The Loews stub includes wholly owned subsidiaries HighMount and Loews Hotels along with cash and investments at the holding company level.  Given the current relationship between Loews stock price and the quotations for the three publicly traded subsidiaries, market participants are effectively saying that the intrinsic value of the stub is a mere 16 percent of tangible book value.  Either Mr. Market’s adding machine is broken or there are serious problems with the stated tangible book value of the Loews stub.

Overview

Loews may suffer from the perception that it is an unwieldy conglomerate with a complex structure making it difficult to fully understand the factors that make the overall company tick.  However, investors have the advantage of market quotations for CNA Financial, Diamond Offshore, and Boardwalk Pipeline as well as detailed financial statements filed with the SEC by these subsidiaries.   Although intelligent investors can never take market quotations alone as a reliable indicator of intrinsic value, in the case of Loews we can use these quotes to understand what value the market is implicitly placing on the parts of Loews that are wholly owned.

According to the company’s latest 13F report, Loews owned 242.4 million shares of CNA, 70.1 million shares of Diamond Offshore, and 102.7 million common units of Boardwalk Pipeline as of December 31, 2011.  The chart below shows a breakdown of the value attributed to each share of Loews based on the closing price of Loews, CNA, Diamond Offshore, and Boardwalk Pipeline on Friday, March 9:

For each share of Loews purchased at $38.65, investors are effectively receiving $37.19 worth of stock in CNA Financial, Diamond Offshore, and Boardwalk Pipeline common units at current market prices and paying an additional $1.46 for the Loews stub.  The question of whether CNA Financial, Diamond Offshore, and Boardwalk Pipeline common units are undervalued, overvalued, or fairly valued is an important consideration for an investor contemplating a purchase of Loews common stock.

While our analysis of each of these companies makes us comfortable with recent market quotations, this article will not attempt to provide intrinsic value estimates for CNA, Diamond Offshore, or Boardwalk.  Instead, we will focus on whether the implied value of $580 million, or $1.46 per Loews share, is a reasonable value to assign to the Loews stub given the stub’s tangible book value of $3.7 billion, or $9.35 per Loews share.

What’s in the Loews Stub?

The Loews stub, as we define it, includes all sources of value within Loews Corporation that are not attributed to holdings in CNA Financial, Diamond Offshore, and Boardwalk Pipeline common units.  As noted previously, the implied valuation of the stub is currently $580 million based on taking Loews market capitalization and subtracting the value of the stakes in CNA, Diamond Offshore, and Boardwalk common units.

Loews provides segmented balance sheets and income statements that allow analysts to understand the economics of the stub more clearly.  The company provides three main categories for the stub:  HighMount, Loews Hotels, and Corporate.  Corporate includes net cash and investments held at the parent company level, 22.9 million Boardwalk Class B units, the Boardwalk Pipeline general partner interest and Boardwalk subordinated debt.  In total, the stub had tangible book value of $3.7 billion as of December 31, 2011.  We will take a brief look at each component of the stub with the goal of assessing whether stated tangible book is reasonable.  We spend most of the discussion on HighMount given our belief that this subsidiary’s value alone far exceeds the market’s implied value for the entire stub.

HighMount

HighMount is engaged in the production, exploration, and marketing of natural gas, oil, and natural gas liquids.  The company’s proved reserves are mostly located in the Permian Basin in West Texas.  The company was founded in 2007 based on an assumption of assets from Dominion Resources for approximately $4 billion.  The following exhibit provides a summary of HighMount’s results since inception.  As of December 31, 2011, HighMount had total shareholders’ equity of $2,032 million and tangible equity of $1,448 million.

As we can see from the exhibit, HighMount has taken substantial impairment and goodwill losses over the past few years.  The impairments were due to a combination of reduction of reserve estimates and the impact of lower natural gas prices on the present value of HighMount’s estimated reserves.  HighMount follows the full cost method of accounting (as opposed to successful efforts) and capitalizes all direct costs of property acquisition, exploration and development.  Depletion charges reduce the capitalized amount based on the units-of-production method but failure of impairment tests can result in charges as was the case in 2008 and 2009.

HighMount’s production and sales statistics are provided in the exhibit below.  We can see that the company has been able to partially mitigate the decline in natural gas prices over the past few years through hedging activity.  However, with natural gas prices recently under $2.50/mcf, it is likely that revenues will be adversely affected this year and further impairments may be likely.

As of December 31, HighMount had $902 million of reserves according to the standardized measure which attempts to estimate the present value of net cash flows expected to be realized based on the company’s reserves.  The following exhibit shows HighMount’s proved reserves as of December 31:

Obviously, the ultimate value of the company’s reserves will depend on the price received for natural gas, oil, and natural gas liquids over a long period of time.  HighMount expects to spend $320 million in capital expenditures in 2012 to develop natural gas and oil reserves with a focus on liquid rich and oil drilling opportunities.  The focus on oil and liquids, if successful, would increase the proportion of reserves attributable to liquids and result in a more favorable outlook if natural gas prices remain at historically depressed levels.

In light of the low level of natural gas prices, we find it prudent to disregard the value of HighMount’s goodwill and focus on tangible book value of $1,448 million as of December 31, 2011.  It is possible that HighMount will be forced to write down the value of natural gas related properties in 2012 if natural gas prices remain at very low levels.

Loews Hotels

Loews Hotels currently operates seventeen luxury lodging facilities located in the United States and Canada with a combined total of 7,641 rooms.  The hotels range from business oriented lodging to family resort destinations and are generally regarded to be upscale.  As of December 31, 2011, Loews Hotels had total equity of $194 million, of which $191 million was tangible equity.

The exhibit below provides key operating data for Loews Hotels for the past five years:

We can see that the company has posted improving results since the recession although key metrics such as revenue per available room and occupancy rate have yet to fully reach 2007-2008 levels.  Although the company is still posting sub-optimal returns on capital, it does not appear unreasonable to believe that the vast majority of the $191 million in tangible book remains intact.  Indeed, if net income rises to 2007-2008 levels, $191 million may significantly understate the intrinsic value of this business unit.

Corporate Investments

Loews carries substantial cash and investments at the holding company level and has a multi-decade history of intelligent deployment of capital.  As of December 31, 2011, Corporate had $2,071 million of tangible equity.  We will discuss the key investments held by corporate to judge whether it is reasonable to believe that this tangible equity exists.

Boardwalk Pipeline General Partner and Class B Units

In addition to holding 102.7 million common units of Boardwalk Pipeline, Loews also owns the general partner interest as well as all 22.9 million Class B units.  Only the value of the common units are reflected in the “sum-of-the-parts” exhibit presented earlier in this article. Although a full discussion of Boardwalk’s business and corporate structure is beyond the scope of this article, we will take a brief look at the economics of the general partner and Class B units.

The general partner controls Boardwalk’s operations and has the rights to regular and incentive distribution rights (IDRs).  Class B shares have rights to receive up to $0.30 per unit in quarterly distributions.  In 2011, Loews received $27.5 million in Class B unit distributions and $30.7 million in general partner distributions including IDRs.  The payments under the IDRs escalate based on the distributions paid to common unit holders beyond specified “target” amounts.  Substantial future upside for the general partner exists based on Boardwalk’s recent distribution policy.  Full details regarding the distribution policy may be obtained in Boardwalk’s 2011 10-K.

According to Boardwalk’s 10-K, the general partner’s equity is $62.1 million and the Class B unit holder equity is $678.7 million.  We believe that these values are easily justified by the figures presented here and in conjunction with a more complete review of Boardwalk’s SEC filings which we encourage interested readers to pursue.

Investments

In addition to investments in the capital stock of public and private subsidiaries and the Boardwalk general partner and Class B interests described above, the holding company also holds a substantial investment portfolio.  Current assets of the holding company, which were principally in short term instruments, was $2,267 million as of December 31, 2011.  In addition, the holding company balance sheet shows $1,140 million of investments in securities which would include the Boardwalk general partner and Class B interests described above.  The holding company had $1,467 million in liabilities which included $694 million in long term debt, $233 million of current liabilities, and $540 million of deferred income taxes.

Although there is limited transparency regarding the specific investments in the portfolio, there appears to be no reason to substantially discount the tangible book value related to the investments made at the holding company level.  Overall, we believe that the tangible book value attributed to the corporate holding company is well supported.

Conclusion

In this article, we have not presented a complete evaluation of Loews Corporation or its diverse subsidiaries.  Instead, we have approached the company with a more narrow focus.  Specifically, we ask:

Is the implied valuation of the “Loews Stub” reasonable?

We believe that the answer to this question is a definitive “no”.  The market is placing an implicit valuation of $580 million on a group of businesses and investments with a stated tangible book value of $3.7 billion on the Loews balance sheet.

Mr. Market’s implied  valuation asserts that Loews has seriously overstated the value of these businesses and investments.  However, the value of HighMount alone clearly far exceeds the market’s valuation of the entire stub.  One could stop right there if the only goal is to determine whether the market’s implied valuation is correct.  However, by also looking at the value of the Boardwalk Pipeline Class B and general partner interests along with Loews Hotels and other corporate investments, it becomes abundantly clear that most if not all of the $3.7 billion in tangible book value is very well justified.

In order to own Loews, an investor must be satisfied that the publicly traded common stocks — CNA, Diamond Offshore, and Boardwalk common units — are good values, or at least not grossly overvalued.  CNA is perhaps the most problematic given the spotty record of its insurance underwriting in recent years and a pattern of substantial “reserve strengthening” due to underestimating losses in past years.  Mitigating this history is CNA’s substantial discount to tangible book value.

Investors who wish to gain exposure to the Loews stub but have doubts about CNA, Diamond Offshore, or Boardwalk Pipeline common units can attempt to hedge out exposure to these companies through offsetting short positions.  In a theoretical trade where one is long Loews and short proportional shares of CNA, Diamond Offshore, and Boardwalk common units, exposure would be limited to the “stub” itself. However, there are practical considerations that may preclude this option for most individual investors.

Just as one does not require a scale to determine whether an obese man is overweight, precision is not required to see that there is something very wrong with the manner in which Mr. Market is pricing Loews stock relative to CNA Financial, Diamond Offshore, and Boardwalk common units.  We believe Loews is worth at least its book value of $47.49 per share and perhaps significantly more given management’s proven track record of intelligent capital allocation over long periods of time.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Loews Corporation.

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Many value oriented websites such as Guru Focus are taking a close look at 2011 results and focusing on some of the key points that matter when it comes to evaluating Berkshire’s business performance.  Rather than writing about the specifics of Berkshire’s performance in 2011, we find it more useful to step back and assess Berkshire’s performance over a much longer time frame – a full decade.  While many investors will debate whether one, three, or five years should be considered “long term”, very few would claim that a full decade doesn’t qualify as a long term horizon.  To illustrate the experience of a ten-year shareholder, we will examine the fictional story of Jane, a Berkshire shareholder who bought her shares on December 31, 2001 and is now assessing how Berkshire has performed over her ten years of ownership and trying to evaluate prospects for the next decade.

Jane’s Windfall

In the fall of 2001, Jane was shocked to receive a certified letter from an attorney informing her of a $750,000 inheritance from a distant relative she only vaguely recalled from her childhood.  The relative had died in early 2001 and had left no will.  The probate process finally identified Jane as the sole living heir and she received the funds in October 2001.

Jane was 45 years old at the time, had two years of college education, earned the median wage at a very secure job, and owned a median priced home in Omaha, her lifelong home town.  Although Jane’s only debt was a modest mortgage on her home due to be paid off in twenty years, she had no meaningful savings outside of a small emergency fund and no background or experience investing significant sums of money.

Mysteriously, helpful sounding financial planners and brokers starting calling Jane almost immediately after the close of probate.  However, after meeting a few of these planners, Jane felt more confused than before regarding how to invest her windfall.  Fortunately, Jane had attended Berkshire Hathaway’s annual meeting the prior spring with a friend who owned shares of Berkshire.  Several comments made by Warren Buffett and Charlie Munger seemed to cast doubts on the wisdom of entrusting money to financial “helpers”.

Impressed by Warren Buffett’s statements at the annual meeting and after reviewing the past few years of shareholder letters, on December 31, 2001 Jane decided to purchase 10 Class A shares for $75,600 each, a total investment of $756,000.  Jane’s time frame for holding her shares was indefinite, although she hoped that the funds would appreciate significantly over the next twenty years to provide a source of funds during her retirement which would begin in 2022.

Berkshire’s Stock Price Performance:  2002 to 2011

Jane read Warren Buffett’s annual letter each year and attended several annual meetings but she did not conduct any in-depth analysis of Berkshire’s business during her period of ownership nor did she pay excessive attention to daily or weekly movements in Berkshire’s stock price.  However, Jane felt a sense of satisfaction when her holdings passed the $1 million mark as Berkshire closed above 100,000 for the first time in October 2006 and as Berkshire neared $150,000 in December 2007, Jane felt strongly that her investment had been a wise one.  However, Berkshire’s stock price fell by nearly fifty percent at the worst of the financial panic of early 2009 and on a few dark days in early March even fell below Jane’s cost basis.  Since that time, shares have recovered in an uneven manner to 120,000 on February 24, 2012.  The chart below shows Berkshire’s share price during Jane’s period of ownership:

Berkshire’s stock price has fluctuated significantly over the years, particularly since the financial crisis of 2008-2009.  For the ten year period from December 31, 2001 to December 30, 2011, Berkshire appreciated from $75,600 to $114,755 for a total return of 51.8 percent, or 4.26 percent annualized.  Over the same period, a popular exchange traded fund tracking the S&P 500 (SPY) rose from $114.30 to $125.50 while paying $21.88 in dividends representing a total return of 28.9 percent, or 2.57 percent annualized.

Although Jane is pleased that Berkshire has outpaced the S&P 500 index fund and has provided a return in excess of inflation over her period of ownership, she can’t help but feel somewhat underwhelmed by the performance of her investment and feels mentally anchored to the $150,000/share price that Berkshire briefly reached in late 2007. However, Warren Buffett’s latest shareholder letter clearly signals that he believes Berkshire’s intrinsic value is materially higher than the current stock price.  Given that Jane is at roughly the half way point in her likely two decade ownership of Berkshire, she decided to dig a bit deeper by looking at the performance of the business rather than focusing only on the stock price.

Berkshire’s Book Value Performance:  2002 to 2011

Warren Buffett has often stated that percentage changes in Berkshire’s book value per share roughly approximate percentage changes in Berkshire’s intrinsic value while emphasizing that Berkshire’s book value significantly understates intrinsic value.  In the late third quarter and early fourth quarter of 2011, Mr. Buffett backed up this assertion by spending $67 million to repurchase Berkshire shares.  Berkshire’s press release announcing the repurchase program stated the following:

Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares.  In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.

In Mr. Buffett’s letter to shareholders, he explicitly addresses the question of Berkshire’s intrinsic value relative to book value for each of Berkshire’s major business segments.  While shareholders are not provided any specific figures, with a couple of minor exceptions it is clear that Mr. Buffett strongly believes that the intrinsic value of each of Berkshire’s important business groups is far higher than 110 percent of book value.

The  following chart replicates the stock price chart shown above but also includes Berkshire’s latest reported book value for each quarter over the ten year period.  We can see that the ratio of Berkshire’s price to book value per share fluctuates significantly over time.

We can also readily observe the fact that Berkshire’s book value changes much more slowly than its stock price over time.  While it is likely that Berkshire’s appropriate price/book ratio changes somewhat over long periods of time, it clearly does not change quickly enough to justify the market fluctuations observed in the chart.  A more clear way of examining the relationship between price and book value is to plot the price to “trailing” book value ratio as shown below:

Here we can see that Berkshire’s price/book ratio was nearly 2.0 at the time of Jane’s initial purchase and fluctuated between 1.4 and 2.0 for most of the first seven years of the investment period.  However, after the onset of the financial crisis, Berkshire’s price/book ratio dropped into a lower range of between 1.0 and 1.5.  At year-end 2011, the price/book ratio was 1.15 and has since increased to 1.20.

Price/Book Ratio Compression

Berkshire’s book value per share was $37,920 on December 31, 2001 and rose to $99,860 as of December 31, 2011.  This represents a 163 percent increase, or 10.2 percent on an annualized basis.  It is clear that Berkshire’s book value has significantly outperformed the company’s stock price over the ten year holding period of Jane’s investment.

If Berkshire’s price/book ratio on December 31, 2011 had held at the nearly 2.0 level that prevailed at the time of Jane’s purchase on December 31, 2001, Berkshire’s stock price would have been nearly $200,000 per share and the performance of Jane’s investment would have been exactly the same as the advance in book value:  approximately 10.2 percent annualized. If Berkshire’s price/book ratio on December 31, 2011 had been approximately 1.5, the average price/book ratio since 2000, Berkshire’s stock price would have been nearly $150,000 per share and Jane would have achieved a 7.1 percent annualized return.  The relatively disappointing performance of Jane’s investment is not attributable to poor business performance at Berkshire but due to the compression in the multiple of book value that the market has assigned to Berkshire’s shares.

Business Results:  2002 to 2011

The advance in Berkshire’s book value was accomplished through retention of earnings and unrealized appreciation of investments over a ten year period.  A full assessment of Berkshire’s many business units is well beyond the scope of this article but we can look at some key aggregate figures to get a sense of the scope of the company’s accomplishments over a decade:

• Shareholders’ Equity increased from $58 billion to $164.9 billion.  Shares outstanding increased from 1.528 million to 1.651 million resulting in book value per share advancing from $37,920 to $99,860.  Most of the share count dilution can be attributed to Berkshire’s acquisition of BNSF in early 2010.
• Cumulative net income of $88.8 billion.  Although annual results were uneven, Berkshire posted significant net income over the ten year period.  Net income ranged from a low of $4.3 billion in 2002 to a high of $13.2 billion in 2007.  Berkshire’s net income can be heavily influenced by insurance results and the timing of realized capital gains and losses and are generally meaningless over short periods such as a quarter or a year. However, a full decade begins to reveal Berkshire’s formidable earnings power.
• Cumulative Free Cash Flow of $84.1 billion.  Free cash flow is calculated by taking the total net cash flows from operations and subtracting capital expenditures.
• Berkshire spent $51.1 billion of cash for acquisitions.  The majority of Berkshire’s free cash flow was devoted to purchasing wholly owned subsidiaries.  This figure does not include stock issued in connection with acquisitions.  It is notable that Berkshire spent nearly as much cash on acquisitions over the decade as the company held in shareholders equity on December 31, 2001.
• Berkshire’s Insurance operations posted underwriting profits in all years except 2002.  As Warren Buffett points out in his shareholder letter, Berkshire’s insurance businesses are unusual.  The insurance industry as a whole tends to post underwriting losses on average.
• Insurance Float grew from $35.5 billion to $70.6 billion.  Insurance float represents liabilities earmarked to pay the claims of policy holders but available for Berkshire to invest.  The presence of cost free float has enabled Berkshire to generate investment returns over long periods of time using “other people’s money” without the negative qualities of using traditional leverage.

While these bullet points merely provide a 30,000 foot view of Berkshire’s progress over the past decade, we can begin to get a sense of how Berkshire has managed to compound book value per share at a rate in excess of 10 percent while starting from a very large base of capital.  It seems very clear that Berkshire is a vastly more valuable enterprise today than it was when Jane made her investment ten years ago.  Furthermore, while we are not providing a specific valuation in this article, the qualities of the business appears to support Mr. Buffett’s assertion that the business is worth more than book value.

The Next Ten Years

Getting back to Jane’s story, we recall that her investment time frame was for twenty years which means that she is only at the half way mark in her ownership of Berkshire Hathaway.  Jane’s original investment of $756,000 has appreciated to $1.2 million, a compound annual return of 4.6 percent.  Jane could sell her shares at the current price but would owe taxes on her $444,000 gain.  After paying federal and Nebraska taxes at a combined rate of about 21.7%, she would be left with slightly over $1.1 million to reinvest for the next ten years.  Alternatively, Jane could retain her Berkshire holdings and defer taxes on her gains for another decade, but she has to be convinced that Berkshire’s prospects going forward are acceptable.

There are many valuation approaches analysts have used to estimate Berkshire Hathaway’s intrinsic value, many of which have been discussed on this site in the past.  However, for purposes of addressing Jane’s decision, we will approach the problem in a very simple manner in an attempt to estimate a ballpark price level for Berkshire in ten years.

In Warren Buffett’s 2010 letter to shareholders, he provided rare guidance to readers regarding Berkshire’s “normal” earnings power.  Mr. Buffett stated that Berkshire’s after-tax “normal” earnings power was approximately $12 billion excluding any capital gains or losses.  In addition, he estimated that Berkshire’s share of undistributed earnings of investees – a figure not reflected in Berkshire’s net income – was more than $2 billion in 2010.  Significant equity investments over the past year, including a large purchase of IBM shares, have likely raised the figure to $3 billion currently.  The undistributed earnings of investees can be reasonably expected to show up in capital gains over long periods of time.  The table below shows a hypothetical projection of Berkshire’s net income and undistributed investee income over the next ten years assuming a modest 3 percent growth rate:

Since Berkshire does not pay a dividend and has not repurchased a material number of shares, we assume that the aggregate net income will be added to retained earnings over the ten year period.  Assuming that the undistributed investee income, on average, shows up in appreciation of the equity securities held, the aggregate figure will be accretive to Berkshire’s equity either via net income if investments are sold or through other comprehensive income if the investments are held.

The table below calculates a projection of Berkshire’s share price in ten years based on the assumption that the earnings are retained and the share count remains the same.

Our assumption of 3 percent growth in normalized earnings power implicitly assumes that Berkshire will not find attractive places to invest the significant cash generated by businesses owned today.  Instead, the assumption, which is arguably unrealistic, is that cash languishes on Berkshire’s balance sheet rather than being distributed to shareholders or invested in new businesses.

If these assumptions hold, book value per share in ten years would approximately double from today’s level to $204,000.  We assign a price/book ratio of 1.4 at the end of the ten year period to arrive at a price projection of approximately $286,000.  This is below the average price/book ratio that has prevailed since 2000 but above the typical price/book ratio since the financial crisis. If we instead assume that the price/book ratio will remain unchanged at today’s level of 1.2, the price projection would be approximately $245,000.

From today’s stock price of $120,000, Jane might expect annualized returns of between 7 to 9 percent using the assumptions provided above and depending on the terminal price/book ratio that is used.  Keeping in mind the fact that the assumptions used here “bake in” the lack of meaningful reinvestment opportunities, book value could very well be materially higher that our estimate in ten years.  For example, if Berkshire achieves the same 10.2 percent annualized rate of increase over the next ten years that it achieved over the past ten years, book value would be $264,000 in ten years and a price/book ratio of 1.4 would yield a stock price of $370,000 which would represent a 11.9 percent annualized return from the current stock price.

Water Under the Bridge

With the benefit of perfect hindsight, Jane would have been wise to avoid paying nearly twice book value for Berkshire shares at the end of 2001, a valuation level that has not been achieved since that time.  As a result of buying at a high valuation, Jane’s results have significantly trailed Berkshire’s business results over her period of ownership.  However, this is “water under the bridge” and all that matters today is whether Berkshire’s performance going forward justifies continued ownership of the shares.

It appears that Berkshire’s book value progress over the next decade is likely to be very satisfactory even if it does not match the results of the past ten years.  Furthermore, if Warren Buffett’s assessment of Berkshire’s current undervaluation is correct, Jane may expect to see expansion in the price/book ratio over the next decade which would further enhance returns.  As a final consideration, Jane can benefit from continued deferral of the tax liability on her capital gains if she holds Berkshire rather than selling and looking for a new investment.

If the assumptions in the table above prove to be in the ballpark, Jane might conservatively expect to own Berkshire shares worth $2.8 million in a decade which would represent a 6.8 percent annualized rate of return from her $756,000 purchase ten years ago.  This would trail Berkshire’s progress in book value unless Berkshire trades at the unlikely valuation of 2 times book value in the future.  However, very long holding periods tend to lessen the pain of mistakes provided that the business in question is compounding intrinsic value at a satisfactory rate.  In the case of Berkshire, the overwhelming evidence is that this will be the case going forward.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.  This article is not investment advice and involves a fictional character rather than a real individual. 

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We published a report on Platinum Underwriters in late October 2011.  At the time of publication, the report was offered for sale at a cost of $30.

Since three months have passed since the report was originally published, we are pleased to now offer the report to readers free of charge.  The investment thesis remains unchanged since the date of the report although the share price has advanced slightly.

To download the report, please visit the original article and click on the download button at the bottom of the post.

We are interested in knowing whether readers find this type of report useful and wish to read similar content in the future.  Please feel free to leave comments at the bottom of this post or send an email via the “Contact the Author” link below.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Platinum Underwriters at the date of this report on October 21, 2011 and as of January 23, 2012.

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– Warren Buffett

The wide variety of investments held by successful value investors indicates that there are many different approaches that can yield excellent results over long periods of time. Hyperactivity and a search for instant validation may be exciting but such vices are the sworn enemies of investors seeking to achieve their long term goals.  Success requires an inquisitive mind, reading widely, and acting in a judicious manner when presented with understandable opportunities with a margin of safety.

Thousands of “Pitches” — Where to Start?

When he was getting started in the 1950s, Warren Buffett was known for reading every page of the Standard & Poor’s stock manuals in search of opportunities.  The modern day equivalent might be repeating this process using Value Line and there is much to be said for wide exposure to voluminous data.  Each page of data in Value Line can be viewed as a “pitch”.  Most pitches do not come anywhere close to qualifying for further research let alone a “swing” involving an allocation of capital.  Often only one or two companies in a Value Line issue of 130-140 companies may spark an interest in pursuing further work.

There is no short cut that can replace in depth research and every investor should, at a minimum, read a company’s latest 10-K, proxy statement, and 10-Q filings.  However, there are ways to increase the percentage of “pitches” that are interesting enough to justify further work.  The value investing community may be small but seems to have an unusually large number of investors willing to exchange ideas via blog posts and discussion forums.  At a relatively modest cost relative to the  potential value of ideas, some investors share their best ideas exclusively with subscribers.

Ultimate Value Finder — Three Researched “Pitches” Each Month

We recently had the opportunity to review a new subscription based newsletter published by Mariusz Skonieczny, founder and president of Classic Value Investors.  Mr. Skonieczny is the author of Why Are We So Clueless About the Stock Market?  which we reviewed in 2009 as well as a useful e-book on understanding financial statements which we reviewed in 2010. 

Ultimate Value Finder provides readers with three investment ideas each month.  Based on the free sample issue and the inaugural January 2012 issue, it is clear that the ideas presented are well researched and presented in a clear and compelling manner.  Most importantly, Mr. Skonieczny clearly takes a value oriented approach when selecting companies for the newsletter and bases his valuation on conservative assumptions.  Most of the companies he has covered are not widely followed by analysts and have been misunderstood or simply ignored by the stock market.

Premier Exhibitions

One unique situation identified in the January issue involves a company that has received some attention in the value investing community over the past few years but has been largely ignored by the market until very recently.  Premier Exhibitions (NASDAQ: PRXI) is in the business of presenting museum quality exhibitions of artifacts from the Titanic wreck as well as educational exhibits of preserved human body parts.

Premier Exhibitions has long held clear title to 2,000 artifacts from a 1987 exhibition but the status of 3,000 artifacts recovered after 1987 were in question until August 2011 when a U.S. District Court awarded a specie salvage award to Premier.  In total, the artifacts have an appraised value well in excess of Premier’s market capitalization.  However, certain limitations on the sale of exhibits intended to keep the artifacts together as a collection may have tempered the market’s enthusiasm and the court victory was largely ignored.

The January 2012 issue of Ultimate Value Finder presents research on Premier that goes beyond what one may have read about the company from other sources.  Through a diligent review of company filings, clues were found that indicated that an auction of the Titanic artifacts may be imminent.  On December 23, shortly before the close of trading on a slow day right before the Christmas holiday, Premier announced that it had hired  an auction house to conduct a sale of the collection.  The news did not trigger an immediate rise in Premier’s stock price.  In a strange delayed reaction, the stock did not rise significantly until December 28, nearly two full trading days after the news was revealed. However, Mr. Skonieczny released the January issue on December 26 to allow his subscribers to investigate and potentially act on the opportunity.

Separating the Wheat from the Chaff

There is no shortcut to success in investing and we view most newsletters with skepticism — particularly those promising a “system” that is guaranteed to produce short term results.  However, well researched ideas grounded in a value investing mindset have the potential to improve results by identifying companies worthy of additional research.  Not every company in Ultimate Value Finder or any other newsletter will spark an interest in further research.  However, with thirty-six ideas provided each year, it is more likely than not that at least a few companies will warrant further study and perhaps one of the opportunities may result in an actual investment.  At the very least, one is likely to see more attractive “pitches” by reading Ultimate Value Finder which we enthusiastically recommend to our readers.

Disclosure:  No position in Premier Exhibitions. The Rational Walk receives a review copy of the newsletter but does not receive commissions or other compensation for referrals.

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Introduction

In late November, many Berkshire Hathaway shareholders were surprised to learn that the company reached an agreement to acquire the Omaha World-Herald in a $200 million transaction.  Warren Buffett, Chairman and CEO of Berkshire, has commented on the difficulties facing the newspaper industry on numerous occasions but seemed bullish on the Omaha economy and prospects for the paper to deliver “solid profits” in the future.  Berkshire has owned the Buffalo News for over three decades and has a significant minority interest in the Washington Post.  As a result, Mr. Buffett clearly knows the industry and feels comfortable enough with the future of newspapers in his hometown to make a long-term ownership commitment.

Although we do not know if Berkshire Hathaway Vice Chairman Charles Munger was involved in the Omaha World-Herald decision, he may have had something to add regarding the prospects for newspapers in general.  In addition to his role at Berkshire, Mr. Munger has been Chairman of Daily Journal Corporation since 1977.

Daily Journal (Nasdaq: DJCO) publishes several newspapers in California and Arizona with a specific focus on topics of interest to the legal and real estate professions.  Daily Journal, which is unaffiliated with Berkshire Hathaway, has a market capitalization of approximately $90 million.  Based on the most recent proxy statement, Mr. Munger owns 9 percent of Daily Journal’s common stock. Over the past few years, Daily Journal’s business has enjoyed exceptionally strong advertising revenues due mainly to increased public notice advertising driven by foreclosure notices. However, dark clouds loom on the horizon as circulation continues to decline and advertising spending appears destined to normalize at much lower levels.  In such a situation, a poorly run company would desperately deploy temporarily high cash flows toward ill advised “diversification” schemes while a well run company would responsibly decide to return cash to shareholders and decline gracefully.  Mr. Munger appears to have settled on another approach:  Daily Journal has effectively transformed into an investment vehicle where a highly concentrated marketable securities portfolio now accounts for the vast majority of the company’s intrinsic value.

Click on this link to read the full article

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Update:  As of January 23, 2012, we are pleased to make the report available to readers free of charge.  The investment thesis remains substantially unchanged in the three months since original publication of the report.  To obtain the report, click on the download button at the bottom of this post.

Introduction

In the midst of a persistent soft market, equity valuations in the reinsurance industry have been under pressure with many companies trading at substantial discounts to tangible book value.  Skepticism regarding reserve adequacy and underwriting discipline have combined with concerns regarding the long-term impact of recent natural disasters to create a “perfect storm” for the industry.

2002 Spin-Off Offers a “Clean Slate”

Platinum Underwriters Holdings Ltd. (NYSE:  PTP) is a Bermuda-based company organized in 2002 as a spin-off of The St. Paul Companies reinsurance operations.  Platinum has no exposure to legacy adverse loss development prior to 2002 and has posted consistently strong results over the past decade.  Prior to 2011, Platinum posted underwriting profits in all years except for 2005.  Favorable loss development has been recorded for each year since inception with cumulative favorable development of $837 million.

Focus on Underwriting Discipline, Not Market Share

Platinum does not seek to maximize market share and has been willing to shrink premium volume drastically in response to the soft market.  Earned premiums declined from $1.7 billion in 2005 to $780 million in 2010.  Written premiums as a percentage of shareholders’ equity declined from 112% to 40% over the same period.  Management has maintained a strong equity position despite share repurchases of $1.2 billion since 2005.  Book value per share advanced at a 9% annualized rate from 12/31/2002 to 9/30/2011.

Market participants have taken note of Platinum’s net loss of $231 million for the first nine months of 2011 due to earthquakes in Japan and New Zealand, springtime tornados in the United States, and the impact of Hurricane Irene in August.   These disasters have resulted in a year-to-date combined ratio of 156% putting Platinum on track for a full year underwriting loss for the first time since 2005.

Negative Headlines Offer Opportunity

Negative headline news often causes investors to abandon entire industry sectors without regard to the circumstances of individual companies.  Momentum based systems such as the Value Line Investment Survey’s Timeliness system suggests that investors should steer clear of the entire sector. However, there are significant differences between reinsurers when it comes to reserve adequacy, underwriting discipline, and balance sheet strength.  Discerning investors with a long-term focus can often find bargains in such an environment.

Platinum currently trades at approximately two-thirds of September 30, 2011 fully diluted tangible book value per share of $45.68.  Investors clearly appear to be skeptical regarding Platinum’s reserve adequacy and prospects for future underwriting profitability.

Steep Discount Unwarranted Despite Soft Market Conditions

The current steep discount to book is unwarranted even assuming continued soft market conditions for reinsurance.  In this report, we examine Platinum’s track record, future prospects, and valuation.  Based on current business fundamentals, we estimate the intrinsic value of Platinum at between $37 and $53 per share.

While no immediate catalyst exists to narrow the gap between the share price and intrinsic value, we note that increased merger and acquisition activity in the sector could lead to offers for the company given its strong track record, bargain basement valuation, and lack of pre-2002 legacy liabilities.

As of January 23, 2012, The Rational Walk’s 21 page report on Platinum Underwriters is available free of charge.  Click on the download button below to obtain the PDF file (1.3 MB).

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Platinum Underwriters at the date of this report on October 21, 2011 and as of January 23, 2012.

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On March 1, 2011, The Rational Walk published “Berkshire Hathaway:  In Search of the Buffett Premium”. The new report represents a major expansion and update to the earlier analysis and includes updated data and valuation models.  Readers who find the 2010 report interesting may want to purchase the more recent report.

The complimentary report appears below in Scribd format.  Readers may also click on the link below to download the report in pdf format.

Click on this link to download the report

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The Rational Walk was created in February 2009, a time that most investors would probably prefer to forget since market indices were flirting with the bear market lows that finally came in early March.  Value investors, on the other hand, look back at February and March 2009 as a period of unprecedented opportunity.  However, the number of investors who self-identify as “value investors” has always been a small minority and those who actually are value investors represent an even smaller group.

The Rational Walk has always focused on providing news and commentary, but never investment advice, to this small subset of the investment community.  This effort has been a great deal of fun, particularly in terms of striking up conversations with readers sharing similar interests.  However, in recent weeks, I have taken a careful look at The Rational Walk in the context of other ventures and recently made the difficult decision that it is time to end regular operations on the site.

The remainder of this post contains some parting thoughts as well as information for Berkshire Hathaway Corner subscribers and individuals who may be interested in reading The Rational Walk’s report on Berkshire Hathaway, In Search of the Buffett Premium, at a newly discounted price.

Berkshire Hathaway Corner Subscribers

While The Rational Walk has been publishing regularly for over two years, the subscription service named The Berkshire Hathaway Corner was launched more recently in January 2011.  The launch of the service predates any contemplation of ending operations on the site and I regret any disappointment that this causes for the subscribers who have signed up in recent weeks.

Although subscribers have received In Search of the Buffett Premium, a report on Berkshire’s equity portfolio, an article on Berkshire Hathaway’s retroactive reinsurance transaction with CNA Financial, and an analysis of the Lubrizol transaction, the overall goal of providing ongoing coverage of Berkshire was not fulfilled.  Due to the very brief history of the service, all subscribers will receive a complete refund.

A separate note to paying subscribers will be sent out later today with further information on the refund.  If you are a paying subscriber and do not receive communication from The Rational Walk by the end of the day, please write to administrator @ rationalwalk.com.

Berkshire Hathaway:  In Search of the Buffett Premium

Warren Buffett is clearly the most famous investor who remains active today but Berkshire Hathaway continues to be shrouded in mystery for most journalists, investors, and other commentators.  It is unclear why this is the case given the clarity of Mr. Buffett’s communications to shareholders and the financial information available in annual reports.  The company is complex but it is not incomprehensible.  At least in comparison to many other large companies, Berkshire is much less opaque for those who care to delve into the publicly available information that is available.

One of the goals of The Rational Walk since its inception has been to provide intelligent coverage of Berkshire Hathaway.  Over the past two years, 263 articles have been posted that were related to Berkshire, all of which were offered at no cost to readers.  In addition, The Rational Walk released a comprehensive report on Berkshire shortly after the 2009 annual report was released in February 2010.  More recently, The Rational Walk released Berkshire Hathaway:  In Search of the Buffett Premium on March 1, 2011, a few days after the release of Berkshire’s 2010 annual report.

One of the themes of the report involves the question of how succession will impact Berkshire’s intrinsic value.  While David Sokol’s resignation has changed the game in terms of the individual most observers (including The Rational Walk) considered most likely to succeed Mr. Buffett, the overall process remains the same. Many commentators believe the succession process is fatally flawed.  I strongly disagree for the reasons outlined in the report.

Although the time investment in the report precludes it from being offered at no cost to readers, it has always been my goal to provide high quality coverage of Berkshire and to disseminate the information as broadly as reasonably possible.  Therefore, in light of the time that has passed since the report was published and the decision to discontinue regular operations on the site, I have decided to make the report available for $30, a 70 percent discount from the previous listed price.

To order the report for immediate download, click on this link.

Concluding Thoughts

Value investing works because it is unpopular and very few investors are willing to match their claims to be followers of Benjamin Graham and Warren Buffett with actual investment behavior.  Most professional investors seek career security over the opportunity to significantly outperform and most individual investors like to be invested in exciting securities that can serve as the basis for interesting discussions at the weekend barbeque or cocktail party — not investments with the “ick factor” that often accompany value situations.  Of course, the very unpopularity of value investment ideas that makes publishing on such topics a challenge also makes investing in such situations unusually attractive.  This will always be the case barring a complete reversal in human nature.

While The Rational Walk will no longer provide new content, I plan to keep the site online indefinitely going forward as a resource for investors and others who may wish to read past articles.  In addition, new content may be provided on a very irregular basis in the event of a major event taking place.  Readers who currently subscribe to The Rational Walk via RSS Feeds can simply keep doing so in order to receive notification of any future articles.

As mentioned before, I have enjoyed writing for The Rational Walk and value the thoughts and interactions with readers which hopefully will continue in the future.

Best Regards,

Ravi Nagarajan
Editor, The Rational Walk

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In his forthcoming book, The Most Important Thing, scheduled for release in May, Mr. Marks expands on the themes he covered in the Columbia presentation and goes into much depth on the concept of “second-level thinking”.  At the risk of oversimplifying the concept, second-level thinking essentially boils down to the ability to think in probabilistic terms about the set of outcomes that could occur rather than to make investment decisions based only on the investor’s notion of what the most likely outcome might be.  Avoiding “single scenario investing” would have spared many investors much of the pain that was experienced during the financial crisis.

Based on an electronic review copy of the book obtained by The Rational Walk, we highly recommend that all investors obtain a copy in May and also consider attending the Value Investing Congress in Pasadena.  Investors who are looking for a formulaic “cookbook” for how to achieve superior investment returns will not find what they are looking for in the book, but those who are seeking to improve their general thought process and approach will find much value.

Readers of The Rational Walk are eligible for a $300 discount for the Value Investing Congress in Pasadena on May 3 and 4.  To qualify for the discount, please use the following link and be sure to specify Discount Code W11RW10 upon check out.  The discount expires on April 14, 2011 at which time the price to register will increase.  Disclosure:  The Rational Walk receives a referral fee for registrations generated through the link.

Click on this link to register for the Value Investing Congress

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We previously published our thoughts on Mr. Sokol’s actions with respect to Lubrizol including a timeline of events, an account of Mr. Sokol’s statements after his resignation, and apparent inconsistencies between his statements and information appearing in the Lubrizol proxy statement.  We will not rehash these subjects in this article.  Instead, we wish to revisit Mr. Sokol’s investment in Middleburg Financial.

Background

Although various newspapers have covered Mr. Sokol’s investment in Middleburg Financial in recent months, we believe that the Rational Walk’s article published on March 26, 2010 was the first detailed report of the investment.  We followed up on the story in late October 2010 when Mr. Sokol received approval from Middleburg’s Board of Directors to increase his stake from 20 percent to a maximum of 30 percent.

A review of Mr. Sokol’s filings on the SEC website indicate that he has been buying additional shares of Middleburg Financial with a small purchase of 300 shares on March 29 being the most recent transaction.  Mr. Sokol currently owns slightly over 1.4 million shares, or 20.2 percent of the company.  His ownership interest is worth approximately $22.5 million as of April 1, 2011.

Did Sokol Pitch Middleburg to Buffett?

In his recent CNBC appearance, Mr. Sokol made the following comments in response to questions from Becky Quick:

BECKY: So does this, is this a pattern of trading activity like this that has happened with other deals that you’ve brought to Berkshire’s attention?

SOKOL: Ah. No, ’cause the other deals that I’ve brought to Warren, he hasn’t had an interest in. But, you know, Berkshire furnishes us a list of companies that Berkshire has a conflict in —

BECKY: Sorry, just to go back to that. You looked at other companies before, bought a stake in it, mentioned it to Berkshire, Warren wasn’t interested, but you still maintained those stakes in those companies?

SOKOL: Um. Well, only one which is a small bank but it never would have been of interest to Berkshire.

With a market capitalization of $111 million, it seems obvious that Middleburg Financial is far too small for Berkshire to invest in, but it is interesting that Mr. Sokol appears to have mentioned the bank to Mr. Buffett.  It may have been another bank, although it seems more likely than not that Mr. Sokol was referring to Middleburg Financial.  It seems doubtful that Mr. Sokol seriously “pitched” Middleburg Financial to Mr. Buffett and we see no conflict of interest between his ownership of the bank and his position at Berkshire, in stark contrast to his actions with respect to Lubrizol.

A Foundation for Sokol’s “Mini Berkshire”

It seems highly doubtful that Mr. Sokol plans to use Middleburg Financial as a basis for building a “mini Berkshire”.  The bank’s recent financial results have not been particularly strong and there does not seem to be much advantage in using the bank as a basis for acquiring stakes in non-financial companies.  In addition, there are many problematic aspects associated with banks owning non financial companies.

However, this does not mean that Mr. Sokol may not attempt to exert more influence over the operations of Middleburg Financial.  In a recent article in the Washington Business Journal (in which The Rational Walk is quoted), Middleburg’s management stated that Mr. Sokol is a “great source of advice” but is “too busy” to serve on the board.  The bank recently changed its bylaws to allow non-Virginia residents to serve on the Board and presumably Mr. Sokol now has more time on his hands to provide management with more “great advice”.

Bottom Line:  Not a “Mini-Berkshire” But Sokol May Get More Involved

Middleburg Financial’s shares jumped sharply on Thursday, March 31 after Mr. Sokol’s comments on CNBC led to speculation that Middleburg Financial would serve as his base for future business activities.  This seems almost entirely unwarranted.  Investors may wish to examine Middleburg Financial as a potential bet on the recovery of a small bank in a prosperous area of the country but the company is not going to become the next Berkshire Hathaway.

The media frenzy over David Sokol’s potential involvement will probably prompt enterprising reporters to descend on the small town of Middleburg on April 27 for the company’s annual meeting.  Perhaps Mr. Sokol will be there and will make a move to become Chairman or at least to join the board.  Or this could be an entirely wasted exercise and reporters could be left covering the minutiae of a relatively unknown and not particularly cheap regional bank.

If there turns out to not be much of a story at the annual meeting, not all is lost.  Middleburg is located in a spectacular small town country setting, spring is one of the nicest seasons in Virginia, The Red Fox Inn serves a lovely brunch, and Market Salamander has wonderful dessert.  It could be a great boondoggle for reporters, although we warn that typical per-diems may be insufficient to fully enjoy all the town has to offer.

Disclosure:  No position in Middleburg Financial, Long Berkshire Hathaway.

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