com/finance/deals/arbitrageSpreads
Excellent write up on Visteon by Average odds investing
Hat tip to mwhitman for doing all the heavy lifting
Thesis:
The Visteon Corporation is a classic post reorg/special situation with a large margin of safety and substantial near-term upside potential.
Brief Business Description:
Visteon Corporation is a global Tier 1 supplier of automotive products to original equipment manufacturers (OEM’s). Visteon is a market leader in each of its three core product groups: climate, electronics, and interior systems. Visteon is geographically diversified and is not overly reliant on any one particular OEM. The company’s three largest customers are Ford, Hyundai/Kia, and Nissan/Renault (which make up 29%, 27%, and 9% of the company’s revenues respectively).
Opportunity Overview:
Visteon’s shares are currently trading on a “when issued” basis at roughly 3x 2011 EBITDA, and after backing out the company’s significant ownership in high growth subsidiaries, we believe the core Visteon business trades for between 1.5x and 1.7x EBITDA. Given Visteon’s multiple internal and external catalyst’s, highly attractive absolute valuation and the outsized spread between the company’s “when issued” shares and the already depressed valuation’s of its global competitors, we think that the stars are aligning for bargain hunting investors to generate spectacular returns of 30%+ in a short period of time with relatively low risk. Keep in mind that this isn’t “your father’s” Visteon, as the company will exit bankruptcy permanently improved and completely transformed, offering investor’s both a 1) quick, high-return, relatively risk-free arbitrage and/or 2) an inexpensive way to play any upturn in – or at least the stabilization of – global auto sales and economic activity in general.
The idea here is simple. As Visteon exits chapter 11, the near to medium-term upside will likely be driven by a combination of 1) a couple of imminent, high probability catalyst’s that should force the market to assign this company with a much more appropriate valuation on an absolute basis and relative to its peers and 2) various operational and financial enhancements that the company recently undertook while in bankruptcy should continue to yield visible and increasingly positive operating results for the foreseeable future.
Our expectation is that the initial roughly 30%+ will come almost instantaneously (within a month or so) as 1) the stock begins to trade regular way 2) equity analysts initiate coverage and 3) various institutional and index funds that have been unable to purchase the stock up until this point (due to restrictions on purchasing company’s in Ch. 11), begin buying in droves. Notably, the return assumption above assumes that upon re-emergence the company trade’s at an incredibly non-demanding multiple of 3.75x EBITDA or, to put it another way, in line with the cheapest automotive suppliers within the industry as a whole. Keep in mind that we think this estimate is very (almost unjustifiably) conservative given that on average Visteon’s peers tend to be considerably more levered, and typically possess both lower EBITDA margins as well as less attractive long-term growth prospects.
http://aboveaverageodds.wordpress.com/2010/09/24/investment-analysis-the-visteon-corporation-vstnq/
Thesis:
The Visteon Corporation is a classic post reorg/special situation with a large margin of safety and substantial near-term upside potential.
Brief Business Description:
Visteon Corporation is a global Tier 1 supplier of automotive products to original equipment manufacturers (OEM’s). Visteon is a market leader in each of its three core product groups: climate, electronics, and interior systems. Visteon is geographically diversified and is not overly reliant on any one particular OEM. The company’s three largest customers are Ford, Hyundai/Kia, and Nissan/Renault (which make up 29%, 27%, and 9% of the company’s revenues respectively).
Opportunity Overview:
Visteon’s shares are currently trading on a “when issued” basis at roughly 3x 2011 EBITDA, and after backing out the company’s significant ownership in high growth subsidiaries, we believe the core Visteon business trades for between 1.5x and 1.7x EBITDA. Given Visteon’s multiple internal and external catalyst’s, highly attractive absolute valuation and the outsized spread between the company’s “when issued” shares and the already depressed valuation’s of its global competitors, we think that the stars are aligning for bargain hunting investors to generate spectacular returns of 30%+ in a short period of time with relatively low risk. Keep in mind that this isn’t “your father’s” Visteon, as the company will exit bankruptcy permanently improved and completely transformed, offering investor’s both a 1) quick, high-return, relatively risk-free arbitrage and/or 2) an inexpensive way to play any upturn in – or at least the stabilization of – global auto sales and economic activity in general.
The idea here is simple. As Visteon exits chapter 11, the near to medium-term upside will likely be driven by a combination of 1) a couple of imminent, high probability catalyst’s that should force the market to assign this company with a much more appropriate valuation on an absolute basis and relative to its peers and 2) various operational and financial enhancements that the company recently undertook while in bankruptcy should continue to yield visible and increasingly positive operating results for the foreseeable future.
Our expectation is that the initial roughly 30%+ will come almost instantaneously (within a month or so) as 1) the stock begins to trade regular way 2) equity analysts initiate coverage and 3) various institutional and index funds that have been unable to purchase the stock up until this point (due to restrictions on purchasing company’s in Ch. 11), begin buying in droves. Notably, the return assumption above assumes that upon re-emergence the company trade’s at an incredibly non-demanding multiple of 3.75x EBITDA or, to put it another way, in line with the cheapest automotive suppliers within the industry as a whole. Keep in mind that we think this estimate is very (almost unjustifiably) conservative given that on average Visteon’s peers tend to be considerably more levered, and typically possess both lower EBITDA margins as well as less attractive long-term growth prospects.
http://aboveaverageodds.wordpress.com/2010/09/24/investment-analysis-the-visteon-corporation-vstnq/
Sunday, October 3, 2010
Insights from Mohnish Pabrai's annual meeting
Pabrai Funds Annual Meeting
Chicago Illinois
September 25th 2010
Prepared Comments:
The meeting started with an overview of how the fund has performed. Since the fund was started in 2001, it has returned 15.1% annually compared to -1.5% for the S&P 500.
$100,000 invested in the fund in June of 2000 would be $408,000 today.
Mohnish’s goal is to beat the index by 3% annually.
This past summer 3 interns worked part time on the checklist 2.0. They identified mistakes by great investors that resulted in a permanent loss of capital and analyzed why the mistakes occurred. They looked for commentary by the fund managers on these mistakes. They found that these investors almost never discussed their mistakes.
The biggest mistake was an investment in AIG by the Davis Fund which resulted in a $2 billion loss for the fund.
Mohnish said that the checklist is a great weapon in the Pabrai Funds arsenal.
Mohnish then went through one winner and one loser in the portfolio.
The worst investment during the period was Ternium which was actually sold at a small gain.
The winner he discussed was Teck cominco. This is the best investment the fund has ever made. The Pabrai Funds made an 8x return in only 3 months. Mohnish invested because they have some of the lowest cost mines in the world. The reason they were so cheap was because of a liquidity mismatch on the balance sheet. It had a large amount of debt coming due in a year. Mohnish felt that if they weren’t able to refinance the debt that they could sell assets piecemeal because of their highly diversified operations. In the worse case, the company would be worth a lot even in reorganizations because its book value was so high.
Question and Answer:
How Long did you follow Teck Cominco before buying?
Mohnish said he spent less than 5 days researching Teck because there were so many bargains at this time. Teck had a very solid moat because it was the lowest cost producer. To find Teck he looked at industry cost curves and paid attention to the lowest cost producers. The most important question to figure out was the liquidity mismatch.
Thoughts on Fairfax?
He doesn’t discuss current holdings.
Why don’t you discuss current holdings?
If investors get in the habit of discussing their investments they may end up suffering from commitment bias. If they constantly talk about how great a company is, they may suffer from a bias that could impair their judgment.
What are your views on position sizing?
His allocation policy changed in 2008 to reflect slightly elevated investment risks of his investment baskets and prior mistakes. If he has 10% positions it’s very hard to recover from a mistake. He discussed his new allocation framework with Charlie Munger who disagreed at first. After Mohnish explained it further, Charlie agreed that Berkshire Hathaway has achieved success with a more diversified portfolio. Mohnish talked about basket bets. When the risk is slightly elevated he will buy a basket of companies with small weightings. For example, he said he is currently researching companies in Japan. If he ends up buying companies there, he will buy a basket of companies each with small weightings in the portfolio. He said stocks there are very cheap.
Please read the rest here. Thanks Guru Focus
http://www.gurufocus.com/news.php?id=108213
Chicago Illinois
September 25th 2010
Prepared Comments:
The meeting started with an overview of how the fund has performed. Since the fund was started in 2001, it has returned 15.1% annually compared to -1.5% for the S&P 500.
$100,000 invested in the fund in June of 2000 would be $408,000 today.
Mohnish’s goal is to beat the index by 3% annually.
This past summer 3 interns worked part time on the checklist 2.0. They identified mistakes by great investors that resulted in a permanent loss of capital and analyzed why the mistakes occurred. They looked for commentary by the fund managers on these mistakes. They found that these investors almost never discussed their mistakes.
The biggest mistake was an investment in AIG by the Davis Fund which resulted in a $2 billion loss for the fund.
Mohnish said that the checklist is a great weapon in the Pabrai Funds arsenal.
Mohnish then went through one winner and one loser in the portfolio.
The worst investment during the period was Ternium which was actually sold at a small gain.
The winner he discussed was Teck cominco. This is the best investment the fund has ever made. The Pabrai Funds made an 8x return in only 3 months. Mohnish invested because they have some of the lowest cost mines in the world. The reason they were so cheap was because of a liquidity mismatch on the balance sheet. It had a large amount of debt coming due in a year. Mohnish felt that if they weren’t able to refinance the debt that they could sell assets piecemeal because of their highly diversified operations. In the worse case, the company would be worth a lot even in reorganizations because its book value was so high.
Question and Answer:
How Long did you follow Teck Cominco before buying?
Mohnish said he spent less than 5 days researching Teck because there were so many bargains at this time. Teck had a very solid moat because it was the lowest cost producer. To find Teck he looked at industry cost curves and paid attention to the lowest cost producers. The most important question to figure out was the liquidity mismatch.
Thoughts on Fairfax?
He doesn’t discuss current holdings.
Why don’t you discuss current holdings?
If investors get in the habit of discussing their investments they may end up suffering from commitment bias. If they constantly talk about how great a company is, they may suffer from a bias that could impair their judgment.
What are your views on position sizing?
His allocation policy changed in 2008 to reflect slightly elevated investment risks of his investment baskets and prior mistakes. If he has 10% positions it’s very hard to recover from a mistake. He discussed his new allocation framework with Charlie Munger who disagreed at first. After Mohnish explained it further, Charlie agreed that Berkshire Hathaway has achieved success with a more diversified portfolio. Mohnish talked about basket bets. When the risk is slightly elevated he will buy a basket of companies with small weightings. For example, he said he is currently researching companies in Japan. If he ends up buying companies there, he will buy a basket of companies each with small weightings in the portfolio. He said stocks there are very cheap.
Please read the rest here. Thanks Guru Focus
http://www.gurufocus.com/news.php?id=108213
Saturday, October 2, 2010
Thursday, September 30, 2010
Recent pick Analysis
One of my friends recommended me to start writing detailed analysis on my picks so that one understand my thought process. Here is the analysis of a recent pick
Nobody likes discretionary income retailers these days in this tough economy. How much would you pay for a company that does online retailing who earns close to $30MM EBITDA and $25MM free cash flow? I would say 7 times EBITDA on a conservative basis which is $210MM. Here is a simple stat for conservativeness – At the end of Aug, the average digital ecommerce retailer is traded at 17.3X times EBITDA
If I say that this is a market leader in that category, One of the major three major players, taking market share from others with strong brand/moat (good share of mind) , has very low cap-ex requirement compared to other retailers, how much would you pay conservatively pay? 10-12 times EBITDA -$300- $360MM.
The best part is they made $58MM EBIDTA when the economy was doing well with bloated expense line. Even if the economy picks up slightly they could make $40MM conservatively. With a 10 multiple they could easily be $400MM market cap. Additionally they have launched another category and this could exceed the major category in next few years, could potentially launch new products using this great platform
Will this be a deal if this whole company is selling for less than $120MM and an enterprise value of close to $155MM, 5xEBITDA? I am talking about 1-800-Flowers. 1-800-Flowers is the leading flower gift shop. This provides flowers, plants, gift baskets, gourmet foods, confections, balloons and plush animals perfect for every occasion. It offers best of both worlds - exquisite arrangements from top floral artists and hand delivered same day and flowers shipped overnight from its Fresh Growers collection. It also has another line of business Bloomnet - international floral service which provides a broad range of quality products and value added services designed to help professional florists grow their business profitably.
"Gift Shop" also includes gourmet gifts such as popcorn and specialty treats from the Popcorn Factory; cookies and baked gifts from Cheryl Co; premium chocolates and confections from Fannie May(r) confections brands and Harry London; wine gifts from Ambrosia(r) and Geerlings&WadeSM; gift baskets from 1-800-BASKETS.CO M(r) (www.1800baskets.com) and DesignPac(r) gifts as well as Celebrations(r) (www.celebrations.com), a new premier online destination for fabulous party ideas and planning tips
The company grew its revenue from $498.4MM to $668.0MM from FY05 to FY10. The revenues are divided by consumer floral (54%), Gourmet Food and Gift Baskets (36%), BloomNet Wire Service (9%).
Historically management has made some bad decisions but they are getting their act together in the last two years. They divested noncore business and paid off $70MM of debt in the last two years. It still has $45MM in long term debt. It has recently launched 1-800-BASKETS, which is picking up lot of pace. It has also reduced its operating expenses by $50MM. Reduced salaries by 15%, Consolidated its IT infrastructure, moved to Virtualized customer platform. This company is not perfect. It takes bonuses based on its EBITDA, not the metric I like to take it on. It took a good will charge of $85MM in 2009 which implies historically made bad acquisitions. This year, management was granted 257,500 options at a strike price of $3.5.
Very few times Mr. Market will provide a market leader with a decent moat, which has a potential to expand, launch new categories with low capex selling at cigarbutt price. Can you imagine how tough for someone to start something like 1-800-Flowers. How much capital one needs to spend on branding to get the share of the mind. Can you provide value to these intangibles? Look beyond the numbers. 50% of the customers are repeat customers and they attract more 9MM customers per year. How many businesses have this kind of stickiness?
Do you think one of the competitors like FTD or Tele Flora would like to buy this at 10-15 times EBITDA? I am sure they would love to. Not the least we have couple of value investors who could put them on the line if necessary which include Royce & Associates, Tocqueville Asset Mgmt.
To statistically minded friends, here are some numbers
Revenues ($MM)
2005 - 498.4
2006 - 584.8
2007 - 725.7
2008 - 739.2
2009 - 714
2010 - 668
Adjusted EBITDA ($MM)
2005 - 21.7
2006 - 18.1
2007 - 57.2
2008 - 57.1
2009 - 36.5
2010 - 29
Nobody likes discretionary income retailers these days in this tough economy. How much would you pay for a company that does online retailing who earns close to $30MM EBITDA and $25MM free cash flow? I would say 7 times EBITDA on a conservative basis which is $210MM. Here is a simple stat for conservativeness – At the end of Aug, the average digital ecommerce retailer is traded at 17.3X times EBITDA
If I say that this is a market leader in that category, One of the major three major players, taking market share from others with strong brand/moat (good share of mind) , has very low cap-ex requirement compared to other retailers, how much would you pay conservatively pay? 10-12 times EBITDA -$300- $360MM.
The best part is they made $58MM EBIDTA when the economy was doing well with bloated expense line. Even if the economy picks up slightly they could make $40MM conservatively. With a 10 multiple they could easily be $400MM market cap. Additionally they have launched another category and this could exceed the major category in next few years, could potentially launch new products using this great platform
Will this be a deal if this whole company is selling for less than $120MM and an enterprise value of close to $155MM, 5xEBITDA? I am talking about 1-800-Flowers. 1-800-Flowers is the leading flower gift shop. This provides flowers, plants, gift baskets, gourmet foods, confections, balloons and plush animals perfect for every occasion. It offers best of both worlds - exquisite arrangements from top floral artists and hand delivered same day and flowers shipped overnight from its Fresh Growers collection. It also has another line of business Bloomnet - international floral service which provides a broad range of quality products and value added services designed to help professional florists grow their business profitably.
"Gift Shop" also includes gourmet gifts such as popcorn and specialty treats from the Popcorn Factory; cookies and baked gifts from Cheryl Co; premium chocolates and confections from Fannie May(r) confections brands and Harry London; wine gifts from Ambrosia(r) and Geerlings&WadeSM; gift baskets from 1-800-BASKETS.CO M(r) (www.1800baskets.com) and DesignPac(r) gifts as well as Celebrations(r) (www.celebrations.com), a new premier online destination for fabulous party ideas and planning tips
The company grew its revenue from $498.4MM to $668.0MM from FY05 to FY10. The revenues are divided by consumer floral (54%), Gourmet Food and Gift Baskets (36%), BloomNet Wire Service (9%).
Historically management has made some bad decisions but they are getting their act together in the last two years. They divested noncore business and paid off $70MM of debt in the last two years. It still has $45MM in long term debt. It has recently launched 1-800-BASKETS, which is picking up lot of pace. It has also reduced its operating expenses by $50MM. Reduced salaries by 15%, Consolidated its IT infrastructure, moved to Virtualized customer platform. This company is not perfect. It takes bonuses based on its EBITDA, not the metric I like to take it on. It took a good will charge of $85MM in 2009 which implies historically made bad acquisitions. This year, management was granted 257,500 options at a strike price of $3.5.
Very few times Mr. Market will provide a market leader with a decent moat, which has a potential to expand, launch new categories with low capex selling at cigarbutt price. Can you imagine how tough for someone to start something like 1-800-Flowers. How much capital one needs to spend on branding to get the share of the mind. Can you provide value to these intangibles? Look beyond the numbers. 50% of the customers are repeat customers and they attract more 9MM customers per year. How many businesses have this kind of stickiness?
Do you think one of the competitors like FTD or Tele Flora would like to buy this at 10-15 times EBITDA? I am sure they would love to. Not the least we have couple of value investors who could put them on the line if necessary which include Royce & Associates, Tocqueville Asset Mgmt.
To statistically minded friends, here are some numbers
Revenues ($MM)
2005 - 498.4
2006 - 584.8
2007 - 725.7
2008 - 739.2
2009 - 714
2010 - 668
Adjusted EBITDA ($MM)
2005 - 21.7
2006 - 18.1
2007 - 57.2
2008 - 57.1
2009 - 36.5
2010 - 29
Monday, September 27, 2010
Bought FLWS @1.85
1-800-FLOWERS.COM, Inc. (1-800-FLOWERS.COM) is engaged in providing flowers and plants, gift baskets, gourmet foods, confections, balloons and plush stuffed animals. Its BloomNet (www.mybloomnet.net) international floral wire service provides a range of products and value-added services designed to help professional florists. The 1-800-FLOWERS.COM, Inc. Gift Shop also includes gourmet gifts, such as popcorn and specialty treats from The Popcorn Factory (www.thepopcornfactory.com); cookies and baked gifts from Cheryl&Co. (www.cherylandco.com); chocolates and confections from Fannie May Confections Brands (www.fanniemay.com and www.harrylondon.com); gourmet foods from Greatfood.com (www.greatfood.com); wine gifts from Ambrosia (www.ambrosia.com or www.winetasting.com or www.Geerwade.com), and DesignPac Gifts (www.designpac.com). In January 2010, the Company announced that it has completed the sale of its Home and Children's Gifts business to PH International, LLC.
Negative: What can go wrong on this stock
- Double dip will drop the stock prices by 50%. This is not an essential commodity
- Slightly higher debt than a typical
- History of bad acquisitions and bad corporate management
Positive:
- Valuation: Cheap, Industry leader selling for less than 5 times depressed EBITDA.
- Paid of $60MM debt in last two years
- Started 1-800-baskets
Purchase Price: $1.85
Fair Value: $3.50
Negative: What can go wrong on this stock
- Double dip will drop the stock prices by 50%. This is not an essential commodity
- Slightly higher debt than a typical
- History of bad acquisitions and bad corporate management
Positive:
- Valuation: Cheap, Industry leader selling for less than 5 times depressed EBITDA.
- Paid of $60MM debt in last two years
- Started 1-800-baskets
Purchase Price: $1.85
Fair Value: $3.50
Saturday, September 25, 2010
Thursday, September 23, 2010
Sold DLIA
Sold DLIA for 2.10. Not bad for a 30% annualized return. The reason why I sold DLIA is it could become a value trap. It continues to bleed and the only end game for this is some one else to buy. The more I read about retail industry, the more it is clearer that it is very tough to invest in this with chaning fashions.
Saturday, June 12, 2010
Fascinating video about Quants
This is a fascinating video of Quants. Why should we bother about quants. We all know that every model is based on historic data. We also know historic data does not capture every possible scenario. This will only provide more opportunities for people like us where we are patient and take opportunities when they come by
Tuesday, June 8, 2010
Charlie Munger - Nuggets of wisdom
Sorry for no updates in the last few months. Been pretty busy as wrote CFA level II test. Here are some words of wisdom from Charlie in the latest Wesco meeting. It is a must read. Thanks inoculated investor.
Charlie Munger: The plan is to follow the procedure from last year and then talk about interesting issues.
Regarding his general observations, he is flabbergasted that so many people came to Pasadena after going
to Omaha. He thought we would have had our fill of his opinions but apparently there are “addicts” out
there. Wesco is a quiet enterprise. It has a $2B market cap, up from $20M at the time they started buying
back stock. That is a failure in comparison to Berkshire Hathaway (BRK), but compared to other
companies it looks alright.
Read the rest here
Charlie Munger: The plan is to follow the procedure from last year and then talk about interesting issues.
Regarding his general observations, he is flabbergasted that so many people came to Pasadena after going
to Omaha. He thought we would have had our fill of his opinions but apparently there are “addicts” out
there. Wesco is a quiet enterprise. It has a $2B market cap, up from $20M at the time they started buying
back stock. That is a failure in comparison to Berkshire Hathaway (BRK), but compared to other
companies it looks alright.
Read the rest here
Saturday, May 1, 2010
Wednesday, April 28, 2010
Monday, April 26, 2010
Friday, April 16, 2010
Excellent interview with Mohnish Pabrai
As you know I am a huge fan of Mohnish. I have started using check list and ultimately I think this will really help me in the long run. http://www.forbes.com/2010/04/09/pabrai-leisure-china-intelligent-investing-technology_print.html. There is no shame in copying from the best
Monday, April 5, 2010
Old Article by Mike Burry - Excellent analysis
Here is an old article of Mike Burry. you can clearly see the excellent analysis he provides. I plan to learn a few things from him. After June, I will start providing a little detailed analysis on my picks.
Strategy lab article by Mike Burry
Strategy lab article by Mike Burry
Sunday, April 4, 2010
Saturday, April 3, 2010
This week news roundup - 10/03 - 10/10
1. Business world has an excellent article about the dish network in India. What is so interesting is these folks are spending crores of rupees. Some one is going to lose their shirt. Just imagine, what will happen to cable and dish network companies where their additional capex is supposed to break even after 5 -10 yrs. They also assume that they are going concern. Behind the numbers.
2. Can you believe the telecom companies in India are consuming so much diesel.
3. Trying to be next Amazon in India.
4. How a little know company made it to No.3 in mobile sets in India
5. Just imagine, how apple could if it would penetrate into India with lower cost phone. Nokia has 60% marketshare in India
2. Can you believe the telecom companies in India are consuming so much diesel.
3. Trying to be next Amazon in India.
4. How a little know company made it to No.3 in mobile sets in India
5. Just imagine, how apple could if it would penetrate into India with lower cost phone. Nokia has 60% marketshare in India
Monday, March 29, 2010
Delia - Unfit Managment robbing shareholders
I recently bought the cheap stock Delias (Dlia). It is typically graham selling less than the liquidation value. It is never a good feeling when the stock drops 20% (10% from the time I bought). I have seen 50% drops before and made more than 3000% in tstocks like GGP. This bothers me. This company historically never made money. Looks like I will be happy only two times like what warren buffett said, the time I bought the stock and the time I sold this stock.
The company had lofty goals of improving gross margins by 50 bps points. In 2006 - 39%, 2007 - 36%, 2008 - 35.7%, 2008 - 35%
Operating expenses - 2006 - 43.7%, 2007 - 45.2%, 2008 - 44.3%, 2009 - 42.4%
I also saw something funny in cash flow statement. It says Prepaid catalog costs of $6.8MM. Did they already spend this or postponing the expense?
It looks like they spend around $25MM - $30MM on catalogs. I am not sure how much of these catalogs are driving the internet sales.
All the senior executives have atleast $3MM compensation and $1MM options. This is outragious when they are losing money and not making a single cent. Almost 5% of the market cap.
Is their retail stores a profitable business at all?
Technically if they expand more stores, the operating expenses as a percentage should decrease. But it is pretty flat in the last 4 years, how are they going to make a profit? They are still expanding. Very interesting. Is this worth more than dead by selling and liquidating. Ofcourse they have off balance items for $113MM. Even though I recently bought this position, I don't know how they are going to make money. They need to find another buyer like Footlocker and sell this for $100MM as they sold CCS for $100MM.
Here are few things Delias mgmt should do
- Cut Mgmt salaries by 50% until they make profit. I am ok with giving more options as long as the strike price is more than $3.5.
- All senior managemnt should buy atleast $4.0MM of stock to have more skin in the game. With out proper incentives and skin in the game, it is tough for share holders to trust them. As they put in more money, they should get more options at higher strike price.
- Reduce operating expenses and bring it close to 33%-35% from 43% typical to other retailers. you are not a start up company. you already have close to 100 retail stores.
- Reduce catalog expenses. I cannot comment a whole lot on this as I cannot see how much of the direct sales are driven by catalogs. But the expenses are pretty high though - almost $30MM
- Do not renew any of the leases ($15MM), unless they are performing stores. Better to close rather than having unprofitable stores. Renegotiate all the leases even though they are not expiring. In this market all the retailers are renegotiating their expenses
- Improve gross margins by atleast 2%. If you think, you cannot raise the prices then you should ask all the supplier to cut the rates by 3%-5%
- Reduce overhead expenses, travelling expenses and any other fancy expenses
- It is better to have lower revenue and profitable rather than higher revenue and unprofitable
- If you cannot do any of these, find another foot locker and sell this for atleast $150MM - $200MM. 1 times the sales.
- Since the brand is valuable, why not find other deals where they can lease their brand name
I had high hopes from both Royce and Tilson. Both of them own close to 25% of the company and so far they have disappointed me. We need Dan Loeb, third point management who has guts to call a spade a "spade".
Since I am trying to be more patient with my stocks after learning from Chris Browne and Walter Schloss. I will give this atleast a year for this to turn around unless I find other values.
The company had lofty goals of improving gross margins by 50 bps points. In 2006 - 39%, 2007 - 36%, 2008 - 35.7%, 2008 - 35%
Operating expenses - 2006 - 43.7%, 2007 - 45.2%, 2008 - 44.3%, 2009 - 42.4%
I also saw something funny in cash flow statement. It says Prepaid catalog costs of $6.8MM. Did they already spend this or postponing the expense?
It looks like they spend around $25MM - $30MM on catalogs. I am not sure how much of these catalogs are driving the internet sales.
All the senior executives have atleast $3MM compensation and $1MM options. This is outragious when they are losing money and not making a single cent. Almost 5% of the market cap.
Is their retail stores a profitable business at all?
Technically if they expand more stores, the operating expenses as a percentage should decrease. But it is pretty flat in the last 4 years, how are they going to make a profit? They are still expanding. Very interesting. Is this worth more than dead by selling and liquidating. Ofcourse they have off balance items for $113MM. Even though I recently bought this position, I don't know how they are going to make money. They need to find another buyer like Footlocker and sell this for $100MM as they sold CCS for $100MM.
Here are few things Delias mgmt should do
- Cut Mgmt salaries by 50% until they make profit. I am ok with giving more options as long as the strike price is more than $3.5.
- All senior managemnt should buy atleast $4.0MM of stock to have more skin in the game. With out proper incentives and skin in the game, it is tough for share holders to trust them. As they put in more money, they should get more options at higher strike price.
- Reduce operating expenses and bring it close to 33%-35% from 43% typical to other retailers. you are not a start up company. you already have close to 100 retail stores.
- Reduce catalog expenses. I cannot comment a whole lot on this as I cannot see how much of the direct sales are driven by catalogs. But the expenses are pretty high though - almost $30MM
- Do not renew any of the leases ($15MM), unless they are performing stores. Better to close rather than having unprofitable stores. Renegotiate all the leases even though they are not expiring. In this market all the retailers are renegotiating their expenses
- Improve gross margins by atleast 2%. If you think, you cannot raise the prices then you should ask all the supplier to cut the rates by 3%-5%
- Reduce overhead expenses, travelling expenses and any other fancy expenses
- It is better to have lower revenue and profitable rather than higher revenue and unprofitable
- If you cannot do any of these, find another foot locker and sell this for atleast $150MM - $200MM. 1 times the sales.
- Since the brand is valuable, why not find other deals where they can lease their brand name
I had high hopes from both Royce and Tilson. Both of them own close to 25% of the company and so far they have disappointed me. We need Dan Loeb, third point management who has guts to call a spade a "spade".
Since I am trying to be more patient with my stocks after learning from Chris Browne and Walter Schloss. I will give this atleast a year for this to turn around unless I find other values.
Sunday, March 28, 2010
Learning from Michael Burry - Excellent post
Here is an excellent post from Street Capitalist.
I spent more than 10 hours reading this Silicon Investor but Street Capitalist did a good job of taking notes.
http://streetcapitalist.com/2010/03/24/learning-from-michael-burry/
I spent more than 10 hours reading this Silicon Investor but Street Capitalist did a good job of taking notes.
http://streetcapitalist.com/2010/03/24/learning-from-michael-burry/
Sunday, March 21, 2010
This week round up
1. Confessions of value investor - Must read by Mr.Bakshi. It takes 15 minutes to download but enjoyed every slide but worth's the effort.. This provides the intelligence equivalent to 1 level of CFA.
2. Good Article from Tip Blog - http://www.tipblog.in/life/conversation-my-first-hour-with-an-ex-collegue/.
I read this article and I cannot imagine after spending 10-15 yrs and you finally say, I am flat and my returns are zero. Obviously it is better than losing but still a sinking feeling.
2. Good Article from Tip Blog - http://www.tipblog.in/life/conversation-my-first-hour-with-an-ex-collegue/.
I read this article and I cannot imagine after spending 10-15 yrs and you finally say, I am flat and my returns are zero. Obviously it is better than losing but still a sinking feeling.
Saturday, March 13, 2010
Warren Buffet 3 hrs on CNBC
When ever we read Warren Buffet, he can summarize what he has learned in years and the summary of more than 5000 annual reports. Always good to learn
Ask Warren Buffett - Complete CNBC Squawk Box Transcript - 2010-03-01
Ask Warren Buffett - Complete CNBC Squawk Box Transcript - 2010-03-01
Saturday, March 6, 2010
This week I picked some CHCG, PARL, DLIA
I will starting posting some of my picks. This week I have picked three cigar butts. Currently these are not doing well. That's why they are cheap. We are hoping that some day thing will turn around hopefully in the next three years.
CHCG - China 3C group:
Profile: The Company is engaged in the business of the resale and distribution of mobile phones, facsimile machines, DVD players, stereos, speakers, MP3 and MP4 players, iPods, electronic dictionaries, CD players, radios, Walkmans, and audio systems. We sell and distribute these products through retail stores and secondary distributors.
Market Cap: $30MM
Cash: $28MM
Working Cap: $55MM
Total Debt: Zero
P/B: 0.3
P/S: 0.1
P/CF: 2.0
PARL - Parlux Fragrances designs and manufactures fragrances and beauty-related products such as lotions, creams, shower gels, deodorants, and soaps. The company offers its products through specialty stores, department stores, mass merchandisers, and pharmacies. Holding licenses to do so, the company manufactures Guess, Paris Hilton, Maria Sharapova, XOXO and Ocean Pacific products. In addition, Parlux offers watches, handbags, and a variety of small leather items under the Paris Hilton brand name.
Market Cap: $35MM
P/B: 0.3
P/S: 0.2
P/C: 24
Cash: $11MM
Working Cap: $95MM
We need to be carefull as the working capital might not be worth much. Remember they make perfumes. They got a new CEO and his options strike price is $5.00. I like that
DLIA:
Delias engages in the direct marketing and selling of its clothing line. Intended for a target market between ages 12 and 19 Delia sells its apparel and accessory products through the Internet, catalogs, and retail stores. It also owns two subsidiaries called Alloy and CCS. Alloy targets the youth junior apparel market and CSS offers snowboarding apparel and accessories. The company currently operates over 60 stores in over 20 twenty states.
Market Cap: $62MM
P/B: 0.6
P/S: 0.3
P/CF: NA
Working Cap: $33MM.
The reason why I bought this, historically they did not make money due to high capital expenditures. Tilson has taken a position on this fund. I am hoping Tilson will make sure that the management behaves in a share holder interest. Let's see what happens. I always like value funds taking positions in my pick as they have the clout to make management behave in a certain manner.
CHCG - China 3C group:
Profile: The Company is engaged in the business of the resale and distribution of mobile phones, facsimile machines, DVD players, stereos, speakers, MP3 and MP4 players, iPods, electronic dictionaries, CD players, radios, Walkmans, and audio systems. We sell and distribute these products through retail stores and secondary distributors.
Market Cap: $30MM
Cash: $28MM
Working Cap: $55MM
Total Debt: Zero
P/B: 0.3
P/S: 0.1
P/CF: 2.0
PARL - Parlux Fragrances designs and manufactures fragrances and beauty-related products such as lotions, creams, shower gels, deodorants, and soaps. The company offers its products through specialty stores, department stores, mass merchandisers, and pharmacies. Holding licenses to do so, the company manufactures Guess, Paris Hilton, Maria Sharapova, XOXO and Ocean Pacific products. In addition, Parlux offers watches, handbags, and a variety of small leather items under the Paris Hilton brand name.
Market Cap: $35MM
P/B: 0.3
P/S: 0.2
P/C: 24
Cash: $11MM
Working Cap: $95MM
We need to be carefull as the working capital might not be worth much. Remember they make perfumes. They got a new CEO and his options strike price is $5.00. I like that
DLIA:
Delias engages in the direct marketing and selling of its clothing line. Intended for a target market between ages 12 and 19 Delia sells its apparel and accessory products through the Internet, catalogs, and retail stores. It also owns two subsidiaries called Alloy and CCS. Alloy targets the youth junior apparel market and CSS offers snowboarding apparel and accessories. The company currently operates over 60 stores in over 20 twenty states.
Market Cap: $62MM
P/B: 0.6
P/S: 0.3
P/CF: NA
Working Cap: $33MM.
The reason why I bought this, historically they did not make money due to high capital expenditures. Tilson has taken a position on this fund. I am hoping Tilson will make sure that the management behaves in a share holder interest. Let's see what happens. I always like value funds taking positions in my pick as they have the clout to make management behave in a certain manner.
Friday, March 5, 2010
20 lessons from Seth Klarman from 2008
Thanks Value Investor Insight / Seth Klarman
Twenty Investment Lessons of 2008
1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
Twenty Investment Lessons of 2008
1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
Thursday, March 4, 2010
Great Article about Dr.Mike Burry
Thanks to Vanity Fair
http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004?printable=true¤tPage=8
Go BackPrint this page
Excerpt
Betting on the Blind Side
Michael Burry always saw the world differently—due, he believed, to the childhood loss of one eye. So when the 32-year-old investor spotted the huge bubble in the subprime-mortgage bond market, in 2004, then created a way to bet against it, he wasn’t surprised that no one understood what he was doing. In an excerpt from his new book, The Big Short, the author charts Burry’s oddball maneuvers, his almost comical dealings with Goldman Sachs and other banks as the market collapsed, and the true reason for his visionary obsession.
By Michael Lewis• Photograph by Jonas Fredwall Karlsson
April 2010
Dr. Michael Burry in his home office, in Silicon Valley. “My nature is not to have friends,” Burry concluded years ago. “I’m happy in my own head.”
Excerpted from The Big Short: Inside the Doomsday Machine, by Michael Lewis, to be published this month by W. W. Norton; © 2010 by the author.
http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004?printable=true¤tPage=8
Go BackPrint this page
Excerpt
Betting on the Blind Side
Michael Burry always saw the world differently—due, he believed, to the childhood loss of one eye. So when the 32-year-old investor spotted the huge bubble in the subprime-mortgage bond market, in 2004, then created a way to bet against it, he wasn’t surprised that no one understood what he was doing. In an excerpt from his new book, The Big Short, the author charts Burry’s oddball maneuvers, his almost comical dealings with Goldman Sachs and other banks as the market collapsed, and the true reason for his visionary obsession.
By Michael Lewis• Photograph by Jonas Fredwall Karlsson
April 2010
Dr. Michael Burry in his home office, in Silicon Valley. “My nature is not to have friends,” Burry concluded years ago. “I’m happy in my own head.”
Excerpted from The Big Short: Inside the Doomsday Machine, by Michael Lewis, to be published this month by W. W. Norton; © 2010 by the author.
Monday, February 8, 2010
My top 10 articles this week 2/8 - 2/15
I will keep adding the best articles I find this week in various blogs
1. Benjamin Graham six articles from Valuehuntr blog
2. http://toddsattersten.com/2010/02/fixed-to-flexible---the-ebook.html
3. Interesting Article on Sovreign Debt
4.
1. Benjamin Graham six articles from Valuehuntr blog
2. http://toddsattersten.com/2010/02/fixed-to-flexible---the-ebook.html
3. Interesting Article on Sovreign Debt
4.
Saturday, February 6, 2010
Excellent presentation from Ackmann on Kraft- looks like a deal
This is an excellent return for US stocks where we can get 15% in the next three years. Thanks my little investing note book. The more I read this blog, the more I like it. This provides more details about margins for various food segments in various categories.
http://myinvestingnotebook.blogspot.com/2010/02/ackmans-presentation-on-kraft.html?utm_source=feedburner&utm_medium=twitter&utm_campaign=Feed%3A+MyInvestingNotebook+%28My+Investing+Notebook%29
http://myinvestingnotebook.blogspot.com/2010/02/ackmans-presentation-on-kraft.html?utm_source=feedburner&utm_medium=twitter&utm_campaign=Feed%3A+MyInvestingNotebook+%28My+Investing+Notebook%29
Thursday, February 4, 2010
Why Micro Technologies (India) is a Sell
Well I started this blog recommending Micro Technologies but after gaining more than 200% in less 8 months,I have asked my friends to sell this stock not because it is not undervalued but due to debt it has taken. It's P/E is closer to 3 and P/B is less than 0.70. In all traditional terms it looks cheap and probably still some value is left.
Recently after reading alot about Walter Schloss, my thought process has changed significantly. I am more aware of the perils of the debt. I am willing to look at companies with debt but only when the cash flows are predictable. This is the biggest lesson I have learned in the last one year.
I also do not like any businesses that raise capital give convertible warrants especially to promoters or friends of promoters. That's why Micro Technologies India is a sell.
Recently after reading alot about Walter Schloss, my thought process has changed significantly. I am more aware of the perils of the debt. I am willing to look at companies with debt but only when the cash flows are predictable. This is the biggest lesson I have learned in the last one year.
I also do not like any businesses that raise capital give convertible warrants especially to promoters or friends of promoters. That's why Micro Technologies India is a sell.
Tuesday, February 2, 2010
Most Amazing video I have seen related to physical world and virtual world
This is the most amazing video I have seen between the interaction of physical world and virtual world.
Sunday, January 31, 2010
Real Estate bubble in China??
If everyone has the same information, it is tough to get the edge. At the same time we need to be continuos learning machines. I am trying to keep an habit of reading Chinese business news once a month. Read this interview from CEO of SOHO china. She thinks there is a real estate bubble in China
http://www.cibmagazine.com.cn/Features/Face_To_Face.asp?id=1190&zhang_xin.html
http://www.cibmagazine.com.cn/Features/Face_To_Face.asp?id=1190&zhang_xin.html
Wednesday, January 27, 2010
Tell Me if I am Wrong - Howard Marks from Oaktree
Here is an excellent Letter from Howard Marks. I am not a Macro guy but we all need to understand the risks of investing. It is tough to quantify the probability of these events. Whether we are investing in India, China or Emerging markets, we all need to understand the current risks in the US market.
The only thing I know is , If we are buying at deep discounts to intrinsic value, we will do fine in the long run
Memo to: Oaktree Clients
From: Howard Marks
Re: Tell Me I’m Wrong
My readers treat me well. They indulge my penchant for dissecting the past, and they send kind
messages of encouragement. To repay their generosity, I’m going to venture into something I
usually avoid: the future of the U.S. economy.
This memo won’t be about the future in general, just the elements I find worrisome. As I see it,
every investor is either predominantly a worrier or predominantly a dreamer. I’ve come clean
many times: I’m a worrier. By saying that, I absolve myself of having to describe the whole
future. I’m going to cover the negatives, starting with the immediate and ending with the
systemic (some of the latter repeats themes from “What Worries Me,” August 28, 2008). For
the other side of the story, I’d suggest you consult the optimists who seem to be in charge of the
markets these days.
The only thing I know is , If we are buying at deep discounts to intrinsic value, we will do fine in the long run
Memo to: Oaktree Clients
From: Howard Marks
Re: Tell Me I’m Wrong
My readers treat me well. They indulge my penchant for dissecting the past, and they send kind
messages of encouragement. To repay their generosity, I’m going to venture into something I
usually avoid: the future of the U.S. economy.
This memo won’t be about the future in general, just the elements I find worrisome. As I see it,
every investor is either predominantly a worrier or predominantly a dreamer. I’ve come clean
many times: I’m a worrier. By saying that, I absolve myself of having to describe the whole
future. I’m going to cover the negatives, starting with the immediate and ending with the
systemic (some of the latter repeats themes from “What Worries Me,” August 28, 2008). For
the other side of the story, I’d suggest you consult the optimists who seem to be in charge of the
markets these days.
Tuesday, January 12, 2010
Read Bruce Greenwald's interview
I agree to some of his comments. I cannot believe that I have the same hedges for my portfolio as he is talking. Recently I bought S&P puts and gold as hedges for blackswan events. I also agree that some of the best values are on franchises.
Interview - Part1
Read Bruce Greenwald's interview - part2
Interview - Part1
Read Bruce Greenwald's interview - part2
Saturday, January 9, 2010
A one in Billion - True inspirational story - Must read
Some times you can really underestimate, the power of hardwork, determination. culture can be a true advantage a company has. Think about replacing L&T in India, it is almost impossible.
Thanks to Rajeev Desai
Anil Naik......CMD of L&T....
Read On:
A. M. Naik is the Chairman and Managing Director of Larsen & Toubro, one of the most popular Indian companies. He was awarded the Padma Bhushan,India's 3rd highest civilian award,on January 26, 2009. Mr. Naik was also the recipient of the prestigious 'Economic Times Awards-Business Leader of the Year' award, for the year 2008[1]. Anil M. Naik joined L&T in 1965 as a junior engineer and shortly became the youngest manager in Larsen & Toubro's history.
After joining L&T as Junior Engineer in 1965, he rose rapidly through its ranks; he became General Manager in 1985, and Vice President (Operations) and Member of the Board in 1989 (in charge of the erstwhile Group II, now bifurcated into E&C and Heavy Engineering). In 1995, he was appointed President (Operations) and in April 1999, he took over as Chief Executive Officer and Managing Director. On December 30, 2003, he was appointed as the Chairman & Managing Director[2]. Naik is also extensively involved in social work and is currently developing the educational institution set up by his father in a region called Kharel, Gujarat.proud to be anaval Mr.Naik has been announced as an awardee of the Padma Bhushan in India on 26 Jan 2009[3]. AM Naik - A rare interview to MoneyLIFE
September 15, 2008 By 2010, we will hopefully come to the take-off point to becoming a true Indian multinational in our sector He came from a family of teachers, but was essentially a kid from a village in south Gujarat who, by his own admission, was poor in English because he used to think in Gujarati and then translate his thoughts. But language was no barrier to Anil Manibhai Naik, 65, in rising to the top slot in Larsen & Toubro, an engineering and construction giant, or putting it on the path to being a multinational entity and creating enormous value for shareholders. He achieved this through sheer hard work and through what he calls “devotion beyond dedication”. He is the first professional to head the blue-chip company set up by two Danish engineers, Henning Holck-Larsen and Soren Kristian Toubro with financial help from the father of NM Desai (another former L&T chairman). As the executive chairman of Larsen & Toubro, Naik has steered the company through some of its most turbulent times. Under him, L&T has recorded probably the most robust performance and the scrip has had the fastest rise in its history. His prime concern now is attracting and retaining talent for L&T, his biggest pride is in being “partners in nation building” and his big regret is that he has been such a workaholic that he did not spend enough time with his family
ML: Would you start by telling us something about your background?
Ricoh India - Still some value left
I liked the way this author thought about this. Even though it is not as compelling at 26 compared to 32 now. Read this article and make your own judgement. Couple of things I liked about this is it is recurring revenue and dependent on Indian Economy. What I don't like it is importing most of the stuff from Japan. China can kill in the long term.
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have raised for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
The above paragraph is from the “letters to the shareholder” in 2005 by Mr Warren Buffet to the shareholders of his holding company Berkshire Hathway.
As an investor, our sole intention is to find a well-run and sensibly-priced business with fine economics …… and stay invested ignoring the gyrations of the market. But if a stock appreciates rapidly to the point where it no longer represents excellent in absolute terms or reasonable value relative to prospective purchases, or if new information comes to light that causes us to revaluate , it may be sold quite quickly. In this respect, I can’t resist the temptation of quoting Mr. Buffet from his “letter to the shareholders – 2003 ”. “…. We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current price, reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our large holdings during the great babble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I ”
Ricoh India Limited (RIL) is one of India’s leading sellers of office automation equipment like copiers, printers and multifunctional devices. It is the subsidiary of Ricoh, Japan, one of the world’s leading players in the office automation industry. The parent company owns 73.9% of the equity of Rs 39.7 crore.
The Indian office automation market is one of the fastest growing in the world and being driven mostly by BFSI sector (banking/financial service/insurance etc). The Industry in all likelihood will continue to grow in foreseeable future.
Ricoh (Japan) used to operate two units in India , Ricoh India and Gestetner India ( manufacturer of duplicating machines). Few years back, Gestetner India was merged into Ricoh India. The duplicating division was closed and all the employees were given VRS. The cost of closure was charged in the accounts of Ricoh India already. The goodwill arised out of merger was written off in the accounts and as on 31.3.09, entire Goodwill amount was already written off in the accounts.
http://www.capitalideasonline.com/articles/index.php?id=3217
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have raised for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
The above paragraph is from the “letters to the shareholder” in 2005 by Mr Warren Buffet to the shareholders of his holding company Berkshire Hathway.
As an investor, our sole intention is to find a well-run and sensibly-priced business with fine economics …… and stay invested ignoring the gyrations of the market. But if a stock appreciates rapidly to the point where it no longer represents excellent in absolute terms or reasonable value relative to prospective purchases, or if new information comes to light that causes us to revaluate , it may be sold quite quickly. In this respect, I can’t resist the temptation of quoting Mr. Buffet from his “letter to the shareholders – 2003 ”. “…. We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current price, reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our large holdings during the great babble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I ”
Ricoh India Limited (RIL) is one of India’s leading sellers of office automation equipment like copiers, printers and multifunctional devices. It is the subsidiary of Ricoh, Japan, one of the world’s leading players in the office automation industry. The parent company owns 73.9% of the equity of Rs 39.7 crore.
The Indian office automation market is one of the fastest growing in the world and being driven mostly by BFSI sector (banking/financial service/insurance etc). The Industry in all likelihood will continue to grow in foreseeable future.
Ricoh (Japan) used to operate two units in India , Ricoh India and Gestetner India ( manufacturer of duplicating machines). Few years back, Gestetner India was merged into Ricoh India. The duplicating division was closed and all the employees were given VRS. The cost of closure was charged in the accounts of Ricoh India already. The goodwill arised out of merger was written off in the accounts and as on 31.3.09, entire Goodwill amount was already written off in the accounts.
http://www.capitalideasonline.com/articles/index.php?id=3217
Bata - In Indian Psyche - some value still left
Whether we believe it or not, Bata is ingrained in indian Psyche. Now the question is whether the latest generation is going to adapt or not. How the competition is going to respond to it. The best thing is they have 235 acres and developing 25 acres with out any initial investment.
I also like these kind of companies because even though there is a global crisis, people still need to buy shoes and chappals. For Indian roads, we walk more and they worn out quickly. Can you belive we sell 1B shoes/chappals per year. It makes sense with 1B people. With 35% of the branded market share and 9% overall, this is a good thing for BATA. There are couple of huge tailwinds with, the percapita income is increasing and the economies of scale and power of branding will improve as they open up more stores. By they way, you should always use the broker report for information gathering but not necesarrrily decide based on their recommendation. I have also seen their turns have improved in the last three years. They are better utilizing their assets, inventory.
I have seen a lot Emerging Funds in US buy technology stocks in India. They forget if some headwinds are there in US, these businesses are getting affected. If they truly want to diversify they should invest in business which depends on the Indian population, percapita and GDP income/growth. Some times these concepts are simple but you only learn these lessons after a few scars
Read the detail report here
http://www.joindre.cmlinks.com/ResearchReport.aspx?Stype=1&Rtype=3&Ntype=5&id=1#
I also like these kind of companies because even though there is a global crisis, people still need to buy shoes and chappals. For Indian roads, we walk more and they worn out quickly. Can you belive we sell 1B shoes/chappals per year. It makes sense with 1B people. With 35% of the branded market share and 9% overall, this is a good thing for BATA. There are couple of huge tailwinds with, the percapita income is increasing and the economies of scale and power of branding will improve as they open up more stores. By they way, you should always use the broker report for information gathering but not necesarrrily decide based on their recommendation. I have also seen their turns have improved in the last three years. They are better utilizing their assets, inventory.
I have seen a lot Emerging Funds in US buy technology stocks in India. They forget if some headwinds are there in US, these businesses are getting affected. If they truly want to diversify they should invest in business which depends on the Indian population, percapita and GDP income/growth. Some times these concepts are simple but you only learn these lessons after a few scars
Read the detail report here
http://www.joindre.cmlinks.com/ResearchReport.aspx?Stype=1&Rtype=3&Ntype=5&id=1#
Poker and Investing
As I am a poker fan and also into investing..Read this fantastic article from David Einhorn. He also talks about ROE which is very important asset heavy companies and not necessarily on asset light companies.
Thanks Value investing Congress and Manual of Ideas
http://manualofideas.com/files/blog/einhornspeech200611.pdf
Transcript of David Einhorn’s Speech
at the Value Investing Congress
Friday, November 10, 2006
When people ask me what I do for a living, I generally tell them “I run a hedge fund.” The majority give me a strange look, so I quickly add, “I am a money manager.” When the strange look persists, as it often does, I correct it to simply, “I’m an investor.” Everyone knows what that is.
When people ask me what I did on my summer vacation, I generally tell them “I played in the World Series of Poker.” Nobody gives me a strange look.
So I am at the World Series of Poker in Las Vegas and it is time for a break between rounds. A fellow comes up to me as says, “I am from CNBC and we’d like to interview you.” I ask, “About poker or investing?” The fellow looks at me like this is the strangest thing anyone has asked him in a long time; I realize he obviously picked me out due to my large chip stack or, according to my wife, due to my great looks. “About poker” he says as nicely as he can.
Today, I will discuss both. But for this group, who I bet all know what a hedge fund is, I will mostly discuss investing. Investing and poker require similar skills.
Different people approach poker different ways. Loose aggressive types play lots of hands – virtually any two cards – and try to win lots of small pots. They are the day traders of the poker tables. Others play any Ace or any King or any two high cards. They play too many hands, but don’t play them well. These folks can do fine for a while, but get outplayed after the flop by the loose aggressive types who eventually wear them down so that they wind up in a
1 of 11
desperate spot playing a decent hand against a strong hand for the remainder of their chips. I would compare them to long-only closet indexers who trade too much. Then there are the rocks. These folks sit around waiting for premium hands – high pocket pairs or an Ace, King. They fold and they fold and they fold. They are going to wait until they know they have a huge advantage. Then they bet as much as they can. It is very hard to beat a player like this. They can last a long time. Once people figure them out, nobody will play them when they do play. So they don’t get the chance to get enough chips in when they have a large advantage. Could this be what is becoming of Berkshire Hathaway?
I will tell you my poker style. It is close to the patient players waiting for a big advantage. I don’t play a lot of hands. But I don’t just wait for the perfect hand. They don’t come up often enough. I try to pick out one or two people at the table I want to play against or who I sense don’t want to play against me. When the situation feels right, I put in a big, aggressive raise with a marginal holding. It is very hard to describe how I know the “feel” and sometimes I get it completely wrong. But to do well in a poker tournament, you have to recognize a few non-traditional opportunities and you need to get people to sometimes fold the better hand. I think we invest similarly. By this I mean that most of our investing lines up nicely in the disciplined, traditional value camp – very low multiples of book value, revenues, earnings, etc., but occasionally we are opportunistic and invest in situations that are difficult to justify under traditional criteria but for one reason or another we believe to be better situations than they first appear.
People ask me “Is poker luck?” and “Is investing luck?”
The answer is, not at all. But sample sizes matter. On any given day a good investor or a good poker player can lose money. Any stock investment can turn out to be a loser no matter how large the
2 of 11
edge appears. Same for a poker hand. One poker tournament isn’t very different from a coin-flipping contest and neither is six months of investment results.
On that basis luck plays a role. But over time – over thousands of hands against a variety of players and over hundreds of investments in a variety of market environments – skill wins out.
My experience at the World Series of Poker was more like what can happen to a very lucky player in any given tournament. It sure was a blast. If I played a lot of poker, I know that over time the real pros would eat me alive. Personally, I think CNBC would be better served to ask me about investing. I think I have more to contribute in that area.
So let’s get to that. How many of you heard me last year? Now how many of you heard someone use the PEG ratio and kind of laughed to yourself when you heard it?
This year, I’d like to talk a bit about ROEs. One of the best investors around, Joel Greenblatt, has written a popular, charming and funny book about investing in great companies at low P/E multiples. To simplify an already simple book, great companies are generally measured as companies that can generate lots of profit without requiring a lot of capital. This means that they have high ROEs.
I recently met a smart hedge fund manager who has built a $10 billion fund around screening for companies with high ROEs and low P/E multiples for longs and low ROEs and high P/E multiples for shorts. The manager adds human analytical effort to confirm that the screened results are not anomalous accounting figures but instead generally confirm the performance of the business. This has been a successful approach.
3 of 11
My two cents on ROEs is that there are two types of businesses: there are capital intensive businesses and non-capital intensive business. Capital in this definition is both fixed assets and working capital. I define a capital intensive business as a business where the size of the business is limited by the amount of capital invested in it. In these businesses, growth requires another plant, a distribution center, a retail outlet or simply capital to fund growing accounts receivable or inventory. Examples include almost all traditional manufacturing companies, distribution companies, most financial institutions and retailers.
I define non-capital intensive businesses as businesses where growth is limited by things other than capital. Generally, this means intellectual capital or human resources. Examples of intellectual capital are in the pharmaceutical, computer software industries and even some consumer goods like Coke, which rely on brand equity rather than shareholders equity. For example, drug companies are generally limited by the composition of their patent portfolios rather than by their raw manufacturing capacity. Human resource companies are the ones known for the “business going up and down the elevator” every day. Most service companies qualify, including almost any company that sells labor whether it be nurses, construction workers or consultants.
I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all.
When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses
4 of 11
the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.
For these companies the “reinvestment” question becomes what do they do with the cash. Do they return it to shareholders? Or do they do something worse with the cash? Think of all the beautiful non-capital intensive businesses that have either bought or entered capital intensive areas…mostly because their core business generated more profits than they knew what to do with.
A current example is the investment banks. Think about investment banking. It should be a wonderful non-capital intensive business. People go up the elevator and generate fees. Fees for corporate finance advice. Fees for raising capital. The top firms also benefit from their brand equity as companies actually measure their status by the perceived brand value of their financial advisors. They get still more fees for assisting buy-side customers to execute transactions in the capital markets and serving as custodians for their assets. None of this requires a lot of capital. From there, they can generate more revenue by facilitating customer orders, by committing some capital and by lending them money. So the investment banks become a bit more capital intensive. This has evolved.
Next the banks enter proprietary trading and investing – generally in everything from short-term trades in liquid securities to merchant banking or private equity efforts. All that cash flow from the great non-capital intensive businesses gets sucked into ever growing balance sheets. Before you know it, the investment banks are holding on-balance-sheet assets of 30x their equity in addition to tons of off-balance-sheet swaps and derivatives.
5 of 11
What does all this capital-intensive activity do? It drives down the ROEs. Sure the ROEs still seem good at around 15-20%. But when you consider that underneath all the capital intensive stuff is a wonderful non-capital intensive fee-generating business that should have an astronomical ROE, you see that all the proprietary investing and leverage isn’t adding much to shareholder returns here. The irony of this is that these are the companies that everyone else comes to in order to get advice on corporate finance and capital allocation.
Why did this happen? They say that the reason is to diversify the business to stabilize the results, as the fee streams are too volatile for the tastes of public investors. In my view that is a lot of value to destroy in order to stabilize results that are still pretty volatile.
I suspect a better explanation is the investment banks are run for their employees rather than their shareholders. They are run so that there is just enough shareholder return left so that shareholders don’t complain too loudly and a 15-20% ROE seems to be that level. Of course, the returns could be higher, but around 50% of the revenues go to employee compensation.
Given the risk taking nature of the incremental revenues and the fact that 50% of the revenues go to employee compensation, the investment banks are evolving into hedge funds with…how shall I put this?…above-market incentive compensation fee structures.
We have a company in our portfolio, New Century Financial (NEW), that turned a wonderful non-capital intensive business, the origination and sale of mortgages, and reinvested the cash flows into a mediocre capital intensive business of holding mortgage loans. Worse, they went into the capital markets to raise additional capital to focus on the capital intensive opportunity. I thought this was such a bad idea that I joined the Board with the goal of
6 of 11
unwinding this decision and to free the valuable service business from the investment business. It is too soon to discuss my progress.
One non-capital intensive business we like is Washington Group, which provides design, engineering, construction management, facilities and operations management, environmental remediation, and mining services. Most of Washington Group’s contracts are paid on a negotiated cost-plus basis. The plus is either a percentage of the costs or specific performance incentives or milestone payments.
For 2006, Washington Group is guiding to about $2.50 per share. For 2007, the guidance is $2.60-$2.92 per share. The “Street” has taken that guidance at face value and has declared the stock fully valued at $55.
To us, the shares seem less expensive. There is about $8 per share in cash and a tax NOL worth another $7 per share. Backing these out, the business value is about $40 a share.
We think that guidance is overly conservative. Washington Group’s end markets should experience large growth over the next few years. In 2006, Washington Group will grow backlog more than 16%. The estimates imply earnings growth of about the same percentage.
Until recently, Washington Group also participated in “Rip and Read” bidding for government infrastructure projects. Those projects are contracted based on sealed bids from contractors, all ripped open at the same time. The lowest bid wins the contract. This has not worked out very well for them.
When the customers on those contracts request changes or expansions, Washington Group incurs increased costs. 7 of 11
Washington Group will file a claim for the increased expense with the customer, and it is either paid out or litigated in a process that can take several years. Washington Group has historically recovered money on a good percentage of its claims.
Washington Group accounts for these loss-generating contracts with cost overruns by taking a charge for the expenses expected to be in excess of revenue going forward. Future revenue on the contract is recognized at a 0% EBIT margin. Claims are not recognized in earnings until the cash is received, no matter how far along in negotiations Washington Group and its customer are, or how reasonably claim recoveries can be estimated. In effect, Washington Group will have charges in early quarters, followed by quarters with revenue at 0% EBIT margin, and then later quarters with claims revenue at 100% margin. Washington Group does not include claims recoveries in its guidance.
Lately Washington Group has had three particularly difficult contracts with cost over-runs. This has resulted in repeated charges over the past few years. The 2006 guidance includes $32 million in pre-tax charges that have reduced earnings by about 60 cents per share.
There are other accepted ways to account for cost overruns on government contracts. The largest of these contracts, for which Washington Group has recognized $122 million of the losses, is done through a joint venture for which Washington Group has a 50% share. Washington Group’s publicly traded JV partner estimates $57 million of claims recoveries that it has recorded on its books as an offset to the losses. As I mentioned, Washington Group doesn’t book the recovery until it collects the cash.
I believe that a more reasonable estimate for 2007 starts with 2006, adds back the 60 cents of charges and grows the core business by 16%. That puts me at around $3.60 per share or about 11x
8 of 11
conservatively stated earnings that give no credit for claims recoveries. I do not believe this is a peak result. This seems pretty cheap for a non-capital intensive business with above average growth prospects and a history of using excess cash flow to buy back stock. For what it is worth, the peer group trades at 20x more aggressive earnings.
Coming back to my main theme. I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.
The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.
This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE. ROE can improve three ways: better asset turns, better margins and by adding financial leverage. I like to look for companies that can expand the ROEs in as many of these levers as possible.
This brings me to my second investment idea, which is, I hope, a good example of what I am talking about.
Arkema is a diversified generic and brand name chemicals company that was created in 2004 by the French oil & gas giant TOTAL following the reorganization of its chemicals portfolio. Arkema consists of three divisions: Chlorochemicals, which is a
9 of 11
mature and cyclical segment; Industrial Chemicals, which is growing and moderately cyclical, and Performance Products, that occupies high-value-added non-cyclical niches. Arkema’s products are used in automotive, electronics, hygiene & beauty, construction and chemical industries. Almost half of Arkema’s revenue comes from outside of Europe and about two-thirds of its employees and capital employed are located in Europe, primarily in France.
Arkema was spun off and started to trade in May 2006 on the Paris Stock Exchange under the ticker AKE FP. TOTAL management, more focused on its highly profitable oil and gas businesses, had under-managed the “non-core” Arkema segments that have generated margins considerably lower than its pure-play peers.
Arkema currently trades at €38 per share, which translates into a market cap of €2.3 billion and reflects a valuation of 1.2x book value, which was almost halved by a slew of write-downs and provisions in the three years preceding the spin-off. Arkema currently trades at 38% of revenue and 4.9x our estimate of 2006 EBITDA, representing an industry low multiple of a depressed EBITDA result, caused by an industry low 7.7% margin.
We like Arkema because it has a great opportunity to improve its ROE through improving asset turns, margins and, if it is inclined, by adding leverage.
Arkema was spun off with working capital of 23.6% of sales. Industry peers operate in the mid-teens. If Arkema can shrink this number to 17% over time it will free up cash in excess of €6 per share or alternatively, it could grow revenues by 39% without requiring working capital. Arkema should also be able to expand asset turns as it holds €220 million or almost €4 per share of construction projects that are not yet producing. As these come on line, Arkema will get the revenue and income benefits from these investments that have already been made.
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Additionally, Arkema has a good opportunity to expand its margins, as Arkema’s recent “recurring” operating results had significant embedded undisclosed one-off costs depressing these results. The Industrial and Performance Chemicals divisions, Arkema’s two largest, which account for 75% of revenue and all of EBITDA, have had average margins over the last eight years that were significantly higher than recent levels. Arkema’s most comparable company, Degussa, has operating margins almost three times Arkema’s recent results.
We believe that just with the return of Arkema’s two largest divisions to their historical long-range profitability and a modest fixing of its troubled Chlorochemicals division, Arkema should be easily able to expand its EBITDA margin to 10% which would imply only 3.6x “reasonably achievable” EBITDA. After executing an authorized buy-back for 10% of its shares, such results would demonstrate €5 in EPS, implying a 7.6x P/E, and a 12% ROE. This is a dramatic improvement from what we think this year will be €2.50 in EPS and a 7.6% ROE. As I dream into the distant future of possibilities, if Arkema achieves Degussa’s margins, they would earn €8.60 per share, implying a 4.4x P/E, and a 20% ROE.
So I went back to the CNBC reporter and asked him to read my speech and summarize it with a title. He read it, thought long and hard, and came up with Winning Poker Strategies from an Investor. I looked at him in the same confused way he had looked at me back in Vegas. So I’ve come up with an alternative title for today’s talk: Financial Learnings for Make Benefit Glorious Wiseguys.
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Thanks Value investing Congress and Manual of Ideas
http://manualofideas.com/files/blog/einhornspeech200611.pdf
Transcript of David Einhorn’s Speech
at the Value Investing Congress
Friday, November 10, 2006
When people ask me what I do for a living, I generally tell them “I run a hedge fund.” The majority give me a strange look, so I quickly add, “I am a money manager.” When the strange look persists, as it often does, I correct it to simply, “I’m an investor.” Everyone knows what that is.
When people ask me what I did on my summer vacation, I generally tell them “I played in the World Series of Poker.” Nobody gives me a strange look.
So I am at the World Series of Poker in Las Vegas and it is time for a break between rounds. A fellow comes up to me as says, “I am from CNBC and we’d like to interview you.” I ask, “About poker or investing?” The fellow looks at me like this is the strangest thing anyone has asked him in a long time; I realize he obviously picked me out due to my large chip stack or, according to my wife, due to my great looks. “About poker” he says as nicely as he can.
Today, I will discuss both. But for this group, who I bet all know what a hedge fund is, I will mostly discuss investing. Investing and poker require similar skills.
Different people approach poker different ways. Loose aggressive types play lots of hands – virtually any two cards – and try to win lots of small pots. They are the day traders of the poker tables. Others play any Ace or any King or any two high cards. They play too many hands, but don’t play them well. These folks can do fine for a while, but get outplayed after the flop by the loose aggressive types who eventually wear them down so that they wind up in a
1 of 11
desperate spot playing a decent hand against a strong hand for the remainder of their chips. I would compare them to long-only closet indexers who trade too much. Then there are the rocks. These folks sit around waiting for premium hands – high pocket pairs or an Ace, King. They fold and they fold and they fold. They are going to wait until they know they have a huge advantage. Then they bet as much as they can. It is very hard to beat a player like this. They can last a long time. Once people figure them out, nobody will play them when they do play. So they don’t get the chance to get enough chips in when they have a large advantage. Could this be what is becoming of Berkshire Hathaway?
I will tell you my poker style. It is close to the patient players waiting for a big advantage. I don’t play a lot of hands. But I don’t just wait for the perfect hand. They don’t come up often enough. I try to pick out one or two people at the table I want to play against or who I sense don’t want to play against me. When the situation feels right, I put in a big, aggressive raise with a marginal holding. It is very hard to describe how I know the “feel” and sometimes I get it completely wrong. But to do well in a poker tournament, you have to recognize a few non-traditional opportunities and you need to get people to sometimes fold the better hand. I think we invest similarly. By this I mean that most of our investing lines up nicely in the disciplined, traditional value camp – very low multiples of book value, revenues, earnings, etc., but occasionally we are opportunistic and invest in situations that are difficult to justify under traditional criteria but for one reason or another we believe to be better situations than they first appear.
People ask me “Is poker luck?” and “Is investing luck?”
The answer is, not at all. But sample sizes matter. On any given day a good investor or a good poker player can lose money. Any stock investment can turn out to be a loser no matter how large the
2 of 11
edge appears. Same for a poker hand. One poker tournament isn’t very different from a coin-flipping contest and neither is six months of investment results.
On that basis luck plays a role. But over time – over thousands of hands against a variety of players and over hundreds of investments in a variety of market environments – skill wins out.
My experience at the World Series of Poker was more like what can happen to a very lucky player in any given tournament. It sure was a blast. If I played a lot of poker, I know that over time the real pros would eat me alive. Personally, I think CNBC would be better served to ask me about investing. I think I have more to contribute in that area.
So let’s get to that. How many of you heard me last year? Now how many of you heard someone use the PEG ratio and kind of laughed to yourself when you heard it?
This year, I’d like to talk a bit about ROEs. One of the best investors around, Joel Greenblatt, has written a popular, charming and funny book about investing in great companies at low P/E multiples. To simplify an already simple book, great companies are generally measured as companies that can generate lots of profit without requiring a lot of capital. This means that they have high ROEs.
I recently met a smart hedge fund manager who has built a $10 billion fund around screening for companies with high ROEs and low P/E multiples for longs and low ROEs and high P/E multiples for shorts. The manager adds human analytical effort to confirm that the screened results are not anomalous accounting figures but instead generally confirm the performance of the business. This has been a successful approach.
3 of 11
My two cents on ROEs is that there are two types of businesses: there are capital intensive businesses and non-capital intensive business. Capital in this definition is both fixed assets and working capital. I define a capital intensive business as a business where the size of the business is limited by the amount of capital invested in it. In these businesses, growth requires another plant, a distribution center, a retail outlet or simply capital to fund growing accounts receivable or inventory. Examples include almost all traditional manufacturing companies, distribution companies, most financial institutions and retailers.
I define non-capital intensive businesses as businesses where growth is limited by things other than capital. Generally, this means intellectual capital or human resources. Examples of intellectual capital are in the pharmaceutical, computer software industries and even some consumer goods like Coke, which rely on brand equity rather than shareholders equity. For example, drug companies are generally limited by the composition of their patent portfolios rather than by their raw manufacturing capacity. Human resource companies are the ones known for the “business going up and down the elevator” every day. Most service companies qualify, including almost any company that sells labor whether it be nurses, construction workers or consultants.
I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all.
When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses
4 of 11
the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.
For these companies the “reinvestment” question becomes what do they do with the cash. Do they return it to shareholders? Or do they do something worse with the cash? Think of all the beautiful non-capital intensive businesses that have either bought or entered capital intensive areas…mostly because their core business generated more profits than they knew what to do with.
A current example is the investment banks. Think about investment banking. It should be a wonderful non-capital intensive business. People go up the elevator and generate fees. Fees for corporate finance advice. Fees for raising capital. The top firms also benefit from their brand equity as companies actually measure their status by the perceived brand value of their financial advisors. They get still more fees for assisting buy-side customers to execute transactions in the capital markets and serving as custodians for their assets. None of this requires a lot of capital. From there, they can generate more revenue by facilitating customer orders, by committing some capital and by lending them money. So the investment banks become a bit more capital intensive. This has evolved.
Next the banks enter proprietary trading and investing – generally in everything from short-term trades in liquid securities to merchant banking or private equity efforts. All that cash flow from the great non-capital intensive businesses gets sucked into ever growing balance sheets. Before you know it, the investment banks are holding on-balance-sheet assets of 30x their equity in addition to tons of off-balance-sheet swaps and derivatives.
5 of 11
What does all this capital-intensive activity do? It drives down the ROEs. Sure the ROEs still seem good at around 15-20%. But when you consider that underneath all the capital intensive stuff is a wonderful non-capital intensive fee-generating business that should have an astronomical ROE, you see that all the proprietary investing and leverage isn’t adding much to shareholder returns here. The irony of this is that these are the companies that everyone else comes to in order to get advice on corporate finance and capital allocation.
Why did this happen? They say that the reason is to diversify the business to stabilize the results, as the fee streams are too volatile for the tastes of public investors. In my view that is a lot of value to destroy in order to stabilize results that are still pretty volatile.
I suspect a better explanation is the investment banks are run for their employees rather than their shareholders. They are run so that there is just enough shareholder return left so that shareholders don’t complain too loudly and a 15-20% ROE seems to be that level. Of course, the returns could be higher, but around 50% of the revenues go to employee compensation.
Given the risk taking nature of the incremental revenues and the fact that 50% of the revenues go to employee compensation, the investment banks are evolving into hedge funds with…how shall I put this?…above-market incentive compensation fee structures.
We have a company in our portfolio, New Century Financial (NEW), that turned a wonderful non-capital intensive business, the origination and sale of mortgages, and reinvested the cash flows into a mediocre capital intensive business of holding mortgage loans. Worse, they went into the capital markets to raise additional capital to focus on the capital intensive opportunity. I thought this was such a bad idea that I joined the Board with the goal of
6 of 11
unwinding this decision and to free the valuable service business from the investment business. It is too soon to discuss my progress.
One non-capital intensive business we like is Washington Group, which provides design, engineering, construction management, facilities and operations management, environmental remediation, and mining services. Most of Washington Group’s contracts are paid on a negotiated cost-plus basis. The plus is either a percentage of the costs or specific performance incentives or milestone payments.
For 2006, Washington Group is guiding to about $2.50 per share. For 2007, the guidance is $2.60-$2.92 per share. The “Street” has taken that guidance at face value and has declared the stock fully valued at $55.
To us, the shares seem less expensive. There is about $8 per share in cash and a tax NOL worth another $7 per share. Backing these out, the business value is about $40 a share.
We think that guidance is overly conservative. Washington Group’s end markets should experience large growth over the next few years. In 2006, Washington Group will grow backlog more than 16%. The estimates imply earnings growth of about the same percentage.
Until recently, Washington Group also participated in “Rip and Read” bidding for government infrastructure projects. Those projects are contracted based on sealed bids from contractors, all ripped open at the same time. The lowest bid wins the contract. This has not worked out very well for them.
When the customers on those contracts request changes or expansions, Washington Group incurs increased costs. 7 of 11
Washington Group will file a claim for the increased expense with the customer, and it is either paid out or litigated in a process that can take several years. Washington Group has historically recovered money on a good percentage of its claims.
Washington Group accounts for these loss-generating contracts with cost overruns by taking a charge for the expenses expected to be in excess of revenue going forward. Future revenue on the contract is recognized at a 0% EBIT margin. Claims are not recognized in earnings until the cash is received, no matter how far along in negotiations Washington Group and its customer are, or how reasonably claim recoveries can be estimated. In effect, Washington Group will have charges in early quarters, followed by quarters with revenue at 0% EBIT margin, and then later quarters with claims revenue at 100% margin. Washington Group does not include claims recoveries in its guidance.
Lately Washington Group has had three particularly difficult contracts with cost over-runs. This has resulted in repeated charges over the past few years. The 2006 guidance includes $32 million in pre-tax charges that have reduced earnings by about 60 cents per share.
There are other accepted ways to account for cost overruns on government contracts. The largest of these contracts, for which Washington Group has recognized $122 million of the losses, is done through a joint venture for which Washington Group has a 50% share. Washington Group’s publicly traded JV partner estimates $57 million of claims recoveries that it has recorded on its books as an offset to the losses. As I mentioned, Washington Group doesn’t book the recovery until it collects the cash.
I believe that a more reasonable estimate for 2007 starts with 2006, adds back the 60 cents of charges and grows the core business by 16%. That puts me at around $3.60 per share or about 11x
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conservatively stated earnings that give no credit for claims recoveries. I do not believe this is a peak result. This seems pretty cheap for a non-capital intensive business with above average growth prospects and a history of using excess cash flow to buy back stock. For what it is worth, the peer group trades at 20x more aggressive earnings.
Coming back to my main theme. I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.
The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.
This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE. ROE can improve three ways: better asset turns, better margins and by adding financial leverage. I like to look for companies that can expand the ROEs in as many of these levers as possible.
This brings me to my second investment idea, which is, I hope, a good example of what I am talking about.
Arkema is a diversified generic and brand name chemicals company that was created in 2004 by the French oil & gas giant TOTAL following the reorganization of its chemicals portfolio. Arkema consists of three divisions: Chlorochemicals, which is a
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mature and cyclical segment; Industrial Chemicals, which is growing and moderately cyclical, and Performance Products, that occupies high-value-added non-cyclical niches. Arkema’s products are used in automotive, electronics, hygiene & beauty, construction and chemical industries. Almost half of Arkema’s revenue comes from outside of Europe and about two-thirds of its employees and capital employed are located in Europe, primarily in France.
Arkema was spun off and started to trade in May 2006 on the Paris Stock Exchange under the ticker AKE FP. TOTAL management, more focused on its highly profitable oil and gas businesses, had under-managed the “non-core” Arkema segments that have generated margins considerably lower than its pure-play peers.
Arkema currently trades at €38 per share, which translates into a market cap of €2.3 billion and reflects a valuation of 1.2x book value, which was almost halved by a slew of write-downs and provisions in the three years preceding the spin-off. Arkema currently trades at 38% of revenue and 4.9x our estimate of 2006 EBITDA, representing an industry low multiple of a depressed EBITDA result, caused by an industry low 7.7% margin.
We like Arkema because it has a great opportunity to improve its ROE through improving asset turns, margins and, if it is inclined, by adding leverage.
Arkema was spun off with working capital of 23.6% of sales. Industry peers operate in the mid-teens. If Arkema can shrink this number to 17% over time it will free up cash in excess of €6 per share or alternatively, it could grow revenues by 39% without requiring working capital. Arkema should also be able to expand asset turns as it holds €220 million or almost €4 per share of construction projects that are not yet producing. As these come on line, Arkema will get the revenue and income benefits from these investments that have already been made.
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Additionally, Arkema has a good opportunity to expand its margins, as Arkema’s recent “recurring” operating results had significant embedded undisclosed one-off costs depressing these results. The Industrial and Performance Chemicals divisions, Arkema’s two largest, which account for 75% of revenue and all of EBITDA, have had average margins over the last eight years that were significantly higher than recent levels. Arkema’s most comparable company, Degussa, has operating margins almost three times Arkema’s recent results.
We believe that just with the return of Arkema’s two largest divisions to their historical long-range profitability and a modest fixing of its troubled Chlorochemicals division, Arkema should be easily able to expand its EBITDA margin to 10% which would imply only 3.6x “reasonably achievable” EBITDA. After executing an authorized buy-back for 10% of its shares, such results would demonstrate €5 in EPS, implying a 7.6x P/E, and a 12% ROE. This is a dramatic improvement from what we think this year will be €2.50 in EPS and a 7.6% ROE. As I dream into the distant future of possibilities, if Arkema achieves Degussa’s margins, they would earn €8.60 per share, implying a 4.4x P/E, and a 20% ROE.
So I went back to the CNBC reporter and asked him to read my speech and summarize it with a title. He read it, thought long and hard, and came up with Winning Poker Strategies from an Investor. I looked at him in the same confused way he had looked at me back in Vegas. So I’ve come up with an alternative title for today’s talk: Financial Learnings for Make Benefit Glorious Wiseguys.
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