Value Discipline

Book Review-"Even Buffett Isn't Perfect"

2008-07-20T18:52:00.002-04:00

I am a complete sucker for investment books. My wife accuses me of owning several thousand books that have essentially the same title, usually some variant of Value Investing, valuation, or intrinsic value, or securities analysis. Of course, I have every Buffett or Munger book known to man as well as everything about or by Benjamin Graham. By the way, speaking of Graham, my good friend Geoff Gannon is putting together a series which will review Securities Analysis chapter by chapter. For those who are serious value investing students, I suspect that you will enjoy Geoff's always thorough and thoughtful posts.

Vahan Janjigian, a fellow CFA, is executive director of Forbes Investment Advisory Institute and publishes a number of newsletters with Forbes. He also has a blog and serves on the investment committee of a large RIA.

Dr. Janjigian's book gingerly attempts to criticize some of Buffett's mistaken investments and controversial points of view. I think the book is more successful with the latter than the former.

Janjigian admires Buffett's discipline and capital allocation methodologies. He admires Buffett's ability to manage executive talent. His last sentence in the book summarizes his viewpoint,"Based on the evidence, it is certainly fair to conclude that WB is one of the greatest investors-if not the greatest investor-of all time."

So where are Buffett's mistakes? Janjigian criticizes Buffett's views on taxation, especially those on estate taxes. I agree with Janjigian that there is an irony if not an artificiality or phoniness about urging the continuity of high estate taxes and concomitantly avoiding the situation through setting up trusts and foundations Evidence of avoiding income taxes is evident throughout Berkshire's life...the company and Buffett have always used the IRS Tax Code to their advantage. There is clearly nothing wrong with that but similarly. it is somewhat disingenuous to urge higher taxes after a career of avoiding them.

Like any investor, Buffett has made some mistakes. This is not a game of perfect, but rather one where investors should attempt to understand the downside risks in making an investment. The outcomes can be highly uncertain...the future always is hazy and usually, initial assumptions are plain wrong, either on the optimistic or the pessimistic side of expectations.

Janjigian addresses the Buffett diversification versus concentration question. "Buffett believes that if you can't invest enough money to have some say in how the company's capital is to be deployed, you are better off diversifying your portfolio." This is simply not true. Most Buffetteers and wannabes certainly attempt to focus their portfolios. WB does not say not to diversify...in fact, for the average investor who is not inclined to do sufficient due diligence, diversification is a salvation. For many professional portfolios, the great bulk of the portfolio is indexed. But in cases where one has specialized knowledge or skills, satellite investments outside the cord index are made and should add performance. Diversification is a protection against ignorance. If one is able to do due diligence, and select successful businesses at reasonable valuations, diversification will not serve you other than to reduce volatility and an unfortunate corollary, reduce returns.

VJ does a decent job in discussing attributes of diversification in a non-mathematical approach to statistical correlation. This is one of the strongest elements in this book.

Much of the rest of the book is in my view, completely obvious. "Buffett buys stocks cheap, not cheap stocks." "Successful investors must be able to distinguish between great companies and great stocks." VJ has an amazing grasp of the obvious and adds little insight into valuation of growth stocks. There are far better sources than this book for this element.

VJ addresses the fact that value works over the long run but growth or rather momentum can work over the short run. Buffett never trashes growth but views it as a partner in helping undervalued stocks recover when growth becomes temporarily disrupted. Other than Buffett's famous comments about lemmings, he has never discussed momentum investing per se, at least to my knowledge.

VJ makes some dangerous statements about PIPE stocks indicating that WB has been successful in buying special issue "Private Investment in Public Equity" holdings such as Salomon Brothers or US Air. True, these had special terms that a large buyer can extract but it is misleading to believe that what some brokers present as PIPEs will offer the average investor better returns. Most PIPE offerings are made in very small cap, highly risky businesses. VJ does suggest that the best access to such investments is through a hedge fund or through Berkie itself.

VJ makes the point that "Unless you have access to Buffett-like resources, it is better to think of yourself as a stock buyer than a business buyer." The argument that managements will rarely listen to outside advice is humbling for both institutional and retail investors. However, retail investors and small institutional investors can be very successful in motivating and organizing larger investors to add pressure to a board. The principle of thinking long term as an owner of a business rather than a punter of stocks is an important part of any real value investor's credo. I have had former business partners who "played" stocks rather than owned businesses and who were looking for trends rather than valuation rationales for stocks. I have had investee company managements who have indicated that I should just sell the stock if I didn't like what they are doing. If the business has a strong moat that is not being defended, get rid of the management but hang onto the business. VJ's advice is ill-conceived at best in this topic.

Swinging for the fat pitch is WB's approach. WB does not suffer from analysis paralysis and VJ believes that some of WB's recent deals have had inadequate due diligence. Sometimes the obvious should not take very long!

WB readily admits to being "dead wrong." Salomon was a mistake that took an extraordinary amount of work to escape. Gen Re was much worse with poor judgment on WB's part re underwriting discipline and the derivatives book of GenRe securities. NetJets capital intensity does not seem to fit the usual Buffett textbook. Pier One had no moat. Mistkaes all. VJ actually misses the most egregious errors that I recall, namely Dexter Shoe which gave away 1.6% of BRK or about $3.5 Billion in value for what is now a tiny fragment of H.H. Brown Shoe Group, another BRK sub. Dexter, Buffett calls his worst mistake. VJ doesn't even address this. There have been others. WB was the largest investor in Handy and Harman, the silver processor and refiner. Unfortunately, it was also an auto parts supplier and metal bender. Buffett's endless fascination with silver attracted him to H&H. H&H ultimately merged into WHX, which went chapter 11 in 2003. Berky had escaped H&H many years before this ignominious end.

VJ dislikes WB's views about corporate governance. It is incorrect to say that Buffett opposes employee stock options. It was the accounting for them that he faulted as well as the low hurdles that most company's managements clear to get them. In many cases, the only requirement for managements to achieve is respiration, and there are even cases where compensation continues into the after-life!

The composition of WB's board has been controversial in the past. No it certainly was not independent historically with Warren and Charlie, Susan and Howard Buffett; Malcolm Chace, Walter Scott were old business cronies; Ron Olson was a partner in Munger's old firm. But VJ missed the most obvious point, Buffett for most of the time that he was involved in BRK owned over half the stock. It was absolutely iron clad clear that management's interests were aligned with shareholders. Unlike most public corporations, management owned most of the stock. The role of the board is not to protect minority shareholder interests but rather to ensure that shareholders' interests are protected. This point is missed by VJ.

Bottom-line, if you are looking for advice to imitate WB's investment style, this is not the best source. If you are looking for a comprehensive list of WB's mistakes in judgment, this is incomplete. If you are looking for views on taxation contra to those of WB, read Steve Forbes rather than VJ's book.

The key takeaways after each chapter provide an excellent summary of each chapter. The final chapter, "Conclusion" successfully highlights the important points.

Dr. Janjigian has attempted to provide an antidote to the usual glorious heaping of praise that most Buffett books (and CNBC coverage) provide. The reality is that nobody walks on water (or parts the sea depending on your point of view.) Even great investors frankly screw up royally. But the incidence in the case of Buffett is remarkably low, the damage is a scratch or fender bender rather than a complete wreck. Should all of us be so fortunate, or disciplined!!

John Templeton- The Triumph of Optimism

2008-07-09T08:44:00.002-04:00

Sir John Templeton passed away yesterday. He died, much as he spent his life, peacefully.Geoff Gannon (and it is great to have him back in the blogosphere) has an extensive list of articles outlining Templeton's life as well as a list of his books. John Bethel of Controlled Greed also has a good post on Templeton, with reminiscences about Templeton's appearance on Wall Street Week immediately following the October 1987 crash.

Templeton's life was one of great inner reflection and his original sale of Templeton, Dobbrow and Vance was motivated partially by his resolve to never let himself get so busy in managing clients that he ran out of time to think, not only about investments, but also about the larger world, especially spiritual matters and religion. His investment career became focused on just one thing, a small Canadian domiciled mutual fund that Piedmont Management, the buyer of the rest of his firm had declined. So at age 56, Templeton started his career with a clean slate and a single client, the mutual fund.

I believe there is a valuable lesson in Templeton's life, the importance of keeping your perspective. The distance from his home at Lyford Cay to the floor of any global stock exchange was measured in psychological light years, not unlike the distance from Buffett's Kiewit Plaza office to those exchanges.John Train, in his book Money Masters describes this as "a silent reproach to excitement and hyperactivity."

One of the best books about Templeton's investment approach is,at least in my opinion, The Templeton Touch by William Proctor, published in 1983.In it, he highlights twenty-two maxims that Templeton said were his enabling principles. Let me highlight them:

For all long-term investors, there is only one objective-"maximum total real return after taxes."
Achieving a good record takes much study and work, and is a lot harder than most people think.
It is impossible to produce a superior performance unless you do something different from the majority.
The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
To put "Maxim 4" in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.
To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
Bear markets have always been temporary. Share prices turn upward from one to twelve months before the bottom of the business cycle.
If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and, when lost, won't return for many years.
In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.
In free-enter[rise nations, the earnings on stock market indexes fluctuate around the book value of the shares of the index.
If you buy the same securities as other people, you will have the same results as other people.
The time to buy a stock is when the short-term owners have finished their selling, and the time to sell a stock is often when the short-term owners have finished their buying.
Share prices fluctuate more widely than values. Therefore, index funds will never produce the best total return performance.
Too many investors focus on "outlook" and "trend." Therefore, more profit is made by focusing on value.
If you search worldwide,you will find more bargains and better bargains than by studying only one nation. Also, you gain the safety of diversification.
The fluctuation of share prices is roughly proportional to the square root of the price.
The time to sell an asset is when you have found a much better bargain to replace it.
When any method for selecting stocks becomes popular, then switch to unpopular methods. As has been suggested in "Maxim 3," too many investors can spoil any share-selection method or any market-timing formula.
Never adopt permanently any type of asset, or any selection method. Try to stay flexible, open-minded, and skeptical. Long-term top results are achieved only by changing from popular to unpopular the types of securities you favor and your methods of selection.
The skill factor in selection is largest for the common-stock part of your investments.
The best performance is produced by a person, not a committee.
If you begin with prayer, you can think more clearly and make fewer stupid mistakes.

Templeton was never afraid to maintain cash reserves when he got edgy about market opportunities, though he always said he had little ability to time markets. He was a pioneer in international investing, as much at home in Japanese and Canadian exchanges as he was in American exchanges. His funds frequently had positions in small, less familiar names.Basically, it came down to this:

"Search among many markets for the companies selling for the smallest fraction of their true worth."

He was always ware of socialism and regulation, which he viewed as disguised expropriation...entanglements that inhibit business and destroy the investor's incentive.

Like Buffett, he greatly feared the impact of inflation on his investments and sough beneficiaries of inflation, companies that possessed the ability to pass through cost increases.

A confident optimistic outlook and a willingness to not follow the crowd over the cliff with momentum stocks served his clientele very well.

And hopefully, following such discipline will continue to serve all of us well. I am grateful for the contribution he made to to world.

May he rest in peace.

An Interesting Screen-Deteriorating Operating Margins and Increasing Capital Intensity

2008-04-20T18:51:00.002-04:00

As one would expect, deterioration in operating margins will occur in economic slowdowns. Marginal competitors frequently will try to clear inventories at ever lower margins in order to generate cash flow. I am particularly interested concerned if a company exhibits not only operating profitability deterioration but also a build up in working capital intensity (i.e. accounts receivable and inventories may be building and cash is not coming in as quickly as one would like.) Finally, if at the same time, the company is building capital expenditures, free cash flow generation can be impeded.

In this screen, I am taking trailing four quarter observations and comparing these to trailing four quarter observations lagged back one year prior. I have confined my screen to non-financial stocks in the S&P 1500.

There is no attempt to scale the amount of deterioration. For example, in 3M, a company which I continue to like, the operating margin has decreased from 22.57% to 22.53%, hardly alarming. Operating working capital to revenue has increased to 14.1% from 10.35% which still represents significant improvement from working capital levels which hit 20%+ levels of two years ago. Similarly, capex at 3M as it undertakes its international expansion is at 7.52% of revenues versus 6.94% four quarters prior, again, not an alarming pace. Bottom-line, this is a screen which is designed to raise some questions and further analysis, not to prompt an instant sell or a short.

The data is from Cash Flow Analytics, a company founded by Professor Chuck Mulford of Georgia Tech.

Finally, the ultimate test of investment is a test of market price versus intrinsic value, clearly a judgment that each investor should make for him or herself.

You will find the screen in this link: http://tinyurl.com/3oayag

Disclaimer: I, my family, or clients have a current position in 3M

Recurring Revenues and Financial Services- The Competitive Moat of Fiserv

2008-04-08T14:00:00.003-04:00

In our last post, we discussed the notion of recurring revenues as it pertains to companies in the industrial sector. The genesis of this idea was a reaction to the prevailing wisdom of many investment strategists to find recurring revenue streams in consumer staple or health care stocks. It is my contention that there are recurring revenue themes across many sectors that remain unrecognized in the marketplace.

As a brief aside, I will mention that our posture on MSC Industrial Direct (MSM) has received some nice support from Mr. Market since our post. Today's earnings release and conference call continue to support our thesis.

Though financial services revenues from a 30,000 foot perspective seem to be one of the last sectors one would consider to have recurring revenues, particularly in light of recent experience, there are some companies whose competitive advantages provide some assurance that business remains relatively stable despite the vagaries of the economy. Switching costs are a major advantage for many companies in this sector. Even small community banks can have a reasonably sacrosanct deposit base and provided that their lending operations remain conservative and sound, they can fit a recurring revenue theme. We think some insurance companies also fit this theme especially when their business is specialized or niche in nature.

Today's post is written by my colleague and friend, John Moran. John joined us as a portfolio manager in January. As a fellow CFA, he brings considerable analytical skill to our firm. Previously with Cohen & Company, he was a portfolio manager and senior research analyst focused on financial services in an alternative asset platform. Between 2001 and 2006, he was employed by Ryan Beck and a predecessor firm (Gruntal & Co.) as an equity analyst in various sectors including financial institutions, consumer products, and healthcare.Before entering the investment industry, John worked for Lucent Technologies in real estate finance and at Chubb Corporation, a leading property and casualty insurance company, where he held various accounting and finance positions.

Here are John's thoughts regarding Fiserv (FISV), in our opinion, a strong moat company in financial services.

Intro.

Fiserv trades at 12.5x 2009 cash earnings and 8x EV/2009 EBITDA. This is a small price to pay for a business that should grow earnings in excess of 15% per year with several sustainable competitive advantages leading to a highly recurring revenue stream. Down nearly 15% since credit issues began to take a toll on its core customers in the financial industry, market price reflects a discount of 30% to the value of the business.

Business Description.

Fiserv Inc. (FISV) is a leading provider of IT services to U.S. banks, thrifts, and credit unions. The company also provides administrative support services and processing to the insurance industry. The business was repositioned late last year through the sale of selected nonbanking businesses and the $4.4 billion acquisition of CheckFree, the market leader in electronic billing and payment (EBP) market. Just over 80% of Fiserv’s 2008 sales will come from its main business of core processing and related products for financial institutions and CheckFree. The balance will be derived from the company’s insurance service segment, which provides policy, rating, and claims administration as well as billing and reinsurance services.

Core Processing.

Core processing is the nuts-and-bolts infrastructure that allows checks to be posted, payments to be tracked and processed, and accounts to be managed. The company’s products and services form the backbone of its client’s back-office systems and are critical to conducting business – they are not discretionary in nature. Moreover, changing core processing systems is costly and time consuming in implementation and employee training for customers. System changes also increase the risk of potential interruptions and service issues. Clients are therefore unlikely to leave due to a modestly cheaper or slightly superior product – once a contract has been added, the client relationship tends to be fairly sticky and pricing is reasonably inelastic. Longer-term contracts with early termination fees are the norm and renewal rates consistently run 90+%, leading to a revenue stream that is highly recurring and reasonably predictable.

The high switching costs for core processing, arguably the company’s best sustainable competitive advantage, is a double edged sword since the company’s competitors also benefit from installed bases. As such, Fiserv’s biggest challenge in this segment is generating organic sales growth. The company controls 34% of the core processing market, more than 2.5x its nearest competitor. Cost advantages from this scale position combined with a diverse and tightly integrated product set positions Fiserv better than many of its competitors to win new business. This is evidenced from the company’s 40% win rate on new core processing deals – exactly 2.5x greater than its nearest competitor according to the 2007 Automation in Banking report. Organic revenue growth has averaged just over 5% over the last five years and the business has generated operating margins near or above 20% on a consistent basis.

Consolidation among core processing companies has led to a concentration of larger players and several smaller competitors that are increasingly disadvantaged due to limited product sets and scale. The market is dominated by six major competitors with a combined 75% share down from 24 major companies in 1987 and 55% of the market is now controlled by the top three companies. While there are few compelling or willing acquisition candidates remaining, there are still some 15 independent processing companies with a little less than 25% market share – some are owned by their customers and some are small segments of larger companies. As industry dynamics continue to shift toward an oligopolistic structure, it seems highly likely that smaller competitors will either exit the business or lose clients to larger competitors due to service, product capabilities/breadth, pricing, or some combination thereof. Moreover, consolidating competition has intensified barriers to entry and should lead to higher marginal returns on incremental business for the companies that remain.

Electronic Billing and Payment (EBP)

Fiserv repositioned its business late last year and early this year by selling certain nonbanking businesses and acquiring CheckFree for $4.4 billion. The strategic rationale for moving away from businesses where the company lacks scale in nonbanking businesses (Fiserv Health, Investment Support, and two mortgage/lending services related businesses) and moving more aggressively into higher growth businesses where it does is compelling. The acquisition also reinforces Fiserv’s position as the leading provider of technology solutions for financial institutions and proceeds from the sales of other segments will be used to pay down debt.

CheckFree is the market leading electronic bill payment and Internet banking service provider and one of only three scale providers in a growing industry. The company was an early mover in the EBP market and has a 27% market share – more than 3.5x the share of its nearest competitor. Like the company’s competitive advantages in processing, CheckFree benefits from high switching costs and has a marked cost advantage due to scale economies of the EBP business. Also like FISV’s core processing business, more than 90% of revenues are recurring in nature.

Historically, Fiserv’s clients tended to be small and mid sized institutions that had limited internal technology groups and contracted for a fairly wide range of its services. While it maintained client relationships with larger institutions, the top 25 banks tended to buy only a handful of Fiserv’s services. With CheckFree, the company has increased exposure to larger bank clients and, as the CheckFree products are fully integrated with its existing offerings, FISV might have the opportunity to sell a broader range of existing services to larger institutions. These upstream sales opportunities are likely somewhat limited – besides which, incremental sales to top 25 banks would likely come with pricing concessions and increased customer concentration risk (pro forma for CheckFree, we estimate that Bank of America is the largest customer at somewhat under 5.5% of combined revenues). However, the company appears to have a tremendous opportunity to increase penetration of CheckFree’s bill payment and internet banking solutions within Fiserv’s core client base, where 52% of customers have yet to install an EBP solution and 25% use a competitive product.

Also, CheckFree has a reasonably long runway in the bill payment and internet banking space. Consider the following:

- Just over half of the 70 million U.S. households with access to internet banking are actually using it; customers appear to be fairly early in the adoption cycle.
- Of those 36 million households that use internet banking, only 13.4 million households (or just under 40%) currently pay bills online, suggesting that online bill payment is even earlier in the adoption cycle.
- The vast majority of those that have adopted online bill payment are served by the top 25 banks.
- CheckFree has historically grown revenue at 16% compound annual rate with high teen operating margins and 30% EBITDA margins.

Insurance.

The company’s insurance segment focuses on transaction processing and administrations services for the life, property and casualty, and workers’ compensation segments of the insurance industry. It is the largest third party administrator of flood insurance policies and claims in the U.S. and a leader in workers’ comp processing. Outside the flood insurance platform, the company’s competitive advantage in these businesses is somewhat limited as compared to the core processing and CheckFree businesses and competition is more intense. Organic revenue growth in the insurance segments had averaged well more than 5% with operating margins low teen operating margins until the last few years, when internal growth was 0% to slightly negative and operating margins for the business collapsed to a bit under 8%. The segment has faced headwinds as higher margin flood claims processing revenue decreased and lower margin workers’ compensation businesses increased. The 2007/2006 decline in flood claims processing revenues created comparability issues that should not be a factor this year.

Financials.

Full-year 2008 internal revenue growth is expected to be 5% to 7%, with the financial segment at the upper end of the range and the insurance segment at the lower end of the range. This is possibly conservative given that 25% of the financial segment will now be comprised of revenue from the faster growing CheckFree business. Moreover, downstream revenue synergies that could begin materializing in the back half of this year could increase the revenue growth rate.

Fiserv has completed nearly150 transactions since its inception in the mid 1980’s, with acquired companies historically operating their businesses more or less independently. CEO Jeff Yabuki, now entering his third year at the company, has focused more on centralization, cross selling, and operational efficiency. Last year that focus yielded $50 million in incremental operating income or about 130 bps of operating margin ($30 million from integrated sales and $20 million in operational efficiencies). The company has more opportunities in this area and potential cost saves from the CheckFree acquisition should accelerate operating margin improvement – management guides to savings of $100 million, about 24% of CheckFree’s existing cost structure, which strikes us as achievable by the middle of 2009. Moreover, the company will not be up against difficult comparisons in the insurance segment this year. All things considered, the 75 basis points in operating margin improvement that management is currently guiding to for this year appears reasonably easy to achieve and the company should be generating operating margins of about 20% by 2009.

Over the next two years, the company will generate in excess of $1.1b in free cash flow, with the majority being used to pay down debt. By the end of 2008, EBITDA should be at a run rate of $1.5+ billion and the earnings run rate should be in excess of $4/share. Returns on invested capital will be depressed for the next few years due to the increased debt taken on in conjunction with the CheckFree acquisition, but should ultimately revert back to historic low/mid teen levels, well in excess of the company’s cost of capital. Financial technology and outsourced processing businesses with sustainable competitive advantages have traded for between 9.5x-12x EBITDA (on an enterprise value basis) and between 15x-20x earnings – seemingly reasonable for FISV given the competitive landscape. On either basis, the current market price looks like it provides a comfortable discount to underlying value of a high quality business.

Disclaimer: I, my family, or clients have a current position in FISV and MSM.

Recurring Revenues and Industrials

2008-03-29T17:28:00.005-04:00

Economic uncertainty generally steers investors toward steady eddy businesses such as foods, consumer staples, healthcare and utilities. But what investors should be seeking is recurring revenues, predictable and stable revenues with a high degree of certainty.

Recurring revenues are highly desirable and frequently carry a higher level of margin than capital equipment businesses. Even industrial companies can demonstrate a high level of recurring revenue and a fairly low level of capital intensity, both very desirable qualities for these times.

Manufacturing in the States, largely as a function of the weak dollar continues to progress at a fairly decent pace, especially for export related manufacturing. But industrial distributors can benefit greatly from this strength as well. Uniquely, most distributors end up as significant beneficiaries of inflation on two fronts.

Unlike many manufacturers who largely pass on cost increases dollar for dollar, distributors typically have been able to pass on gross margins on top of cost increases, meaning that these companies don't lose their margin percentage. The second point related to inflation is that distributors can sometimes be fortunate enough to get ahead of the curve in dealing with higher costs. These companies can obtain a shorter-term benefit in terms of a one-quarter or longer pickup in their gross margins if lower cost inventory is sold at the higher price points.

I think one of the better opportunities in industrial distribution exists in MSC Industrial Direct, a company I recently reviewed in Marketthoughts.com

MSC Industrial (MSM) is one of the nation's leading industrial supply distributors. With a network of 4 regional Customer Fulfillment Centers and over 90 branches nationwide, the company assures its customers same day shipping, at no extra cost, with over 99.99% availability. The company truly recognizes the importance of satisfying its customers' needs. If they fail to meet the service deadline standard, they send their customer $100.

The company's history dates back to 1941 but became a more significant factor as a direct sales organization with the publication of its first catalog in 1964. In 1994, the company began to expand into maintenance, repair and operations (MRO) products, which provide a more stable demand stream of sales and cash flow for the business. In addition to its master catalogs, the company also publishes 123 specialty catalogs tailored to specific industries or products.

The vp-finance of MSM described in the Wall Street Transcript (TWST.com-subscription required) a couple of years ago the steady demand for this business:

"...we have the ability to reduce the total procurement cost of MRO (maintenance, repair and operating) supplies for our customers. Every business uses MRO. It encompasses everything from abrasives and cutting tools and measuring instruments to lubricants, sanitary supplies, cleaning supplies, chemicals, solvents, hand tools, power tools, hardware, electrical supplies, plumbing supplies, HVAC and more; essentially, if you can think of an MRO item, it's likely that we have it in our catalog."

This is a highly fragmented industry. Again from the interview:

"Why do we grow and why have we grown so fast? Well, the industry that we compete in, the one for industrial supplies, is very, very fragmented. The total MRO marketplace in the United States alone is approximately $300 billion. If you exclude the demand from original equipment manufacturing, you probably have a $150 billion marketplace. that $150 billion represents what we call semi-planned and unplanned needs. Unplanned needs are pretty much self- explanatory ' something breaks and you need to replace it. So you call a distributor and they have the part and you get it. Semi-planned are those things you know you are going to use up over time; you just don't know when you are going to need it and how much you are going to need. Generally, these are things that people stock in tool cribs or in supply
rooms and historically they keep large inventories of these items just in case they need them. They are not things you want to be out of, because you can shut down a machine or a line or an entire factory. I mentioned the industry is very fragmented. There are approximately 150,000 distributors that share the $150 billion marketplace and they employ a sales force somewhere in the neighborhood of half a million sales people. Most of those distributors are very small and have very few SKUs (stock keeping units) on hand. And they generally are niche players. So they may be a safety distributor or an electrical distributor. These people play in a very small marketplace and historically, since MRO in any one particular business has not been paid a lot of attention, people are doing a lot of manual sourcing of MRO
supplies and dealing with a lot of different distributors. MSC is a superior business model because we have 590,000 SKUs in stock compared to the 15,000 or so a small distributor stocks. this allows an individual or a business or an educational institution or a government agency to consolidate their buying to one very reliable vendor that has it in stock and can get it to them quickly. "

The company has a particular competitive advantage in its extensive e-commerce abilities that enable customers to lower their procurement costs. This includes many features such as swift search and transaction abilities, access to real-time inventory, customer specific pricing, workflow management tools, customized reporting and other features. The systems can also interface directly with many purchasing portals such as ARIBA and Perfect Commerce, in addition to Enterprise Resource Planning (ERP) Procurement Solutions such as Oracle, SAP and Infor. Consequently, the firm offers its customers inventory management solutions that reduce sourcing costs, out of stock situations, and inventory investment, all of which become even more important when business slows.

MSM's valuation has contracted significantly of late; likely discounting further manufacturing and economic weakness, yet investors may be ignoring the potential benefits from share gain trends. On a trailing P/E basis, the company is as cheap as it has been in the last decade:

1998....32.8 X
1999....18.4
2000....23.2
2001....34.0
2002....34.8
2003....35.7
2004....30.8
2005....25.0
2006....18.4
2007....15.6
TTM.....15.4

The company is currently trading at an EV/EBITDA of about 8 times despite earning 20% return on invested capital last year. In the last five years, ROIC has averaged better than 15%. Here's a look at the ratio analysis courtesy of tenkwizard.com

Google Docs - msm ratios-marketthoughts

Check out the relatively low level of capital intensity that this company has demonstrated over time. The company has generated over $700 million in cash flow from operations since 2000 and has spent only $128 million in capex over that period. As well, the company has treated shareholders as partners. Share buybacks have returned over $280 million to shareholders. Here is a look at the deployment of cash flow and returns to shareholders since 2000 courtesy of Reuters Knowledge:

http://tinyurl.com/yvfvv2

Dividends, which were instituted in 2004, have grown steadily from an initial rate of $0.32 per share annually to a current annual pace of $0.72 and have returned $231 million to shareholders. The current yield is about 1.9%.

In January, the company announced that it has authorized an increase in its stock repurchase plan to 7.0 million shares, which includes the approximately 1.9 million shares remaining under the previous authorization.

The company has shown steady improvement in working capital utilization and currently operates on a cash cycle of 98 days versus 113 days three years ago.

Effective voting control of the firm is held by the founder and his sister who cumulatively hold 63% of the vote. Lone Pine Capital, run by Steve Mandel, a well-known hedge fund manager holds about 7.9% of the company.

Overall, this is a high ROIC business with a reasonably steady growth in recurring revenues. It is a business that seems to becoming more important to its customers and is grabbing market share in a very fragmented industry of mom and pop shops. Its competitive advantages come from scale and technological prowess as well as logistics. Some slowdown will occur in economic times such as we have but the valuation appears to compensate adequately.

Disclaimer: I, my family, or fclients have a current position in MSC.

A Lemons Market- Information Asymmetry and Bear Stearns

2008-03-14T15:42:00.002-04:00

Asymmetric information gets to the root of today's market problem in Bear Stearns. George Akerlof, Michael Spence, and Joseph Stiglitz won the 2001 Nobel Prize in Economics for their work in this area.

Akerlof, who wrote the earliest paper in this area, "The Market for Lemons: Quality Uncertainty and the Market Mechanism" describes the market for used cars as a market that is distorted by quality uncertainty. Owners of decent used cars are unable to get a "decent" price to make selling these cars worthwhile, therefore they don't place these cars in the market. Because "quality" is not readily ascertainable, the quality of traded automobiles should be sub-average.

A lemon market will be produced by the following:

1. Asymmetry of information
- no buyers can accurately assess the value of a product through examination before sale is made
- all sellers can more accurately assess the value of a product prior to sale
2. An incentive exists for the seller to pass off a low quality product as a higher quality one
3. Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)
4. Deficiency of effective public quality assurances (by reputation or regulation)
5. Deficiency of effective guarantees / warranties

The market in financial services stocks has become a lemons market. Questions about asset value prevail, liquidity concerns arise, and the true condition of the assets is enigmatic. Despite 225 basis points of Fed Funds rates and co-ordinated central bank liquidity, and a broad Term Security Lending Facility, the impact on market sentiment and credit spreads has been negligible.

There is but one solution to the problem... transparency and disclosure, being more open in what is going on and why. The mystery that surrounds the arrangement between JP Morgan and Bear Stearns contaminates the rumor mill and raises investors' concerns.

Bear Stearns may have $84 in book value which certainly gets the Ben Graham instincts going, but the reality is much more uncertain. Valuation in a financial services stock is wholly dependent on future cash flow streams. There is precious little in tangible assets. There is huge uncertainty about valuation of assets comprised of pyramids of paper assets. Given the uncertainty, Bear Stearns' counterparty ratings are clipped and may be viewed by some as almost toxic.

I cannot imagine how difficult it is for BSC employees as they watch their franchise quake in the crisis. We have friends and associates who either work there or have spent part of their careers there. My thoughts are with you.

But in the grand scheme of things, the market will survive this much as it has prior brokerage and banking crises. Great names like Drexel, LF Rothschild, Robertson Stephens, Gruntal, Hutton, and Continental Illinois are no longer part of today's world, having blown up.

Great investors understand the businesses in which they invest and ignore the noise. Focus, do your own work, and understand what it is you own. Emphasize the underlying economics of what you own and avoid the expensive distractions of today's tape.

Disclaimer: I. my family, or clients do not have a position in any of the securities mentioned in this post.

Beliefs, Perceptions and Reality-Semiconductor Capital Equipment

2008-03-12T14:20:00.003-04:00

Growth has a seductive charm. There is a widespread belief that momentum drives growth and that a succession of knocking down challenges and consequent victories is what characterizes a successful business. But sustained growth is seldom straightforward. Sustained growth frequently occurs as a result of changing course, breaking rules, and changing the rules of the game. I think some of the rules have changed for the semiconductor capital equipment companies.

Years ago, within the semiconductor industry, there was a strategy that merging companies would result in a reduction in the historic overcapacity issue. This trend certainly developed as Texas Instruments sold its DRAM capability to Micron and Hyundai and LG merged their operations. Small players would be wiped out or have to find niches to survive.

Last month, the Semiconductor Industry Association (SIA) reported that global sales of semiconductors grew last year by 3.2%. It really is an amazing figure given the fact that cell phone unit shipments grew 20%, that laptops grew 32.2%, that LCD TVs grew 50%, and consumer appetite for electronics seems unabated globally.

Total bit shipments for DRAMs nearly doubled in 2007, but total revenues declined by 7.4 percent due to a decline of more than 39 percent in ASPs. NAND flash revenues were up 26 percent but unit shipments grew even faster at nearly 46 percent, while ASPs declined by 13.7 percent.

Increased concentration in the industry simply has fanned the flames of competition and price cutting rather than quell them. To quote Steve Pelayo of HSBC who recently was interviewed in The Wall Street Transcript (subscription required):

"DRAM manufacturing has been in a state of oversupply, which resulted in greater than 75% average selling price (ASP) declines last year. As a result of the significant ASP pressure, many DRAM players today are now reporting operating margins that are significantly in the red, as much as negative 50% operating margins. So clearly too much excess supply in DRAMs and a lack of profitability is causing a massive contraction in their capital spending plans this year."

Post tech bubble, semiconductor capital spending did a face plant, down 40% in 2001 and another 30% in 2002. The equipment companies responded by diversifying their revenue sources into other segments such as solar equipment and flat panel displays. In past cycles, whenever semiconductor demand slowed or caught a sniffle, pneumonia ensued for their capital equipment suppliers. This time may be different!

Growth has slowed but in fact these businesses have improved. Let's look at the capital intensity of some of the semiconductor companies versus that of their equipment suppliers:

Capital spending as a percentage of revenues (TTM)

Micron (MU) 59.3 %
Intel (INTC) 11.25 %
Advanced Micro (AMD) 24.75 %

Applied Materials(AMAT) 5.08 %
ASML Holding (ASML) 7.46 %
KLA-Tencor (KLAC) 5.09 %
Novellus (NVLS) 2.12 %

With this lower fixed cost intensity, equipment companies should not see their margins crater and improved what Pelayo calls their "cyclical resiliency."

All of the semiconductor capital equipment companies I have cited above generated free cash flow in the last twelve months. Pelayo adds:

"The cash flow generation capabilities have proven much more improved too, with some consistently generating 20% plus returns on operating cash flow, and in some cases similar returns even on a free cash flow basis (including cash outlays for capital spending). All of this positive cash flow just continues to add to the companies' treasure chests of cash, which has resulted in many of the larger players starting to pay dividends and buy back stock. The dividend yields are still less than 2% or so, but I think they have the opportunity to increase over time. So far, equipment suppliers have been really focused on buying back their stocks. Companies like Applied Materials have bought back a tremendous amount and decreased their shares outstanding by as much as 15% or so."

The solar opportunity for these suppliers seems to receive very little attention by investors. Solar manufacturing has many similarities to semiconductor production and presumably, can provide significant fewer growth for these companies. As I suggest earlier, getting knocked down, getting beaten up by too high a reliance on traditional customers helped the semiconductor capital equipment companies approach other niches. Changing course and changing the rules of the game has made them better businesses.

Disclaimer: Neither I, my family, or clients have a position in the securities mentioned in this post with the exception of Intel.

Renaissance and Revival

2008-03-08T21:19:00.002-05:00

It has been an extraordinarily long time since I last published thoughts here for which I truly apologize. Needless to say, capital markets have been challenging and clients prefer a higher level of care and attention when markets are rocky. Businesses evolve through these challenges and create opportunities to add skillsets and analytics and establish an even firmer foundation and discipline. Renaissance and revival are frequently the result of such times.

I particularly want to thank a fellow Canadian, Jay Walker, the Confused Capitalist for his gentle cajoling me back into the blogosphere. Jay has just celebrated the second anniversary of the start of his excellent blog and I congratulate him for his terrific work. His understanding of real estate appraisal and investments make his blog a valuable resource in these times.

One especially interesting e-mail from an anonymous reader suggested that I am Geoff Gannon of Gannon on Investing whose publishing frequency has also been impacted by other projects. I am not, nor is he. Geoff, your insightful commentary and wisdom are missed.

A few other friends that I wish to thank for their help and indulgence in this period of absence. Henry To at Marketthoughts.com continues to provide investors valuable reflections on the stock market and the global economy as well as an outstanding forum. I am pleased to be a monthly contributor to his service. David Korn, who with Henry and Kirk Lindstrom publish the Retirement Advisor, a timely resource for people who are either approaching or in retirement has also been kind enough to publish some of my thoughts in his website, BeginInvesting.com.

To my loyal readers, I appreciate your patience, your readership, and in particular the continued interest in past topics and posts. I endeavor to improve the frequency in sharing our thoughts.

Back to stocks. Many years ago, I was introduced to Alleghany Corp (Y) by a lucky accident. I had previously worked for the Canadian subsidiary of Lincoln National (LNC) which had just sold off its title insurance subsidiary, Chicago Title to Alleghany at what appeared, at least to me, to be a bargain price. Housing back in the early to mid- 80's was reviled as much as it is currently, in fact, in our mortgage department, we were recipients of people's keys that were being mailed in as people were giving up their homes. Title insurance was considered a terrible red-haired step child at the parent company with little chance of earning a return. John Burns, then the CEO of Alleghany saw opportunity in this distress sale. The payback on this investment was 18 months, absolutely remarkable for what was viewed as a no-growth business. Needless to say, I became a big fan of Burns and of Alleghany. Chicago Title was ultimately spun-off to shareholders and later became part of Fidelity National (FNF).

Visiting Burns at Alleghany over the years reinforced the value discipline that this remarkable gentleman has. He is an avid student of value investing and of course Buffett. His attention to detail, his keen awareness of valuation,and his knowledge of the insurance industry were always very impressive.

Many of us value hounds collect stories of Berkshire, White Mountains (WTM), Leucadia (LUK), and Markel (MKL), yet too infrequently is Alleghany mentioned. The objective of the firm sounds very Buffett-like:

"Alleghany's objective is to create stockholder value through the ownership and management of a small group of operating businesses and investments, anchored by a core position in property and casualty insurance. Alleghany is managed by a select company staff which seeks out attractive investment opportunities, delegates responsibilities to competent and motivated managers, defines risk parameters, sets management goals for its operating businesses, ensures that managers are provided with incentives to meet these goals, and monitors their progress.The operating businesses function in an entrepreneurial climate as quasi-autonomous enterprises.Conservatism dominates Alleghany's management philosophy. Alleghany's philosophy shuns investment fads and fashions in favor of acquiring relatively few interests in basic financial and industrial enterprises that offer the potential to deliver long-term value to the investor."

Alleghany has brought some very unique insurance businesses into the fold. Capital Transamerica of Madison, WI was an insurance company with a magnificent underwriting record in specialty lines and a history of shareholders equity growth that George Fait, its founder and president would remind me at insurance conferences actually outgrew Berkshire's record. It was true!

Another successful specialty insurance franchise was acquired with RSUI, Royal Specialty Underwriting, Inc. , the Atlanta, Georgia-based excess and surplus underwriting subsidiary of Royal & Sun Alliance Insurance Group plc.

Alleghany holds a majority ownership in Darwin Professional Underwriters (DR) a company tightly focused on Directors and Officers, and Errors and Omissions insurance. Stephen Sills, the founder and CEO of DR, was the chief underwriter and founder and ultimately the CEO of Executive Risk, a very highly regarded company in this field. Executive Risk eventually went public. Chubb (CB) acquired this business in 1999 at a very full price. Alleghany, on the other hand, established Darwin with Sills in 2003 as an 80/20 venture as an underwriting manager under Capital Transamerica, as usual, avoiding paying a huge acquisition premium.

Years before Berkshire bought its position in Burlington Northern Santa Fe (BNI), John Burns had accumulated a large position in the 1990's. The cost basis, about $12.07 versus today's $88.00.

Strong executive leadership continues to impress since Burns' retirement (he remains Chairman.) Wes Hicks has extensive experience as a senior executive, capital manager and research analyst in the insurance and investment industries. He joined Alleghany from Chubb Corporation, where he was CFO. Prior to Chubb, he was a senior research analyst covering the property-casualty and multiline insurance industries at J.P. Morgan Securities (where he was also a managing director) for two years and Sanford C. Bernstein & Co., Inc for eight years.

Going through the recent 10-K, results remain quite strong. Ex cats and cap gains they earned $30.29 in 2007 vs. $28.20 in 2006. Cash and invested assets are $4.9b and the company's book value grew by almost 16% yoy. All the insurance subs wrote at an underwriting profit for the Q except CATA, which was due to higher loss and loss adjustments (but was offset somewhat by higher net premium). Overall they did a very respectable 77% combined ratio.

Trading at about 1.1x book value, the company appears very well capitalized if not over-capitalized. RSUI’s (66% of underwriting profit) most admired peers (MKL, RLI, and CGI) command multiples of book value between 1.5x and 1.8x – CGI is the object of $2.3b takeout at 1.6x – and a well run, growing, profitable insurance company should go for more than 1.1x. In addition, the firm carries the Darwin (DR) stake and real estate owned in the Sacramento, CA area at below-market historic price, providing hidden asset value and additional upside to book value. This hidden asset value may in fact equate to the stock trading at book.

In my estimation, the fair value for this business is $425-$475. The potent combination of multiple expansion and book value growth as well as outstanding investment ability could prove very profitable over the coming years. The company also recognizes its value and has recently announced a $300 million share buyback.

One negative aside. Standard & Poor's downgraded slightly Alleghany's credit rating to BBB from BBB+, in my view casting more doubt on S&P's credit ranking abilities than on Alleghany's credit. The slight downgrade was done without any discussion with Alleghany executives perhaps leading some of us to question the degree of due diligence that may have been demonstrated here. Wes Hicks also expressed some surprise and disappointment in this.

In my view, among the financial services stocks, the company stands out for its conservatism, its strong underwriting discipline, and its great executive team which has masterfully allocated capital over the years.

Disclaimer: I, my family, or clients hold a position in Alleghany, Berkshire, and Markel.

Happy Thanksgiving!!

2007-11-22T10:00:00.001-05:00

Happy Thanksgiving wishes to our American readers! Certainly, no matter what the circumstances that life may bring you, there is always much for which to be thankful.

It has been said that the hardest arithmetic to master is that which enables us to count our blessings. Albert Schweitzer described the importance of gratitude,

" To educate yourself for the feeling of gratitude means to take nothing for granted, but to always seek out and value the kind that will stand behind the action. Nothing that is done for you is a matter of course. Everything originates in a will for the good, which is directed at you. Train yourself never to put off the word or action for the expression of gratitude."

America's National Day of Thanksgiving actually was proclaimed by President Lincoln in October of 1863 which set apart the last Thursday of November "as a day of Thanksgiving and Praise." The nation was still in the midst of civil war and the battle of Gettysburg had occurred just several months prior. Lincoln had not yet delivered his Gettysburg address.

Despite the horrible anguish of war, Lincoln delivered the following proclamation:

"The year that is drawing towards its close, has been filled with the blessings of fruitful fields and healthful skies. To these bounties, which are so constantly enjoyed that we are prone to forget the source from which they come, others have been added, which are of so extraordinary a nature, that they cannot fail to penetrate and soften even the heart which is habitually insensible to the ever watchful providence of Almighty God"...

"It has seemed to me fit and proper that they should be solemnly, reverently and gratefully acknowledged as with one heart and one voice by the whole American People. I do therefore invite my fellow citizens in every part of the United States, and also those who are at sea and those who are sojourning in foreign lands, to set apart and observe the last Thursday of November next, as a day of Thanksgiving and Praise to our beneficent Father who dwelleth in the Heavens. And I recommend to them that while offering up the ascriptions justly due to Him for such singular deliverances and blessings, they do also, with humble penitence for our national perverseness and disobedience, commend to His tender care all those who have become widows, orphans, mourners or sufferers in the lamentable civil strife in which we are unavoidably engaged, and fervently implore the interposition of the Almighty Hand to heal the wounds of the nation and to restore it as soon as may be consistent with the Divine purposes to the full enjoyment of peace, harmony, tranquility and Union."

Though war rages in many parts of the world, though terrorism remains an ever-present concern to all of us, though there remains "lamentable civil strife" in many nations, the magnificent words of Lincoln ring true today.

My Thanksgiving wishes for all of us include for you and yours the full enjoyment of peace, harmony and tranquility.We have much for which to be grateful and thankful. I count your loyal readership among my blessings! Have a good one!

Fear Brings Opportunity and Digging for Value

2007-11-14T09:01:00.001-05:00

Whitney Tilson is the founder and Managing Partner of T2 Partners, a hedge fund, as well as a mutual fund operation. He has co-founded a terrific newletter and established a semi-annual investment conference, Value Investing Congress, where he features a number of legendary investors. As an extension of the conference, he has introduced a new blog to highlight value investment thinking. One of the recent posts is, in my opinion, quite demonstrative of the "inverse emotionalism" that is required to be a successful value investor.

Zeke Ashton of Centaur Capital describes the fear that has infected financial services stocks very aptly:

"Clearly, we’ve got fear now, and at the epicenter of that fear is the U.S. real estate market. This fear is reflected in extraordinary volatility and stock price declines for those companies seen most vulnerable to the real estate bust – most notably homebuilders, mortgage lenders, and mortgage guarantors – coupled with all-time high prices for disaster protection on these names."

If there is a single mantra for value investors, Ashton nails it here:

"But as all value investors know, fear brings opportunity. One of the axioms of fear-based selling is that everything viewed as being in proximity to the danger gets sold."

Indeed, fear brings opportunity, and panic is never discriminating. Damage occurs at the periphery of the disaster and securities are unjustly marked down. True value investors sift through the rubble to unearth the bargains that were caught in the cross-fire. Timing is impossible, but strict adherence to a discipline and patience will provide great long-term returns. In a behavioral sense, it is always difficult to overcome the social pressure to conform. Being ostracized by others (especially clients who don't yet "get it") is a difficult position to maintain. No wonder closet-indexing is so prevalent; closet indexers turn out to be momentum players, just like the indices they hug! But, doing your own thing, ignoring the noise, celebrating the fear of others is a good high probability bet if your decisions are disciplined.

Here is the direct link.

Where Have All the Deals Gone? and Star Wars Thinking

2007-11-09T16:46:00.001-05:00

There is an interesting dichotomy that exists in capital markets. Not so many months ago, pre-August, there was a widespread perception that we were running out of stocks. Private equity interests were gobbling up anything that had a reasonably steady cash flow. Such companies were easily leveraged by the accommodating banks and investment bankers. Needless to say, the music stopped in the takeover waltz (as all of us can see, Chuck Prince has stopped dancing) In one of the more memorable and now infamous quotes that have come out of this capital market era, Chuck told the FT:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Despite the fact that liquidity had a major hiccup, and deal cancellations have been fairly rampant, U.S. private equity firms are still dancing. They have bested last year's record of $258 billion and have passed the $263 billion mark with a month and a half to spare, according to Dow Jones' Private Equity Analyst.The majority of the capital, just over $200 billion has gone to leveraged buyout shops.

I think this is an important factor to bear in mind. Certainly, every time markets go sour, similar behavior occurs. Fear leads us to truncate our investment horizons, long-term growth is set aside, growth forecasts are reduced, earnings multiples are brought down, required rates of return are brought up. Prices collapse.

But what is different this time is that there is more private equity firepower than ever that is ostensibly on the sidelines for now. Buyouts will continue to occur but will require greater equity funding and less leverage. Returns on equity driven by leverage may well be less than historical returns but perhaps prices to effect a takeover may well be less demanding.

The world has changed as financial institutions are taking hits from CDOs. But it ain't entirely over. At The Deal's M&A conference this week, Leon Black observed, "there's no question that this summer the world changed for private equity" as the credit markets that allowed "private equity to go from being 3% of the M&A market to 35% in 2007 shut down for doing highly leveraged deals." "The ability of private equity and acquisitive strategic buyers to innovate in terms of financing is almost unlimited."

One other observation re innovation in capital markets. Equity capital markets issuance globally totaled $445 billion over the first six months of 2007 on 3,000 deals, the highest dollar volume since the record set in 2000. As some of you may recall, this wasn't exactly a precursor for positive markets for the next two years. Much of the capital raise has occurred in Asia and emerging markets. In the third quarter, a total of 248 IPOs raised $46.8 billion world-wide in the quarter, up from 179 that raised $40.71 billion in the same period last year.

But outside of public equity lives the PIPE market, private investment in public equity, a market that has historically been viewed as a last-ditch source of financing. Historically, small cash-starved tech or healthcare companies that couldn't secure more conventional debt financing utilized this market. According to financial research company Sagient Research Systems, the PIPE market hit historic highs in the third quarter of 2007, with $38.8 billion, or 996 transactions, 33% greater than the volume of PIPE transactions through the same period in 2006.

Private placements such as PIPEs can be done at lower cost than traditional equity deals. Because such deals are sold to accredited or institutional investors, the securities do not require registration with the SEC. Consequently, a great deal of time and expense can be saved. As banks try to value their existing loan and structured portfolios, PIPEs are finding a way to infuse capital into deals.

Credit problems remain a thorny issue for capital markets. But market innovations are more available than ever. Nasty markets will put prices into the gun sights of some of these participants. Prices can be silly and exaggerated at either end of the spectrum, both way too expensive and way too cheap. Technicians may worry about falling knives but decent businesses that have been hacked by fearful sellers may create great buying opportunities.

Consider yesterday's Restoration Hardware news. A private equity company is doing a buyout at 2.5 times Wednesday's price! Though this business has struggled in the retailing slump, obviously there still appears to be some franchise value that many investors missed.

As an investor, don't rely on the short-term trends in a stock to tell you what it is worth. Earnings surprises, earnings revisions represent noise. We cannot guess the unknowable future. We are far better equipped to understand the present and what it means for the future. Use market weakness to rethink your analysis. But analyze rather than rationalize...hang onto your companies that have enduring competitive advantage and great returns on invested capital. Stick with ROIC and dismiss growth for now. A high return on invested capital is the signpost of a great franchise. Ensure that cash flow generation is there, don't rely on earnings and especially earnings forecasts.

Remember that an equity represents a long-term claim on assets. Yet most analysts base their opinion on next year's or maybe two years of forecasts.
That's not how anyone should value a stock.

There is a great line from Obi Kenobi in Star Wars that comes to mind, "Who is more foolish? The fool or the fool who follows him?"

Stay calm, relaxed and aware. There's lots of fat pitches coming our way.

Disclaimer: I, my family, and friends do not have a current position in any securities mentioned in this post.

IT Services and Technology

2007-11-08T16:58:00.001-05:00

Cisco Systems (CSCO)'s results of last night have cratered a lot of tech stocks today, particularly hardware. IBM. EMC, Network Appliance (NTAP) have all had a good drubbing in today's marketplace.

Though the sector has exhibited standout performance relative to most other sectors, notably the ailing banks, there are concerns that the impact of credit markets may lead to a decrease in orders for both tech goods and services.

One of the tech sectors that makes the most sense to me under most economic scenarios is IT Services. The notion of consultative help rather than having permanent staff is attractive in any slowdown scenario.

Cognizant (CTSH) was clipped today on mixed fourth quarter guidance. Cognizant, as well as other Indian IT services providers enjoy an attractive cost advantage that could benefit from additional demand from an economic slowdown. Cognizant is known for its high quality consultative approach. What seems to concern investors about the outlook is commentary from CTSH that it was not seeing a fourth quarter "budget flush." As most of us have experienced, managers have a tendency to spend out whatever remains in their current year budget to ensure that this becomes the base for next year's budget. The flushing through of budgets does not appear to be occurring for CTSH. I believe that one area of particular concern for IT providers is the spending plans of financial services companies.

Concerns about financial services reducing demand for IT may be somewhat misguided in my opinion. Cognizant cited a survey to assess clients' budget plans for 2008 involving about 150 decision makers representing a broad cross section of clients. According to management, 92% of clients do not expect overall IT budgets to decline for 2008. . Clients were also asked what would occur to offshoring budgets in the event of a decline in overall IT budgets. Only 19% felt that an overall budget reduction would meaningfully impact offshore spending plans. Among financial services customers, about 90% do NOT expect outsourcing budgets to decline.

Valuations in the sector are all over the map. CTSH has TTM EPS of $1.13 , equal to its operating cash flow per share. Free cash flow is $0.56 per share.At a 1.8% FCF yield currently, it does not represent a bargain.

On the other hand, Accenture (ACN) has trailing EPS of $2.06, operating cash flow of $2.67, and free cash flow of $2.58. Based on today's close, that's a free cash flow yield of 7.3%! I like the high conversion of operating cash flow into free cash flow. Just over 10% of each dollar of revenue for ACN is free cash flow, slightly higher than CTSH's 8.6%.

Both companies have active buyback programs with CTSH just announcing a $100 million buyback. Last fiscal year, ACN bought back a total of $2.3 billion in stock. There remains an authorization for $1.65 billion.

About 22% of ACN revenues came from financial services in the most recent fiscal year. About 57% of ACN's revenues come from outside the Americas. On the other hand CTSH, unique among Indian IT outsourcers generates some 80% of its revenues from the States. Its reliance on the financial services sector is also somewhat heavier at about 47% for FY 2006 and the most recent quarter.

In my view, Accenture with a market cap of $27 billion, only about $760 million in debt, and cash of $3.5 billion represents excellent value. Its enterprise value to TTM EBITDA is only 8.4 times.

Disclaimer: I, my family, or clients own a current position in ACN. None have a current position in CTSH.

Some Thoughts on Formulaic Investing

2007-11-05T13:49:00.001-05:00

As some of you know, I am an occasional contributor to Shai Dardashti's "Reflections on Value Investing." I think you will be impressed with the quality of serious contributors to the investment thinking that characterizes this blog. I commend it to your attention.

In today's edition, I discuss formulaic investing based on an article written some time ago by my friend Geoff Gannon.

Formulaic investing provides an important discipline to the investing process. It attempts to disengage us from the emotions that are so frequently associated with future poor results. Though not a substitute for thinking about other parts of the mosaic that comprise every investment, formulaic approaches form a very important backdrop to valuing a business. Necessarily, they are backward looking...valuations that depend entirely on formulaic approaches are extrapolating the past into the hereafter, not a sensible approach to looking at a business. After all, a stock's value consists of some sort of discounted value of all future cash flows. The past is, well it's passed. In immutable businesses, of which there are none, the thinking could end there. Remember the Buffett aphorism "The investor of today does not profit from yesterday's growth." Another one comes to mind, " If past history was all there was to the game, the richest people would be librarians." But as a starting point to the question, "What is this business worth?" formulas represent a useful benchmark for the economic reality of a business. Where it goes from here, what competitive influences will do, how it finances itself, how long the competitive advantage period will last are all unaddressed questions that are the add-ons that are needed to fully understand a business.

I apologize for my long absence from the blogosphere. Work expands, time contracts. Market opportunities are expanding with the crescendo of fear. Within portfolios, I continue to uphold the cornerstone of a value investment style, lethargy bordering on sloth.I appreciate your patience!

Don't Blame the Cow- Blame the Cowboy

2007-10-01T23:24:00.001-04:00

Interesting goings on in the financials. UBS got the ball rolling (and a few heads) with the announcement of a write down of SFr 4 billion resulting in a forthcoming loss for the third quarter. Credit Suisse (CS) also taking its truth serum, announced up to SFr 800 million in write-downs but its third quarter will still be showing black ink.

Getting rid of the uncertainty by taking the "big bath" write-off is a cleansing experience, an expurgation of evil, and as market reaction demonstrated, investors welcomed the action.

Citigroup (C) also assesses its credit woes, subprime writeoffs, and consumer linked weakness and announces its $5.9 billion loss but a return to normalcy for the fourth quarter.

Is business truly back to normal or do investors sense the demise of Charles Prince? Has the bleeding actually stopped or is there anticipation of a typical Citi night of the long knives being heralded?

The restructuring announced at the beginning of the year needs to take hold for Mr. Prince to survive. Since the first quarter of 2006, operating results have been frustrating to investors as operating leverage has been negative for every quarter with the exception of the second quarter of this year. Clearly, there is no positive news forthcoming re operating leverage in the third quarter. The "dislocations in the mortgage-backed-securities and credit markets, and deterioration in the consumer-credit environment" are ubiquitous to a degree. With a bank like Citi that covers the "field" as broadly as anyone, it is difficult not to step in a "cowpie." But investors are growing tired of management's inability to navigate the field. Rather than blame the cow, it's getting to be time to blame the cowboy.

It should not go unnoticed, but on Friday, the US suffered its biggest bank failure since 1993. NetBank, a $2.5 billion in assets bank went down the pipe and into the hands of the Office of Thrift Supervision (OTS) who immediately named the FDIC as receiver. NetBank's insured deposits ($100,000 limit, $250,000 for IRAs) were snapped up by another Internet based bank, ING. A reminder that uninsured deposits were not acquired. Customers with uninsured deposits will get 50 cents on the dollar now for uninsured balances. They get to stand in line with other creditors for the other half.

The news release from the OTS spelled out the reasons for failure. "NetBank sustained significant losses in 2006 primarily due to early payment defaults on loans sold, weak underwriting, poor documentation, a lack of proper controls, and failed business strategies." The OTS failed to mention a series of ill-conceived acquisitions and diversification efforts. Trying to manage too many businesses while failing to manage the balance sheet was a prescription for disaster.

Bank investment at times seems carefree and simple. Bank consolidations occur with some regularity and banking essentially is a hedge fund business, controlling a large amount of assets with a sliver of equity, all under the imprimatur of FDIC guarantees. Equity investors generally understand the repercussions of leverage, but depositors sometimes forget.

There is no reason for anyone to have greater than $100,000 exposed in a single bank. Be aware of your bank's balance sheet, its ratings, and its earnings.

Disclaimer: I, my family, or clients have a current position in Citigroup and Credit Suisse. None have a position in any of the other securities mentioned in this post.

The Sub-Prime Crisis and the Hedge Fund Collapse

2007-09-29T20:40:00.001-04:00

Here as we approach the 20th anniversary of the crash of October 19th, 1987, the academic world is starting to read the entrails of the hedge fund crash of 2007 as it relates to the sub-prime crisis.

In August, the financial world trembled as hedge funds involved in CDO's, most notably two funds of Bear Stearns, collapsed. Even this week, news of potential equity investments by Buffett or perhaps others have led to speculation in Bear Stearns stock (BSC).

What is sometimes missed is how verklempt the financial world got in August. A wave of deleveraging of hedge funds ensued which resulted in some very strange occurrences, namely cheap stocks, or value stocks, got pummeled, and expensive stocks, or popularly shorted stocks, rose. This caused a lot of pain on the street, especially among quantitative hedge funds, or quants.

In an academic article "What Happened to the Quants in August 2007?" by Andrew Lo, an MIT prof and a quant hedge fund manager, as well as a letter to clients by Cliff Asness, another well-respected hedgie, the conclusions are pretty much the same:

Here is a quote from Lo in an article in the International Herald Tribune: "Now that we have so many boats in the harbor, you can't whiz by at 50 knots without rocking a few boats." He is referring to the proliferation of hedge funds in equity neutral or long/short equity which ten years ago totaled about $10 billion. Today, that's a $160 billion figure. "In the middle of the ocean, your wake has no impact, but in a crowded harbor, a fast exit can cause quite a disruption."

Asness describes a similar viewpoint, "I have said before that 'there is a new risk factor in our world,' but it would have been more accurate if I had said 'there is a new risk factor in our world and it is us.' In his view, the gulf between cheap versus expensive got way too narrow in August, but has now become wide again. The problem was that too many boats were heading for the same exit.

The most highly shorted stocks showed a big uptick in trading volume. Worse yet, they beat the least shorted stocks by about twelve percentage points through the middle of August.

In Lo's paper he suggests that:

"The losses to quant funds during the second week of August 2007 were initiated by the temporary price impact resulting from a large and rapid unwinding" of one or more quantitative equity market-neutral portfolios. The speed and magnitude of the price impact suggests that the unwind was likely the result of a sudden liquidation of a multi-strategy fund or proprietary-trading desk, perhaps in response to margin calls from a deteriorating credit portfolio, a decision to cut risk in light of current market conditions, or a discrete change in business lines."

Forced mysterious liquidation is very reminiscent of those days in October of 1987, a reminder that an outbreak of fear and panic can occur at any time. Heightened risk sensitivity can often mask opportunity.