Sham Gad on Value Investing: Inspirations from Graham and Buffett

What Investors Really Need to Know About Shareholder Activism

2012-01-26T10:59:00.002-05:00

Corporate attorney Derek Bork at Thompson Hine recently released a gem of an article on shareholder activism. The article is a fascinating insight into one of the most intriguing aspects of investing today. Shareholder activism is not only the Carl Icahn type procedure you see today. Buffett in his early days was a huge activist in many of the investments he made for the Buffett Partnerships.

Most importantly, Mr. Bork's article is a refreshing illustration that successful activism is not only an arena for the large institutional investor or hedge fund, but for the smaller investor as well. With having a clear strategy and plan in mind, activism can clearly back fire, costing investors valuable time and money. Small or big, anyone interested in activism would be well advised to consider the blue print laid out by Mr. Bork.

"One of the biggest mistakes that some activist investors make is engaging in activist tactics without a clear strategy. It is easy to see the tactics that other activists use in the marketplace, but it is not always clear on the surface why they are using them. The tactics that an investor should use may vary widely from one situation to another, depending on the circumstances of the company, its legal defenses, the size of the investor’s position, the make-up of the shareholder base and other factors."

Read the article here.

Avoid the Market to Attain Superior Investment Results, Part 2

2011-07-05T14:07:00.001-04:00

The first part of this two-part article illustrated the importance of gaining an edge in investing. So how do the considerations and thoughts from Part I factor into my thinking with respect to gaining an edge? I can best explain my approach through a simple question: If asked to beat Phil Mickelson, how would you do it? You do it by not playing him in golf. Consider this analogy with respect to the stock market. The best chance of beating the market is by avoiding it. Let me explain.

Today’s market environment is dominated by mutual funds, pension funds, and hedge funds collectively managing trillions of dollars. These large funds demand equity research, analyst estimates, and other investment information services which are gladly catered to by the hundreds of equity research firms and investment banks who exist solely to service those needs.

Because these investment funds are dealing with large pools of capital, they are looking for places to allocate hundreds of millions of dollars in a relatively short amount of time. As a result, the vast majority of investment capital is being spent building castles in the same sandbox. Because asset management fees are paid annually, the goal at the beginning of each year is to be around next year to collect those lucrative fees. By staying in the same sandbox and building castles (portfolios) from the same sand (stock selections), you prosper and perish with the masses. But in the end, they survive another year to earn those lucrative fees.

If one principle characteristic of market efficiency is the existence of many informed participants, then the only possible edge worthy of exploitation is to look and play in areas where the industry pros ignore. Stock prices reflect supply and demand characteristics. An overvalued stock price suggests that demand for that particular security vastly exceeds supply and while an undervalued stock price often confers the opposite condition.

When there is no demand for a particular security, it’s likely due to one of two principal factors. First, the stock may be unknown to the broad investment community. Second, demand is low when a stock is out of favor or in trouble. In both instances, the probability of identifying a business that is trading below its intrinsic value is greatest. Inverting this observation suggests the following: the best way to find a successful investment is by either looking where very few are or finding a business facing problems that are deemed to be temporary and curable. My observation is nothing new:

I am convinced that [investors] with sound principles, and soundly advised, can do distinctly better over the long pull than a large institution. Where the trust company has to confine its operation to 300 concerns or less, the individual has up to 3000 issues for his investigation and choice. Most true bargains are not available in large blocks; by this very fact, the institutions are well nigh eliminated as competitors of the bargain hunter
-Benjamin Graham, September 23, 1974

Occasionally, one can find quality issues trading at reasonable valuations. Late 2008 and 2009 was a good opportunity to buy first rate businesses at exceptional prices. Often, however, a great business is already great in the eyes of many and this perception is already reflected in the underlying stock price.

Simply put, trying to beat the market by playing the same game that is under the constant analysis and microscope of tens of thousands of investors, analysts, journalists, and other interested parties is likely to lead to sub-par results. Play a different game: buy when everyone else is selling, look where no else is looking, and be skeptical when everyone is jubilant.

Avoid the Market to Attain Superior Investment Results, Part 1

2011-05-16T16:06:00.000-04:00

I would say that attaining an investment edge is, in all probability, the most highly pursued activity of investment managers today. After all, the reason anyone should be actively investing money is if they can outperform, net of expenses, the passive benchmark returns over a satisfactory period of time measured in years, not months.

Unfortunately, the amount of time spent in pursuit of an edge is not directly correlated with how successful one becomes at attainting that “edge.” I would argue - and I speak from experience learned from my earliest days investing as a teenager - that often, an investor is incorrectly pursuing this approach by focusing on the little details rather than what matters most.

There are really only two ways to under-perform the passive market indices. The first is by selecting investments that under-perform the benchmark index. The second way is to make market beating investments but under-perform as a result of investment expenses. With respect to the latter, Gad Partners Funds, has eliminated this anchor. By charging no asset management fee and choosing to charge all non-administrative fund expenses (office rents, subscriptions, travel, etc.) to the General Partner (that’s my fancy title), we maximize the amount of the capital available to participate in the awesome power of compounding.

In this business, a little means a whole lot. Consider what a 50 basis point difference in expenses would mean to performance and ultimately, the value of your hard earned wealth. Over a ten year period, $100,000 compounded at 9% per annum is worth just under $237,000. Under the same conditions, but with an 8.5% rate of return, the ending result is $226,000. This 50 basis point difference, or approximately $11,000, represents 11% of the original amount invested. Over a twenty year period, the difference is nearly $50,000, or 50% of the original invested capital. Such is the beauty of the little, but incredibly lucrative nuances of this business.

But in the real world of active money management, fees and expenses are much higher and lead to even greater reduction in value creation. A typical hedge fund with a 2 and 20 fee structure has to significantly outperform the market in order to create value for investors relative to a passive index fund. A 10% performance from such a fund results in a net performance of 6.4% for investors, or a 36% “fee haircut” to investors! In a business where approximately 85% of active money managers under-perform the benchmark market indices, it’s virtually impossible for the vast majority of the industry to truly deliver value for investors under the existing fee parameters.

The primary way to outperform markets is to select securities that overtime, will outperform the market. In order to beat the market, you first have to make successful investments - buying at one price and selling at a higher price.

A successful investment involves two principle considerations. The first is the intrinsic quality of the business being invested in. The second factor that determines whether or not an asset will be a good investment is price. Taken together, a successful investment entails determining the intrinsic worth of a business and then buying at a price that is less than that intrinsic worth.

In attempting to make successful investments, investors go in search of an edge, or an insight they feel they know that other market participants do not yet know or understand. Trying to gain an informational advantage over thousands of other rational and intelligent market participants is extremely difficult. Over the years, as more and more people have entered the market, the result is and added push towards general market efficiency. More market participants do mean that when markets behave irrationally, they tend to greatly over exaggerate as well, providing the enterprising investor with incredible opportunities. The crowd is not always right, but they are often more right than wrong.

As a result, attempting to gain an edge by being smarter than the crowd is not a path to consistent above average results. On the other hand, simply being a contrarian as way to gain an edge is no guarantee of investment success either. Only when backed by rational analysis, is being a contrarian indeed a prudent and profitable approach. Just ask those who continued to short the market in 2009 who correctly based their reasoning on things like continued high unemployment, declining real estate prices, and various other macroeconomic factors.

A contrarian is rewarded by being optimistic when markets are pessimistic and cautious when optimism has taken over the market. This ability does not require above average intelligence. It requires, as Warren Buffett asserts, temperament.

“The most important quality for an investor is temperament, not intellect... You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”

Investing should be an agnostic process, devoid of emotion and temptation to swing for the fences. A long-term successful investment track record can never be attained by ignoring risk in hopes of hitting a homerun. A baseball player is likely to maximize the longevity and value of his career by focusing on his batting average and not the number of home runs he can hit.

Buffett on Gold

2010-11-02T14:59:00.000-04:00

Buffett was recently asked about gold in a conversation with Ben Stein. His answer was typical Buffett: short, direct, and steeped in common sense and logic.

"You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"

No need to for me to ramble any futher on this one. Read the rest by clicking here.

The Opportunity Cost of Investing: A Simple Concept Gone Missing

2010-11-02T13:45:00.000-04:00

Back after months of absence, (quality over quantity right?) here's another post that touches on a basic and valuable, yet often neglected investment process.

We often hear of investing as a zero sum game: one investor's gain can ultimately be traced back to another investor's loss. In the timeless words of Gordon Gekko, "money is not gained or lost but merely transferred...." Yet there is another aspect to this "game" that is often not considered: the economic concept of opportunity cost. Simply, money which is invested today is done at the expense of all other investment options, including the benefits of being in cash.

With a stock market up over 12% in two months, investors seem to be betting on Republican victories in Congress and Ben Bernanke's announcement of further monetary stimulus efforts. While both those outcomes seem likely to occur in line with investor anticipation, investment opportunity cost is very high today. The higher the opportunity cost, the more upside potential an investor should require.

Understanding opportunity cost with respect to investment making decisions lends tremendous value to not only the quality of capital allocation, but investment portfolio composition. The key is in understanding that in investing sometimes the decisions you don’t make are just as valuable as the decisions you do make.

The probability that the markets will suffer a pullback remains elevated for a host of reasons - an increasing deficit, unemployment, legislation, and so forth. Because of this real risk, investors must pay careful attention to the opportunity costs that come with every single investment decision. Capital that one invests today is money that can’t be invested next month. Of course, you could sell anytime but you would be at mercy of Mr. Market’s offer on that particular day. In other words, each incremental amount of invested capital has a higher opportunity cost than the capital that preceded it. So when I’m looking to allocate capital, with respect to my final 20% cash position, my upside requirements are going to be a lot higher than the preceding 20% and so forth. So unless I’m presented with arbitrage or special situation type investments, I’m looking for a two to three fold return before making further investment decisions at current market valuations.

Sounds fairly basic and simple, right? Yet considering the trading volume still going on today, there is an incredible amount of investment activity going on, even from value investors.

Yes I can identify stocks such as Vodafone (and other blue chips), who with its strong dividend yield along with its still unaccounted for 45% minority stake in Verizon Wireless (you can argue that the recent run up in share price is in response to this asset) and quality business models will still likely produce a 10% to 12% annual total return. And yes, a return of 10% to 12% a year is very attractive, but you got to have some holdings that will deliver much higher returns to offset the inevitable laggards in your portfolio year in and year out. A stock that delivers 12% annualized returns may do by being down 5% one year and up 30% the next.

The value of understanding opportunity cost is that it will always ensure the adequate availability of cash when the pool of undervalued investments is at its highest. And availability of such opportunities rises as the market declines. So it makes sense from a value investing approach that as the higher the market goes and hence the smaller the pool of undervalued investment candidates, the more cash a portfolio should hold and vice versa. In reality, however, you see the exact opposite. The fear of buying during declining markets increases portfolio cash levels while the euphoria of bull markets reduces cash on hand.

Thinking in terms of opportunity cost creates a stronger capital allocation discipline which in turn can often lead to above average performance results. When the opportunity cost of investing is low - meaning that the available returns from equities are strong enough to warrant action - odds are that the overall market is cheap and the pool of undervalued stocks is plenty.
Today, the opportunity cost of investing is on the high side. The pool of attractively priced investments, in my opinion, is small and virtually extinct if you're dealing with $500 million or more. The best investments are likely already in your portfolio at buy prices significantly lower than today’s price. When faced with such a dilemma, investors should be extremely picky when making investment selections. .
Today’s value investor is finding slim pickings in the market. The opportunity cost is high at today’s valuations although there are pockets of fertile candidates to be found. Yet as a wise investor once said, “if there is nothing to do, then do nothing.”

The Risk of Market Timing: The Error of Bottom Hunting

2010-07-29T15:30:00.000-04:00

First let me say that this blog is not dead...it's very much alive, but I do apologize for going such a long time without a post. Things have been quite interesting here at Gad Capital. I hope to return back here on a more regular basis. With that.....

History offers some incredibly valuable insight to investors. For investors with a true value orientation, history is even more valuable. As we await for the "double-dip" market decline or run away inflation, spend some time examining the early 1970's. There are valuable lessons there.

For example, during the vicious bear market of 1973-74, the many members of the Nifty Fifty -- the blue-chip stocks of the day -- were trading with P/E ratios of 2-3x, some even lower. Investors who missed that opportunity out of fear decided to wait until the next bear gave them similar valuations. In investing, fear is an emotion that many investors let take over because they simply fail have conviction in their data and analytical reasoning. Those fearful investors back in the early 1970's are still waiting today for those valuations to come back down to where they were in 1974.

While current valuations are far above anything during 1974 -- or March 2009, for that matter -- the point is that investors waiting to bottom fish are often left waiting and waiting. While the market may have dropped 10%, many stocks significantly underperformed it. The mood seems grim today, and market sentiment seems to be looking down rather than up. So, instead of timing the market, I prefer to price stocks.

With no more government stimulus money fueling consumption and housing sales, growth will inevitably slow in the second half of 2010. It's just hard to see how the private sector can pick up the slack that quickly. This could very likely cause greater downward pressure on equity prices. I'm not suggesting that this is the time aggressively shift from cash into equities. I never think about market timing but think about individual businesses and scenarios as to how those businesses will do in various economic conditions. From there, the idea is to compare the current price with future value of the company, the probability of that future value, and from there, determine if a margin of safety exists.

I also know from history that the fiscal and monetary situation for the US is extremely different today than it was back in 1974. But just in the same way that businesses like AutoZone delivered a 14% annualized return during the lost decade of 2000-2009, there are companies today with the business and quality management that will likely do well this decade.

The beginning of 2009 may turn out to be one of the few opportunities in this lifetime to have allocated 100% to equities (I remember Buffett remarking in 2009 that if he could, he would have put his entire net worth into Wells Fargo - WFC was trading at $9 at the time), this is certainly not the time to be 100% in cash because of the likelihood of another market collapse. At some point the market will pull back - it always does. Value the business and its competitive position in the marketplace. If the price is right, then don't hesitate to follow your convictions.

The Curse of the Value Investor Returns

2010-04-13T15:33:00.002-04:00

Decades of market data, media reports, analyst reports, and more players in the finacial arena has led to a major transformation the investment field. That transformation can be summed up in a single word: activity. To many investors, inactivity is viewed as possessing inferior investment knowledge. To the value investor, inactivity is bliss. To the value investor, activitiy or inactivity is determined by one principle factor: valuation.

The time to be active was October 2008, despite the fact that the market was ultimately headed lower. Further activity was warranted over the subsequent 6 months. Today, the value investor is confronted with the preverbial curse: very little value in the market despite a seemingly unending rise in the S&P 500.

However, sometimes the best investment idea is no investment at all. As the market continues to remain strong, the pool of quality investment opportunities naturally declines. An investor used to action will come to realize that today's investing environment, while appearing friendly to stock prices, may turn out to be his worst enemy. On the other hand, the value-seeking investor understands that short periods of excellent buying opportunities are often followed by longer periods of inactivity. I currently find the market in this longer period.

French mathematician Blaise Pascal observed "all men's miseries derive from not being able to sit in a quiet room alone." Indeed this observation hits the bulls eye when it comes to reasons why many investors make mistakes in investing. Emotion, and the need for immediate active results, often lend themselves to poor investment decisions. Looking back at 2008 and the many investors who failed to make it alive, investors will benefit from the quip, "to finish first, you must first finish."

Indeed while the best gains are off the table for now, sitting still does not necessarily mean being 100% in cash although if thats what it takes, so be it. I'm not inclined to think we are anywhere near that point of 100% cash as certain sectors, like those within the agricultural industry, continue to offer tremendous value on a multi-year basis. However, the time to be 100% invested was a little over a year ago and may not come back for some time.

So, while triple-digit gains may be gone for know, investors can be patient with names like Vodafone a global wireless communications provider. The shares yield nearly 6% and the company owns 45% of Verizon Wireless, the largest wireless provider in the U.S. Currently, Vodafone gets no dividend from VW because its majority owner Verizon Communications is requiring VW to use its cash to pay down debt it owes. Yet, once this debt is repaid later this year, an opportunity exists for Vodafone to begin receiving a nice infusion of dividend cash payments.

While investment opportunities can always be found, the key is to understand when the opportunities are ample, and when the well is dry. This understanding comes from an understanding of fundamental valuation. Further, such understanding has nothing to do with market timing. Every rational investor should expect temporary periods where his portfolio will show a decline, as volatility exists in stock markets. For the value-seeking investor, buying at absolute bottoms and selling at the top is not the key to investment success. Instead its buying assets below intrinsic value, and when no such assets can be bought, then buy nothing

Finding an Investment Edge: Management

2010-03-21T11:32:00.000-04:00

The ultimate question people often desire to know of investors or investment funds is what makes them so special or uniquely qualified to outperform the market. The investing landscape has changed dramatically over the past 60 years. Back in the 1950's, a young man by the name of Warren Buffett found his edge by essentially being one in a handful of people that truly applied statistical analysis in a market dominated by investment activity that focused its attention on the most commonly known stocks. Add to that a dose of market inefficiency that does not exist today due to the sheer number of market participants, and Buffett found himself in a money making playground.

Nevertheless, Buffett was different than his mentor Ben Graham. While no one will question Graham's paramount influence on the success of Warren Buffett (not even the man himself), Buffett took the tools and built his own foundation. Buffett is indeed a value investor, but a unique one. Reading over his partnership letters, one can clearly see how Buffett developed his own style - his edge.

Buffett's first edge was his classification of the three areas his participated in - workouts, generally undervalued, and arbitrage. But over time, his edge developed into other areas - control situations, buyouts, etc. Then he moved on to insurance, with gave him the edge of extremely low cost capital. In other words, Buffett created his own form of leverage. The rest is history. As Berkshire grew, so too did Buffett's approach to investing, dictated not by a deviation from his root principles of value, but via the need to properly allocate capital.

Thus the key to successful investing is to develop an edge, but more importantly an edge than you can truly exploit in all environments. Occasionally investors will get thrown a year like 2009, when you can very easily find excellent business trading at substantial discounts to net current assets, P/E ratios of less than 4, or a ridiculous fraction of undervalued book value. In times like these, all one needs is to be ready to act quickly and decisively, and then sit still.

However, during the 80% of the market time when prices are fairly valued at best, a clearly defined investment edge can set one apart. Indeed, value investing, practiced in its true form, is in itself a tremendous edge. The ability to buy unloved businesses or companies currently experiencing temporary problems is not something that relatively many investors can really do. The ability to do nothing while markets are very active is another tremendous edge.

Nevertheless, 2008 showed how just about any approach to investing can suffer a setback. Indeed, while many who were fortunate enough to stick around after 2008 got a chance at retribution in 2009, I continue to refine my investment approach from the experiences of 2008. Like many value funds, we underperformed in 2008. And like many, we vastly outperformed in 2009. Even so, the thinking at Gad Capital has evolved.

Make no mistake, as I outline in my book The Business of Value Investing, my approach still firmly has its roots in six steps I outline in making successful investments:

1. Have a sound investment philosophy
2. Develop a good search strategy
3. Learn to value a business and assess the quality of management
4. Have the discipline to say no
5. Be Patient
6. Have the courage to make a significant investment at maximum point of pessimism.

The order above is deliberate. You can do #3 without #2, and so on.

However, seeing as my fund is relatively small in the investment field, I spend a significant amount of time looking where others simply can not look due to sheer size. For example, this year, we were still able to invest in a sub $10 million company with over twice its market cap in cash and no debt. As one of my potential investment partners told me last year at a meeting, "If the goal in investing is to make money, which is determined by investment returns, it seems to me that having a smaller sum of initial capital makes more sense in generating those returns." There's tremendous wisdom in that comment. Far few funds truly exploit the asymmetrical edge available when working with smaller sums. I know spend a bit more time exploiting this asymmetry.

The other component, and one I have come to realize that I've underappreciated significantly, is the tremendous edge one gets when investing alongside quality management. By this, it's no longer enough for me that a CEO owns 10% of the company or travels coach instead of first class (although I value such alignment of interest immensely). Instead, I become very excited when I see extremely unusual behavior from management. For example, when a CEO of a company decides to borrow money to pay off his divorce settlement so he doesn't have to sell a single share of stock to raise money (true story), that grabs my attention. When a CEO flies across the country to buy a tiny business for $100,000 that is earning $50,000 in net profit, that grabs my attention.

When a CEO decides to stop bidding on contracts to let his competitors take the bids because margins are exceedingly low or negative, that grabs my attention. In essence, this CEO is essentially doing something that will cause his share price to go down in short run, but does so because he knows that in the long run, his firm will be around to take the lion's share of projects when margins are again attractive.

Management that behaves in such extraordinary ways usually produces extraordinary businesses in the long run. Such businesses can and should be held during any market environment. In essence, finding management of this type is like finding the best value investor in that industry. So yes, focusing on quality management is nothing new, but I'd argue that how to really examine management is not often done by many.

Conservative Investing is Successful Investing

2010-02-17T14:21:00.003-05:00

Mention conservative investing and what you often get are people who think that conservative investing means putting money away in the biggest, most stable enterprises which in turn guarantees safety of principal. If the invested capital happens to also appreciate in value, then even the better. But if not, at least being conservative helps one sleep better at night. That may indeed be true, but unless you're ready to ignore inflation, many investors have it backwards when it comes to conservative investing.

While it’s indeed true that enterprises like utilities are defined as conservative, simply buying the large, well known companies does not fulfill the goal of a successful conservative investment approach. Instead, such a viewpoint increases the confusion between acting conservatively and behaving conventionally.

Two Definitions

Conservative investing, when understood and applied properly, is not a low risk low return strategy. Investors must understand two definitions to appreciate the appropriate means by which to invest conservatively.

1. A conservative investment is one which carries the greatest likelihood of preserving the purchasing power of one’s capital with the least amount of risk.

2. Conservative investing is first, the understanding of a conservative investment is, and second, following a specific course of action needed to properly determine whether or not particular investments are indeed conservative investments.

Where many investors falter in attempting to invest conservatively is blindly assuming that by purchasing any security that qualifies as a conservative investment, they are in fact, conservative investors. In other words, such investors simply focus on the first definition.

Such a viewpoint is limited and costly. A successful conservative investment approach requires not only an understanding of what a conservative investment is, but more importantly the correct approach to take in order to identify what truly qualifies as a conservative investment.

Characteristics of Conservative Investment

If based on the first definition, investors already know what qualifies as a conservative investment, then one needs to know what characteristics define a conservative investment which is where the second definition comes into play. There are four broad categories with investors can use to identify a conservative investment.

1. The Safety Factor

Clearly any conservative investment should be able weather market storms better than most. In other to do this, certain characteristics stand out. First, a business should have a low cost of production. Being a low cost producer has the principle advantage that when a bad year hits the industry, the low cost producer has best chance of still churning out a profit or reporting a smaller net loss. Second, a business should have a strong research and marketing department. A company that can not compete by staying abreast of market changes and trends is doomed in the long run. Finally, management should possess financial skill as in doing so they will be well versed in things like per unit cost of production, maximizing return on invested in capital, and other essential elements of business success.

2. The People Factor

This is a rather self-explanatory qualification for a conservative investment. But take notice that excellent people can only be beneficial after a business has demonstrated the signs of quality above. Take note of Warren Buffett’s advice:

“When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

A small company can succeed on the heels of one or two exceptionally talented people. But as a business grows, people throughout the organization must be counted if the company is to succeed and remain a conservative investment.

3. Business Characteristics

This third quality requires a little more work for investors but its well worth the effort. Here, the goal for investors is to determine what advantages or disadvantages may prevent the business from growing and earning more profits despite satisfying the first two conditions. Things to consider are the competitive landscape of the business. The existence of many competitors or the relative ease with which new competition can enter can affect the best of companies. The potential for excessive regulation could also be a game changer.

In essence, remember that just because a company satisfies the obvious conditions of being a conservative investment always remember to consider this third condition. The following examples will illustrate this concept further.

Those Who Fail and Those Who Pass

Great examples of those businesses that pass the test include names like Coca-Cola, Wal-Mart and Johnson and Johnson. These companies have demonstrated time and time again the strength of their franchises. Even more importantly, both of these companies will likely continue to have very favorable future prospects. Coke essentially competes with Pepsi and Dr. Pepper and no one else. More so, it’s unlikely that entrepreneurs are sitting in garages thinking about creating the next great soft drink company.

Because Wal-Mart exists and succeeds, that should raise a red flag for most other retailers, save for Target and a few specailty retailers. Remember Circuit City, which used to be number 2 to Best Buy in electronic retailing? It’s now bankrupt in no small part due to Wal-Mart. Toys ‘R’ Us was taken out in a private transaction a few years ago due to various competitive threats which likely included Wal-Mart's expansion of its toy department.

Of course once a passing company has been identified, the stock price matters only inasmuch as to determine the value gained. Today, names that pass and trade at very attractive prices include Kraft Foods, Pfizer, and Vodafone.

A Collective Approach

Investing conservatively is not about simply identifying large well-known businesses, but going through a process that identifies why a particular company qualifies as a conservative investment. And as you can see from the names above, being an conservative investor can lead to some of most dependable and respectable returns in the market.

Understanding Profits Leads to Better Investment Decision Making

2010-01-15T10:14:00.003-05:00

After 2009’s eye popping market performance, investors need to take a moment and consider what really matters when pouring over company financial reports and earnings statements. It ain't net earnings, although to the detriment of many investors, it's the metric they hinge on. Instead its the one metric that supercedes all others, save for maybe the quality of management. That metric is cash flow.

Investors would be very well served to instead pay attention to cash flows first and foremost. While it’s widely known that earnings can be massaged, investors should be aware that not all attempts to manicure earnings are illegal. Management can legitimately make corporate decisions that have a direct effect on the level of reported earnings.

The most significant decision is the use of depreciation to influence earnings. When a business purchases property, plant, or equipment, it is entitled to depreciate that asset. A growing business will likely have capital expenditures that are significantly above depreciation levels. Such a difference is acceptable for a period of time. And cyclical businesses will likely have periods where cap ex goes up dramatically as they make upgrades or new investments.

However, whenever prolonged periods where depreciation is significantly below cap ex or the other way around, investors should take note. Such discrepancies paint an inaccurate picture of earnings, which demands that investors always examine the cash flows along with earnings. When cap ex consistently exceeds depreciation, then true earnings are actually lower than those reported on the income statement. Conversely, when depreciation exceeds cap ex, then the earnings are better than they appear.

And it’s for the above reasons that value investors typically shun away from capital intensive businesses that earn low returns on invested capital. That’s why Buffett’s deal for railroad Burlington Northern has many scratching their heads. While I’m not investing in any railroads, remember that Buffett’s advantage is the fact that he will own 100% of the business plus the likelihood that Berkshire will own it for decades, which is the only possible way he will get the value he often demands (which coincidentally happens to be pretty darn attractive for the sum of money he is putting up). People often neglect little things like the fact that Burlington’s $470 million or so in annual dividends will now go to Buffett

A good understaning of earnings in relation to cash flows will present the real performance picture.

Where "Value" Investors Often Go Wrong

2009-10-13T16:32:00.002-04:00

After what happened to equity markets in 2008, many financial "experts" began to question whether or not any investing school of thought really worked. Those who believed that the market was efficient found egg on their face when all was said and done. I didn't need 2008 to prove to me that markets were inefficient. The proof positive reason I have for market inefficiency is simple this: the stock market consists of human participants who by their very nature are irrational and inefficient creatures.

The other school of thought that took a beating was that of value investing. I've never really been fond of using the term value investing, since I subscribe to the Charlie Munger view that "all investing is value investing." Further I believe that the value and growth aspects of investing are merely two sides of the same coin. Nonetheless, its because precisely that so few individuals actually subscribe to the tenants of value investing (those being risk aversion, avoidance of crowd psychology, buying businesses in out in favor places, etc.) that we do use the term value investing. So it is in this context that I dispense of the term value investing and how I adhere to it.

Let me use a moment now to throw in a shameless plug for my recent book that was just published by John Wiley and Sons, "The Business of Value Investing" which focuses on precisely how a businesslike mind frame is what true value investors employ in selecting equities. The book focuses on the six essential elements (use of the word element is deliberate - elements are essential to life) that are incorporated in the value investors mind.

Back to the topic at hand. Value investing was left for dead after 2008. I mean when Bill Miller nearly 50% in a year and Mohnish Pabrai drops by nearly 60%, surely the approach is flawed. Never mind that folks criticizing the tenets of value are dismissing over 80 years of results by Ben Graham, Walter Schloss, Warren Buffett, and Seth Klarman. Even I will admit the Gad Partners Funds' had a terrible 2008, down nearly 45 percent. But the value investor sticks to his knitting, obviously willing to tweak his or her approach, but never doubting the inherent success of the foundations of value investing. (By the way, I believe Miller is up nearly 50% this year and Pabrai is up over 100%. As for the GPF, I can't get into the specifics but we are in between Miller and Pabrai. Obviously simple tells you that even those results have yet to get any of us back above 2008 levels, but we are not done, not by a long shot.)

Where many "value" folk go wrong is in a very fundamental sense. Many investors spend far too much time focusing on the income statement first and the balance sheet second. No question, profits are important, but without a solid foundation, those profits are only as good as the business environment. And no business environment stays rosy forever - there are hiccups. And if business setbacks are hiccups, 2008 was a trip to the ICU.

The balance sheet must always be the most relied upon piece of information. In basic value terminology, the balance sheet is the FIRST MOAT. Of course, the balance sheet alone is not enough. The income statement is the SECOND MOAT. A debt free, cash rich company is great, but not so great if that business can't produce profits. Still a profitless company with a sound balance sheet still has value creating catalysts - buyout, liquidation, etc. - that serve to protect the investor. The same is not true for a profitless company loaded with debt or poor assets. The results here can often be massive shareholder dilution in order to keep the company afloat or worse, bankruptcy.

Buffett Talks with Fortune's Carol Loomis

2009-09-17T14:24:00.001-04:00

Click on the link below for the video.

Buffett: 1 year after the crash - Video - Fortune

Macro Matters

2009-09-10T17:16:00.004-04:00

Despite the often perceived notion that adherents of value investing ignore the macro economy, nothing could be further from the truth. Make no mistake: the central tenant of value investing is to buy assets at a significant discount to thier intrinsic value, where such an intrinsic value is typically determined by the cash generation of those assets.

The problem to those outside the value circle looking in is that value investors often make such investments during the most pessimistic market environments, which almost always means that the stock price will fall some more once it is purchases. This leads many to believe that a value oriented approach ignores macro economic considerations.

Such beliefs are myths and if you look at the approaches of the most successful value investors, consideration is always given to certain macro economic factors. Understanding this delicate distinction will prove very fruitful to investors going forward in making investment decisions.

If there is anything that trumps all other considerations to a value investor, it’s the price paid for a security. In many cases, a fire-sale price can be overcome by macro considerations. For example, consider the restaurant industry. For many reasons, many restaurants aside from ultra budget friendly places are relatively unattractive investment candidates to many value investors. Restaurants are often characterized by thin profit margins, extremely low barriers to entry, and the availability of numerous substitutes.

But what is also considered are things like the rate of unemployment, the household savings rate, and consumer spending. You might not see this in the value investor's analysis of the company per se, but they are all seriously considered in any worthwhile analysis.

Nonetheless, where the value investor hinges his ultimate bet on is the price paid for the security.

The Future for Investors

So looking ahead, what doest this mean for investors? It means that just because a stock has a P/E of 8, it might not represent a bargain when you consider the macro environment going forward. As noted investment manager Jeremy Grantham remarked recently after the recent market rally, it appears the market is headed for “seven lean years.”

But it also means that value can be ascertained in various forms. For mental stimulation, consider the following example:

For instance at P/E of 20, many value "wannabes" may be quick to dismiss Hutchison Telecom International a company that provides mobile and fixed line telecommunications services in the Asia-Pacific region, specifically in areas like Indonesia, Vietnam, and Thailand. You’re essentially getting a company with a huge option on increased telecommunications use from the world’s fastest growing region.

Hutchison used to be a huge amalgamation of telecom businesses throughout the emerging world. However, the company recently spun-off the Hong Kong and Macau operations into Hutchison Telecommunications. HTX is now the more “volatile” growth targeting emerging markets provider. Even after the spin-off Hutchison Telecom owned 51% of Partner Communications the number 2 telecom based in Israel. Subsequently the stake was put up for sale for $1.38 billion

Quickly looking at Partner, Hutchison Telecom may seem like an absurd bargain. Hutchison currently has an enterprise value of some $1.5 billion, while the 51% stake in Partner is will fetch HTX $1.4 billion. This might seem that investors are getting to bet on telecommunications growth in Indonesia, Veitnam, and Sri Lanka for free. Unfortunately, the market is already aware of about $900 million in cap ex that Hutchison is planning for expansion into the emerging countries. Still, if any of those emerging countries do as well as India or China in terms of penetration, there’s huge upside.

So Hutchison offers a very interesting play in the fastest growing region in the world. Underlying this thought is a favorable long-term macro view: as a country develops its citizens will need communication capabilities.

If you train yourself to look at a company in such a fashion, you begin to understand what matters most when looking at a business.

Put the Process Before the Outcome

Value investing works if pursued patiently and meticulously. The goal is to always seek out market mis-pricings because when you can, the margin of safety protects you from sudden or temporary shifts in the macro-economic environment. But that doesn’t mean value investors ignore the macro economy, instead it’s always factored into a thorough and quality analytical framework.

Invest Like It's The End of the World and Be Rewarded

2009-04-28T19:06:00.007-04:00

It's been nearly four months since I last posted - it's always about quality not quantity, eh? Needless to say, I've been - and happily so - swamped with reading annual reports and finishing up my first book, due out in October. Nonetheless, with investors of all stripes turning thier heads looking for answers, I'm here to say I don't have any. But I do have some thoughts on what seems to be a prudent approach to our craft.

I have a lot of respect for Ian Cumming and Joe Steinberg, the top brass at Leucadia. Like everyone else, they had a dismal 2008. Many of Leucadia's investments - commodities, real estate, wineries - are simply dependant on the economy turning around. But one year a track record doesn't make. But 30 or so years it does and Leucadia's results over that time have been off the charts: book value per share has increased at a 17.3 compounded annual growth rate from 1979 - 2008.

So naturally, I enjoy reading the company’s annual letter to shareholders for any nuggets of wisdom or investment ideas since Leucadia is nothing more than a conglomerate of investment holdings. Reading Leucadia's annual letter over the weekend, I was intrigued by Cummings and Steinberg's assessment of the future.

"Out of prudence we have a pessimistic view as to when this recession will end. To think otherwise would be to gamble about the beginnings of good times whereas by imagining a bleak future we will most likely survive for the good times to arrive."

I find the above statement to be one of the greatest pieces of investment wisdom I've come across recently. Investors would be well served to take the above assessment and apply it to their investments going forward. I like to call it an “invest for the worst and hope for the best” kind of approach to investing today.

My approach stems from the fact that investors are crazy if they are analyzing most businesses based on 2007 profits/multiples. Don't get me wrong: we could very well be easily sitting in the midst of the greatest buying opportunities of a lifetime. Indeed, I lean towards this view. However, it's with prudence that investors must assume that the market will remain in a funk in order to profit handsomely when spring does come. Because if you assume the worst, your investment process, by default, will become much more skeptical. All investors should arm themselves with a healthy does of skepticism at all times.

The wonderful thing about 45% market declines is that many stocks fall a lot a harder, thus setting the setting for phenomenal returns. Forget the preverbial 50 cent dollar - they are a dime a dozen today. Thirty cent - even ten cent dollars - can be found today with a little extra effort.

True value investors are not afraid to pounce if a security is widely undervalued. They time stock prices and not stock markets. In a recent interview Buffett said he would relish the opportunity to be in his 20's all over again today.

We're certainly not out of the woods yet, and it seems that it really won't be until 2011 until the economy recovers again. But it's a guessing game as to when the stock market will turn - they are forward looking creatures after all. But then again, value investors aren't timing stock markets.

What Really Matters In Investing

2009-01-05T18:35:00.005-05:00

Why Prudent Investors Focus on Holding Period Returns

With 2008 finally over, many investors have equity portfolios that have shriveled by 30% to 70%. Simple arithmetic will tell you that if you're down 50% in 2008, you need a 100% return to get back to even. While possible, it will be a remote possibility for many to earn a triple digit return in 2009 considering that many consider it to be a healing year at best.

Whether we like it or not, investing is most beneficial and pays off when done for a period of many years. As such, investors holding securities are better off focusing on holding period returns, which is what really matters. The stock market swings wildly in the short run, but over time, stock prices have always caught up with the underlying fundamentals of the business. Skeptics will correctly argue that investing a dollar invested in the market over the past decade would be worth slightly less today. But I’m not talking about investing in the broad market, but instead individual securities.

One thousand dollars invested in steel producer Nucor would be worth about $20,000 at the end of 2008. The same $1,000 invested in UnitedHealth Group in 1998 would be worth over $15,000 today once you factor in three 2 for 1 stock splits that occurred in 2000, 2003, and 2005. Even boring old Wal-Mart shares would have been worth about $3,000 today in exchange for putting up $1,000 in 1998, and this is not including the dividend. And even and investment in 1998 in Whole Foods which today trades around $9 share, down from an all-time high of $80, would be up over twofold when accounting for the two stock splits.

The market is tough to beat, but you could have easily made satisfactory returns over the past ten years in which the market went nowhere. And these returns would have outperformed real estate, bonds, and just about any other asset class.

The next decade will be no different even if you started in 2008 and can muster the courage and patience to keep going. No one has a clue what the market performance over the next five and ten years will be. But everyone will agree that there will be many companies that will be bigger, better, and more profitable. And Mr. Market doesn’t care about fundamentals in 2008, businesses that continue to improve profit generation will ultimately be recognized.

History Doesn’t Repeat Itself...But It Does Rhyme

Knowing a little market history after the worst year since the Depression can be very instructive. The following chart shows how the Dow has fared during and after recessions.

Recessionary Period (Change in Dow during recession) (Change one year after)

Aug 1929 - March 1933 (-84.2%) (81.1% )
May 1937 - June 1938 (-23.2%) (-2.4%)
Feb 1945 - Oct 1945 (21.3%) (-9.4%)
Nov 1948 - Oct 1949 (-0.12%) (18.7%)
July 1953 - May 1954 (21.6%) (29.7%)
Aug 1957 - April 1958 (-9.9%) (36.8%)
April 1960 - Feb 1961 (7.5%) (6.9%)
Dec 1969 - Nov 1970 (-1.4%) (4.7%)
Nov 1973 - March 1975 (-19.0%) (30.1%)
Jan 1980 - July 1980 (11.5%) (1.9%)
July 1981 - Nov 1982 (7.4%) (22.8%)
July 1990 - March 1991 (1.2%) (11.0%)
Mar 2001 - Nov 2001 (-5.7%) (-9.7%)

The crucial part, of course, is how long our current recession will affect the market. No one truly knows. What we do know is that the market will have turned by the time we get the “official” word.

But another important chart to look at is below.

Company [2001 Price] [2003 Price] [2007 Price]

Apple [$7-$13] [$6 - $12] [$82 - $200]

Vulcan Materials [$37 - $55] [$29 -$49] [$77 - $129]

Tesoro Corp [$5 - $8] [$2 - $7] [$31 - $66]

Transocean [$23 - $57] [$18 -$26] [$73 - $150]

Fluor [$15 -$31] [$10 - $22] [$37 - $86]

Source: Value Line (note: prices reflected low’s and highs for the year are rounded to nearest dollar for illustrative purposes)

The sample above is instructive in showing us how markets behave. Many securities that were bought in 2001 - a year of double digit market declines - were deeply underwater at the end of the year. Two years later many investors were still down by over 50% on many holdings if they had held on. But by 2007, if you had invested in solid companies with great earnings power, you more than made up for it. Even with a 60% two year decline in share value for Fluor shares in the heavy construction firm more than rewarded long-term investors. Assuming you had bought at $25 in 2001, you were down over 50% by 2003. Assuming you had sold at $65 in 2007, your six year holding period return was $160%. I’ll take numbers like that all day.

This recession is vastly worse than the 2001 variety. But as a long-term investor, you should keep your focus on holding period returns and if you stick with businesses that will be doing well a couple of years from now, you’ll realize that stocks can still produce the best returns.

Mueller Water Arbitrage: Taking Candy from a Baby

2008-12-03T09:30:00.004-05:00

Mueller Water Products (NYSE: MWA & MWA-B) was spun out of Walter Industries in 2006. Prior to the spin-off Mueller’s Class A shares were already trading in the market via an IPO. Subsequent to the spin-off Mueller issued Class B shares to the existing shareholders of Walter Industries. The share structure was that 25 million A shares were floated and 85 million B shares were spun-off. Both classes of stock have identical economic value. The only difference was that the B shares came with eight votes per share versus only one vote for each A share. The superior voting rights would suggest that the B shares should command a premium to the A shares.

Historically, the A shares tended to trade at a premium to the B shares, typically at a level of 5-10%. The only reason explaining this mismatch was the greater supply of B shares and the fact that there was greater selling pressure on the B shares from Walter Industries shareholders who wanted to monetize their Mueller stake. Additionally, unlike a Berkshire Hathaway, where conversion rights exist between the A and B shares, Mueller has no such conversion rights, so there was nothing to prevent shares from trading one to one.

In September of 2008, I noticed that the B shares were trading at $6 while the A shares were hovering around $9, or a 50% premium to the B shares. This was an absurd spread which can only be explained by the irrational market behavior that has engulfed investors recently. The trade was simple: I shorted an equal dollar amount of A shares against a long dollar amount of B shares. Believe or not, there were plenty of A shares to short. Within days the spread had closed to within 20%. My goal was to exit the position when the spread came close to the historical 5-10%. But as luck would have, the company announced that at the next annual meeting, it would put to a vote a resolution to make the A shares convertible to B shares on a one for one basis. The spread closed to within 1% immediately. We didn’t need to conversion announcement to make money but it was icing on the cake. At a 50% spread, the short/long trade was like taking candy from a baby.

Valuations Don't Matter - In the Short Run

2008-11-19T09:30:00.003-05:00

The markets are going through a historic transformation. During this process, all rationality goes out the window. Consider what happened to the tripling in price of credit swaps covering Berkshire Hathaway for a bet they made that doesn't come due until 2019.

Valuations today simply mean nothing...in the short run. "Cheap" has taken on a whole new meaning. And if your business has any amount of meaningful debt, the market hates you even more.

Without a doubt the excessive decline in share prices has been exacerbated by the forced selling--from everyone. Mutual fund redemption's are at an all time high. Pension funds are getting hit. And of course, our hedge fund brethren who decided to buy $15 dollars worth of stock for every dollar handed to them by investors.

I echo Buffett's sentiments that years from now, certain businesses will be earning record profits. Nonetheless, while it's a fools game to attempt to call a bottom, certain things must occur before the environment truly gets better going forward. Mr. Market is confused and it's absurd to see nearly 1,000 point swings in a single day. At this point, a stable 1,000 advance in the market over the course of year would represent over a 12% return - something that every investor would take solace in.

While we value investors prefer to concentrate our efforts in our very best ideas, I think one will do exceedingly well in today's market by buying a less concentrated basket of excellent securities that are trading at magnificent discounts to their true value. Many large-cap companies today are trading at absurd valuations even when you normalize earnings over multi-year periods. ConocoPhillips is absurdly cheap and makes money even when oil is at $50. American Express is another.

Joel Greenblatt has done just this by simply buying hundreds of his Magic Formula stocks and going away. The irony in investing is that as markets tank and performance declines, it's easier to invest going forward. Starting point matters. An amateur investor picking a basket of low P/E, strong balance sheet stocks today will likely produce better numbers over the next year or two than many seasoned pros. This merely a function of getting in at a much lower starting point.

While the re-capitalization of the big financial firms was a big step in the right direction (whether you agree with the actual plan or not, no plan at all would have caused unthinkable consequences), we still need to see:

1. Stabilizing Housing Prices - It's amazing that homebuilders still continue to pump out new houses and even more amazing that no homebuilder has gone under. Supply of new homes need to cease.

2. Resumption of corporate M&A Activity - companies need to start taking their cash and putting it to work. When this happens, everyone on the sideline will take notice.

Now is not the time to be losing faith, but I wouldn't expect much in the short run. Investors could be down another 10% to 15% before finally being vindicated.

Buffett Says "Buy American"

2008-10-17T22:12:00.003-04:00

On October 17, 2008 Warren Buffett wrote a op-ed piece for the New York Times.

All I can say is please read it....Buffett NY Times

One-Hour Interview: A Conversation with Warren Buffett

2008-10-02T09:50:00.001-04:00

Follow the link below to view the one-hour interview of Buffett with Charlie Rose last night:

A Conversation with Warren Buffett

Book Excerpt: THE SNOWBALL

2008-09-28T12:19:00.003-04:00

Below are two excerpt's from Alice Schroeders's The Snowball: Warren Buffett and the Business of Life, the first ever authorized biography of Buffett.

In January 1943, following his father Howard Buffett’s election to Congress as a Republican representing Nebraska, the Buffetts moved to Virginia. The 12-year-old Warren had to change schools. Uprooted and unhappy, his grades suffered and his behaviour took a rapid turn for the worse.

Bad grades were the least of Warren’s troubles in junior high. His parents didn’t know it, but their son had turned to a life of crime.

“Well, I was antisocial, in eighth and ninth grade, after I moved there. I fell in with bad people and did things I shouldn’t have. I was just rebelling. I was unhappy.”

“We’d just steal the place blind. We’d steal stuff for which we had no use. We’d steal golf bags and golf clubs. I walked out of the lower level where the sporting goods were, up the stairway to the street, carrying a golf bag and golf clubs, and the clubs were stolen, and so was the bag. I stole hundreds of golf balls.” They referred to their theft as “hooking”.

Link to: Financial Times Excerpt Part One.

Early on the morning of Sunday August 18, 1991, Warren Buffett met John Gutfreund, Salomon’s outgoing chief executive, and Tom Strauss, shortly to stand down as its president, in one of the many conference rooms on the 45th floor of Salomon’s office downtown, just before the meeting at which the board would ratify Buffett’s apppointment as interim chairman. This was to be announced later that day. The board gathered outside. Suddenly, a lawyer appeared in the conference room where Buffett was meeting Gutfreund and Strauss, waving a message from the US Treasury Department. It was going to announce in a few minutes that Salomon was barred from bidding at Treasury bond auctions, both for customers and for its own account. All of them understood that in minutes Salomon would be shot in the head.

“We immediately saw that this would put us out of business – not because of the economic loss, but because the message that would go out to the rest of the world in headlines in the papers on Monday would be ‘Treasury to Salomon: Drop Dead.’ In effect, the response to installation of new management and banishment of the old would be an extraordinary censure delivered at an equally extraordinary time exactly coincident with the first actions of the new management.”

Link to Financial Times Excerpt - Part Two

Sequoia Fund Annual Q&A

2008-09-04T11:02:00.002-04:00

A wonderful read...

Sequoia Fund Annual Meeting, May 16, 2008, NYC

Longleaf Parnters 2008 Semi-Annual Shareholders Letter

2008-08-27T09:31:00.002-04:00

As always, Mason Hawkins and Co. deliver a must read for the serious investor:

"We do not know how long economic uncertainty and shareholder fear will last. Bear markets do not die of old age. The mispricing, however, is providing the opportunity to own high quality companies with terrific five year outlooks that imply high long-term IRRs.We are aggressively adding personal capital to the Funds and encourage our partners to do the same. Given that bullish sentiment is at its lowest level in 14 years and that some are recommending exiting equities altogether, there is plenty of panic in the air. Historically, the best time to invest has been when owning stocks has felt the worst.

Throughout history a small number of successful investors have used periods of fear to build portfolio foundations for substantial long-term gain. John Marks Templeton was among the greatest.We pay tribute to Sir John who not only provided a rolemodel for investing, but also was a trusted advisor and supportive investment partner."

Link: Longleaf Partners Letter

The Security [Buffett] Liked Best in 1952

2008-08-18T07:12:00.002-04:00

This is a gem article written by Buffett over 50 years ago. I remember in Omaha Buffett telling me that he found this business in the back of the famous "10,000 page Moody's manual" that he went through page by page. Like his approach to GEICO, Buffett's analysis is simple and hits on what counts.

A big thanks to Dah Lau for sending this out.

Western Insurance Securities Company, 1952
by Warren Buffett

Again my favorite security is the equity stock of a young, rapidly growing and ably managed insurance company. Although Government Employees Insurance Co., my selection of 15 months ago, has had a price rise of more than 100%, it still appears very attractive as a vehicle for long-term capital growth.Rarely is an investor offered the opportunity to participate in the growth of two excellently managed and expanding insurance companies on the grossly undervalued basis which appears possible in the case of the Western Insurance Securities Company.

The two operating subsidiaries, Western Casualty & Surety and Western Fire, wrote a premium volume of $26,009,929 in 1952 on consolidated admitted assets of S29,590,142. Now licensed in 38 states, their impressive growth record, both absolutely and relative to the industry, is summarized in Table I below.Western Insurance Securities owns 92% of Western Casualty and Surety, which in turn owns 99.95% of Western Fire Insurance. Other assets of Western Insurance Securities are minor, consisting of approximately $180,000 in net quick assets. The capitalization consists of 7,000 shares of $100 par 6% preferred, callable at $125; 35,000 shares of Class A preferred, callable at $60, which is entitled to a $2.50 regular dividend and participates further up to a maximum total of $4 per share; and 50,000 shares of common stock.

The arrears on the Class A presently amount to $36.75.The management headed by Ray DuBoc is of the highest grade. Mr. DuBoc has ably steered the company since its inception in 1924 and has a reputation in the insurance industry of being a man of outstanding integrity and ability. The second tier of executives is also of top caliber. During the formative years of the company, senior charges were out of line with the earning power of the enterprise.

The reader can clearly perceive why the same senior charges that caused such great difficulty when premium volume ranged about the $3,000,000 mark would cause little trouble upon the attainment of premium volume in excess of $26,000,000.Adjusting for only 25% of the increase in the unearned premium reserve, earnings of $1,367,063 in 1952, a very depressed year for auto insurers, were sufficient to cover total senior charges of $129,500 more than 10 times over, leaving earnings of $24.74 on each share of common stock.It is quite evident that the common stock has finally arrived, although investors do not appear to realize it since the stock is quoted at less than twice earnings and at a discount of approximately 55% from the December 31, 1952 book value of $86.26 per share. Table II indicates the postwar record of earnings and dramatically illustrates the benefits being realized by the common stock because of the expanded earnings base.

The book value is calculated with allowance for a 25% equity in the unearned premium reserve and is after allowance for call price plus arrears on the preferreds.Since Western has achieved such an excellent record in increasing its industry share of premium volume, the reader may well wonder whether standards have been compromised. This is definitely not the case. During the past ten years Western's operating ratios have proved quite superior to the average multiple line company. The combined loss and expense ratios for the two Western companies as reported by the Alfred M. Best Co. on a case basis are compared in Table III with similar ratios for all stock fire and casualty companies.

The careful reader will not overlook the possibility that Western's superior performance has been due to a concentration of writings in unusually profitable lines. Actually the reverse is true. Although represented in all major lines, Western is still primarily an automobile insurer with 60% of its volume derived from auto lines. Since automobile underwriting has proven generally unsatisfactory in the postwar period, and particularly so in the last three years, Western's experience was even more favorable relative to the industry than the tabular comparison would indicate.Western has always maintained ample loss reserves on unsettled claims.

Underwriting results in the postwar period have shown Western to be over-reserved at the end of each year. Triennial examinations conducted by the insurance commissioners have confirmed these findings.Turning to their investment picture, we of course find a growth in invested assets and investment income paralleling the growth in premium volume. Consolidated net assets have risen from $5,154,367 in 1940 to their present level of $29,590,142. Western follows an extremely conservative investment policy, relying upon growth in premium volume for expansion in investment income. Of the year-end portfolio of $21,889,243, governments plus a list of well diversified high quality municipals total $20,141,246 or 92% and stocks only $1,747,997 or 8%. Net investment income of $474,472 in 1952 was equal to $6.14 per share of Western Insurance common after minority interest and assuming senior charges were covered entirely from investment income.

The casualty insurance industry during the past several years has suffered staggering losses on automobile insurance lines. This trend was sharply reversed during late 1952. Substantial rate increases in 1951 and 1952 are being brought to bear on underwriting results with increasing force as policies are renewed at much higher premiums. Earnings within the casualty industry are expected to be on a very satisfactory basis in 1953 and 1954.Western, while operating very profitably during the entire trying period, may be expected to report increased earnings as a result of expanding premium volume, increased assets, and the higher rate structure. An earned premium volume of $30,000,000 may be conservatively expected by 1954.

Normal earning power on this volume should average about $30.00 per share, with investment income contributing approximately $8.40 per share after deducting all senior charges from investment income.The patient investor in Western Insurance common can be reasonably assured of a tangible acknowledgement of his enormously strengthened equity position. It is well to bear in mind that the operating companies have expanded premium volume some 550% in the last 12 years. This has required an increase in surplus of 350% and consequently restricted the payment of dividends. Recent dividend increases by Western Casualty should pave the way for more prompt payment on arrearages. Any leveling off of premium volume will permit more liberal dividends while a continuation of the past rate of increase, which in my opinion is very unlikely, would of course make for much greater earnings.

Operating in a stable industry with an excellent record of growth and profitability, I believe Western Insurance common to be an outstanding vehicle for substantial capital appreciation at its present price of about 40. The stock is traded over-the-counter.

PIMCO's Mohamed El-Erain

2008-07-28T08:23:00.003-04:00

This is an excellent 25 minute interview with whom I think is one of the most sophisticated and astute investors. Three years ago, I had the amazing pleasure of hearing Mr. El-Erian speak live in New York City. The theme of his discussion then? Why the global economic shifts would have to lead to a general rise in oil prices.

Mr. El-Erian is tops on my list of the most qualified individual to assume the Chief Investment Officer position at Berkshire Hathaway (although as CO-CEO at PIMCO, that may not occur).

To view the interview with Charlie Rose, please click here.

Excellent Seth Klarman Interview

2008-06-29T11:41:00.002-04:00

TRUE VALUE Investor Seth Klarman gives a wonderful interview courteous of Alpha Magazine.

For the full interview visit Alpha Magazine here.

Some excerpts.

"We're not the stereotypical hedge fund in terms of an idea a minute. We come in with a view that a security is trading for less than it’s worth, and we buy it."

How did you decide value investing was for you?

I was fortunate enough when I was a junior in college — and then when I graduated from college — to work for Max Heine and Michael Price at Mutual Shares [a mutual fund founded in 1949]. Their value philosophy is very similar to the value philosophy we follow at Baupost. So I learned the business from two of the best, which was better than anything you could ever get from a textbook or a classroom. Warren Buffett once wrote that the concept of value investing is like an inoculation- — it either takes or it doesn’t — and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don’t. Ultimately, it needs to fit your character. If you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that’s great, but you’re not a value investor and you shouldn’t be one. If you are predisposed to be patient and disciplined, and you psychologically like the idea of buying bargains, then you’re likely to be good at it.

Biggest mistakes?
There are too many examples that we could say, “Ah, that was right in our sweet spot, and we should have had it.” All investors need to learn how to be at peace with their decisions. We as a firm are always going to buy too soon and sell too soon. And I’m very at peace with that. If we wait for the absolute bottom, we won’t buy very much. And when everybody’s selling, there tends to be tremendous dislocation in the markets.

What’s the secret to success?
Every manager should be able to answer the question, “What’s your edge?” This isn’t the 1950s, when all you had to do was buy a corner lot and build a small drugstore and it gradually became incredibly valuable land or you owned a skyscraper or you built a small shopping center and it became the big regional mall. The market’s very competitive; there are a lot of smart, talented people, a lot of money chasing opportunity. If you don’t have an edge and can’t articulate it, you probably aren’t going to outperform.

Buffett's Bet Against the Hedge Funds

2008-06-09T16:59:00.005-04:00

Putting his money where his mouth is, Buffett recently disclosed a bet saying that a group of hedge funds, after fees, would fail to outperform the S&P 500 index. Most of you will remember Buffett's references in the 2006 annual report about all the little "helpers" in the hedge fund world that are slowly taking a piece of the pie.

Carol Loomis, long-time Buffett friend and editor of the annual reports, broke the news about this bet in Fortune. The link is below.

Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking.

But in July 2007, Ted Seides, a principal of Protégé but speaking for himself at that point, wrote Buffett to say he'd like to make the bet - or at least some version of it.

Buffett's Big Bet

Why Value Investing Always Wins - Numbers Don't Lie

2008-06-02T06:51:00.004-04:00

This morning an article appeared in the London Free Press titled "Value Investing Rewards Patience." This article provides a wonderful perspective on why "value investing" always outperforms. The article attempts to define the parameters of a value stock. Typically, most academic studies have separated businesses via the following:

Low price to book ratio = Value
High price to book ratio = Growth

While the above categorization does make sense, it's far too rigid today to be taken as the definitive method for distinguishing between the two types of stocks. Newer studies now look at various other metrics such as price to cash flow, price to earnings, etc. in trying to separate the two classes of stock for research purposes. According to these studies, the performance of value investing has vastly outperformed a growth oriented approach.

I have always felt that value and growth are merely two sides of the same coin when it comes to investing. Growth is simply a lever that creates value over time. I think the idea behind this article and the many others that prove that value beats growth is that with value investing, the aim is to pay as little as possible for that future growth. Businesses that are selling for close to the value of tangible assets, high cash flow yields, etc. will experience a dramatic expansion in multiples as they begin to demonstrate sound operating results.

I think the best way to see if someone is a value investor is not by the ratios of the stocks they hold, but instead by a wonderful little quote by Warren Buffett:

"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."

Below are excerpts from the article followed by the link to the whole article.

Judging "value" on the basis of a single financial metric such as book-to-market value was criticized for being too parochial. So, the academic community began to incorporate other relative valuation methods, such as price to cash flow, price to earnings, price to tangible book value and others.

Despite the excellent performance of growth stocks in the 1990s, Chan and Lakonishok show that large-cap value stocks actually outperformed large cap growth by 12.2 per cent annually from 1990 until 2001. The same was true from 1969 until 2001, with value outperforming growth by 10.4 per cent per year.

The small-cap numbers were even more impressive. From 1990 until 2001, value outperformed growth by 19.4 per cent annually. The long-term outperformance number from 1969 until 2001 for this group was 16.5 per cent.

This is really important:

Chan and Lakonishok also argue that value stocks are no riskier than growth stocks. They show that even in down markets, value stocks suffered less than growth stocks -- an important litmus test for investors.

At the end of their study, Chan and Lakonishock subtly conclude that the difference in value and growth returns is largely a result of irrational investor behaviour -- a persistent human trait that they argue will continue to reward patient value investors for a long time to come.

Read the full article:

Value Strategies Reward Patience by Neil Murray

Value Investing Business School

2008-05-22T14:17:00.002-04:00

The desire to become a "better" value investor is arguably one of the most popular discussions of the day amongst the value investing click. I have an MBA degree and I am very proud of it and the school I earned it from. But MBA school did not directly contribute to my becoming a better investor. An MBA has aided me in several invaluable ways, but I'm not here to talk about that.

Instead, to become a better investor you need to be able to do one thing and one thing only: THINK RATIONALLY. Unfortunately, this is not an easy task and no MBA class (at least to my knowledge) trains someone how to really think practically.

While I was somewhat disappointed with the quality of questions at this years Berkshire Hathaway meeting, you can always count on Buffett to deliver. One of this year's gems was when Buffett commented on the fact that nearly all business schools do nothing to train students to become better investors.

If you want to truly succeed as an investor, learn to do two things and two things only:

1. Know how to value a business
2. Learn how to think about stock markets and understand volatility.

In an earlier post, "Where Most Investors Stumble" I commented on the backwardness of many investors when thinking about the stock market:

Whether you realize it or not, many investors often commit mistakes that regularly go unnoticed. Or worse, the mistake is made under the false assumption that the activity is actually correct. Such common traps include...

2. Interpreting market volatility as a destroyer of opportunity when it is instead a creator of opportunity. If your approach is sound then volatility allows you to buy that which was cheap yesterday cheaper today.

If you can truly learn about evaluating businesses and understand that the market is here to serve you and not guide you, your investment performance will truly be off the charts.

If you understand the two concepts Buffett noted above, you will be able to clearly apply the following framework, which I believe is the simplest and most effective way at approaching the stock market.

1. Have a sound investment philosophy
2. A Good Search Strategy
3. Ability to value a business and assess quality of management
4. Discipline to say no
5. Patience

and once you can do the above you will have the ability to...

6. Make a significant investment at the maximum point of pessimism.

Find me a successful investor (Buffett, Berkowitz, Hawkins, Pabrai, Einhorn, etc.) and I'll show you an investor who performs all of the above.

Where Many Investors Trip Up

2008-04-29T14:41:00.007-04:00

Whether you realize it or not, many investors often commit mistakes that regularly go unnoticed. Or worse, the mistake is made under the false assumption that the activity is actually correct. Such common traps include:

1. Investing for capital appreciation when instead you should be investing for capital preservation. Investing in this manner is like crossing the street after only looking straight ahead. The destination might be clear, but without looking left and right, the consequences can be perilous.

2. Interpreting market volatility as a destroyer of opportunity when it is instead a creator of opportunity. If your approach is sound then volatility allows you to buy that which was cheap yesterday cheaper today.

And most important of all: spending time thinking about when to sell a security when all your time should be spent learning when to buy a security. This is a mistake that many investors commit without ever realizing it.

Many people believe that knowing when to buy is much simpler and easier to do than when to sell. However, the real reward in investing comes from making smart buying decisions. Selling is simply the activity that rewards your disciplined buying approach. Far too many investors exaggerate the selling process. In doing this, they subconsciously approach the investment process backwards. In my most recent letter to partners, I discussed the fallacy in "learning" when to sell an asset:

"...you only need to do a few things right to be a successful investor. Knowing when to sell a security is not one of them. Money is made when the asset is bought not when it's sold. Learning when to sell is a task that far too many investors spend far too much time attempting to perfect. In his 50+ years as an investor, Warren Buffett has realized losses on an absurdly low percentage of his investments (less than 5%). Buffett spends little time worrying about when he should sell his investments and instead on focuses on buying assets cheaply. This buying process should be at the center of an investor's focus. You can never go broke by taking profits. If you maintain a disciplined approach to the price you pay for an asset, the selling process will take care of itself. Echoing Shelby Davis, 'you just don't know it at the time.'"

Your profits (or losses) are made the minute you buy an asset. You just won't "see" it until you sell. If you concentrate your efforts on buying businesses selling at a discount to intrinsic value, the odds are favorable that when you need your money, you will sell at a higher price. Understand of course that intrinsic value can be impaired if the fundamentals of the business deteriorate. This is possible with any investment, but much less likely with superior businesses with successful long-term operating performance.

The common mistake is made when investors confuse buying a business and buying a stock. When buying something cheap, investors often take that to mean buying the stock at the bottom. This is flawed thinking. You can still make money even if you buy at top--as long as the intrinsic value is substantially higher.

Also, investors assume that if they sell at a profit only to see the share price advance further, then they made a mistake by selling too soon. But that too reflects the wrong perspective. First of all, anytime you sell an investment at a gain, you have succeeded. I learned at an early age that you will not lose money by selling something for more than you paid for it. So, if that's the name of the game, then mastering the buy side is how you win the game. Warren Buffett once remarked that "investing is simple, but not easy." It's simple in that all you need to do is find a handful of great businesses selling at reasonable prices and let time do its thing.

Yet investing is not easy because most investors have a hard time being patient. Mohnish Pabrai once told me that two things occur to him after he makes an investment: When he buys, the stock usually dives, and after he sells, the stock rockets. Yet in the almost nine years that he's been running the Pabrai Investment Funds, he's boasting an annualized return above 20% -- after fees.

All investors make mistakes. But if you do your work, chances are you won't make many big mistakes. A couple of huge mistakes can wipe you out for good. Concentrate your efforts on a few very simple lessons and you tilt the odds of outperforming most.

Buffett Talks Business

2008-04-16T08:49:00.003-04:00

We all know Buffett is good..but why is he so good?

Simply put, he keeps things simple and logical. While most other investors are busy trying the "crack the code" with some marevlous analytical break through, Buffett simply breaks everything down to its most basic economic fact.

As an illustration, consider Buffett's discourse on brand value, specifically as it realtes to Coca-Cola. The following comments were made by Buffett at the 1993 shareholders meeting and can be found in Andy Kilpatrick's newest edition Of Permanent Value.

Buffett: Will developments in the generic brand area hurt Coca-Cola? That’s a terribly important question.

“Generic brands have been with us a long time. But lately they’ve attracted a great deal of attention—partly because they’re doing better and in particular because of Philip Morris’s actions a few weeks ago—when, in reaction to the threat and the inroads of generics, they cut the price dramatically on Marlboro.

“I wouldn’t say Marlboro is the most valuable brand name in the world. Coca-Cola is more valuable—and I think that’s been proven by subsequent events. But Marlboro earned more money than any brand name in the world.

“And all of a sudden, Philip Morris took some actions which dramatically reduced the earnings of that brand and changed the pricing dynamic that had existed in the cigarette business for many decades. And since then, Philip Morris has had $16 billion lopped off its market value and RJR’s suffered accordingly.

“It’s a terribly interesting case study and it illustrates one of the dangers of generic competition. Philip Morris cigarettes got to where they were selling for $2.00 a pack. The average cigarette consumer uses something close to ten packs a week. Meanwhile, the generic was at about $1 or thereabouts. So you really have a $500 a year differential in cost per year to a ten-pack-a-week smoker. And that is a big annual cost differential. You better have something that people think is dramatically better than the generic for the average consumer to shell out an extra $500 a year. It’s happening in other areas, too—whether it’s corn flakes or diapers or a lot of things...
“In our case, I think the Gillette brand name, for example, is far better protected against generic competition than the main product of Philip Morris—although there always has been generic competition in blades and there always will be.

“The average male purchases something like 30 blades a year. He pays 70 cents each if he buys the best—which is the Sensor. That’s $21 a year. The best he can do if he wants something that leaves him Band-Aids on his face and an uncomfortable experience costs him $10 a year. So you’re talking $11 for a 365-day experience...

“I think there’s a generic threat of some sort in any industry where the leaders are earning high returns on equity. It just stands to reason that that’s going to encourage competition.

“And the threat may be accelerating in many industries. But I think that brand names with the right ingredients are enormously valuable. Sometimes infrastructure is a problem for the generics. The worldwide infrastructure for Coca-Cola, for example, is very impressive and very hard for a generic provider to duplicate.

“But if somebody wants to sell a generic box of chocolates in California against See’s Chocolates, that’s obviously somewhat of a threat. And I just hope that they take them home on Valentine’s Day and say, ‘Here, Honey, I took the low bid.’ ”

“Wal-Mart’s selling Sam’s Cola. And Wal-Mart is a very, very potent force. One thing that’s helpful is that they were selling it as cheap as $4 a case here. And I don’t believe that’s sustainable. That’s 162/3 cents a can.

“It’s been a while since I looked at aluminum—and it’s down. But I think the can is close to a six-cent item by itself. The can is far more expensive than the ingredients... Distribution costs, trucking, stocking and all that sort of thing have to be fairly similar. In a 12-ounce can, there’s 1.3 ounces of sugar—which at the domestic price, would be around 13/4 cents per can. And that’s got to be the same whether it’s Sam’s Cola or Coca-Cola.

“The Coca-Cola Company sells about 700 million 8-ounce servings—largely of Coca-Cola, but also of other soft drinks—worldwide every day. If you take 700 million and multiply it by 365 days, you come up with 250 billion or so 8-ounce servings of Coke or its products in the world each year.
“The Coca-Cola Company made about $21/2 billion pretax last year. That’s one penny per serving. One penny per serving does not leave a huge umbrella. The generic is not going to buy the can any cheaper. And they’re not going to buy the sugar any cheaper and so on. Their trucks aren’t going to be any cheaper.”

So while everyone is busy looking at P/E Ratios and making forecasts into the future, Buffett simply looks at the business from a businessman's point of view. Ands that all you've got to do folks to succeed in this game.

True to form: 'I'm a better investor because I am a businessman and a better businessman because I am an investor.'

A Solid Bet: The Case For Ternium Steel

2008-03-08T09:02:00.005-05:00

My approach to investing has fit the philosophy, "Give a man a fish and you feed him for a day, but teach a man how to fish and you feed him for life."

Today, I'll make an exception and outline my analysis for Ternium Steel, one of the most profitable steel companies in the world.

FULL DISCLOSURE: I currently own shares in Ternium. At any point, this could change. Please do your own DUE DILIGENCE before making any investment decision.

On that note...

Ternium Steel is a Latin-American steel producer with principle operations in Mexico, Argentina, and Venezuela. When I first began going over the financials of Ternium in late September, it didn’t take long to realize that this was one of the most profitable steel companies in the world. The numbers literally jumped out of the page.

At the time, Ternium had an enterprise value (EV = mkt. cap + net debt) of $7.5 billion. In 2006, free cash flow was some $840 million. In 2005 free cash flow was over one billion dollars. EBITDA (earnings before taxes, depreciation and amortization) for 2006 was $1.84 billion, implying that Ternium was selling for only 4.1x EBITDA. Even for a steel company this was absurdly low. A quick comparison of peers yielded an average EBITDA multiple of just over 7. Operating margins, at 27%, were among the highest in the world. Ternium boasted a low-cost structure that was best in its class. Ternuim’s Mexican operations included access to iron ore, the main component in steel production, providing Ternium with a cheaper supply of this raw material.

So what was the catch that made Ternium so incredibly cheap? Simply, the market couldn’t seem to get over Ternium’s exposure in Venezuela. At the time, there were threats that Hugo Chavez would nationalize SIDOR, a Venezuelan steel mill which was 60% owned by Ternium, and 40% owned evenly by the Venezuelan government and SIDOR employees. Some careful analysis suggested that the odds of nationalization were low.

Ternium is run by the Rocca family, which has a stellar reputation of running steel mills spanning decades. Their impressive management of Tenaris, another Latin American based steel producer was indicative of the family’s ability and competence in operating steel companies in Latin America. Overall, Venezuela benefited enormously from having SIDOR remain under the control of current management.

In any case, Venezuelan operations represented 25% of Ternium’s EBITDA. So if the worst case scenario played out and SIDOR was nationalized and Ternium received nothing from Venezuela, EBITDA would decline from $1.84 billion to $1.4 billion. At this rate, Ternium was still selling for much less than comparable international steel companies. In the end, nationalization of SIDOR would not substantially impair the overall operating profitability of Ternium. Ultimately, an agreement was reached that avoided nationalization. In exchange, Ternium agreed to sell more steel to Venezuela at a slight discount (~5%) and agreed to make some capital investments in SIDOR.

In April of 2007, Ternium had reached an agreement to acquire Grupo IMSA for $1.7 billion. IMSA is a dominant steel producer in Mexico with additional operations in the southern and western United States. IMSA would add another 3 million tons to Ternium’s annual finished production, bringing total capacity output to 15 million tons. The deal was closed a few months later and in December, Ternium struck a deal with Australia’s Bluescope Steel to sell off IMSA’s U.S. assets for $730 million, allowing Ternium to focus on the steel industry in Latin America.

According to the International Iron & Steel Institute, steel demand in Central and South America is expected to grow at a 4% clip for the next several years. In Mexico, the steel market is growing by over 6%. Only Asia is consuming steel at a higher rate than Latin America. The threat of cheap Chinese steel imports is minimal at best. The costs of shipping a ton of steel over to Central and South America would make the steel more expensive. And being that Ternium runs a very tight ship (no pun intended), I don’t see Chinese steel imports representing any meaningful threat.

For the first nine months of 2007, Ternium generated nearly $700 million in free cash flow. This figure included a $300 million one-time income tax payment made as a result of the IMSA acquisition which Ternium will be able to use as tax credits in the future.

As a result of the IMSA acquisition, Ternium assumed some $3.6 billion in debt, implying a $10 billion enterprise value. I expect the proceeds of sale of IMSA’s U.S. assets will be used to pay off some of this debt. Actual free cash flow, adjusting for the one-time tax charge was over $1 billion for the first nine months of 2007. EBITDA over the same time period was $1.7 billion. Normalizing these figures over 2007 would imply a FCF/EV yield of 13% and EV/EBITDA multiple of approximately 4.5x.

To be conservative, assume that 2007 free cash flow comes to $1 billion, implying no free cash flow in the last quarter. If over the next five years, FCF were to grow by an unrealistically low 10%, the present value of this sum of money discounted back at 10% would be $5 billion. Applying a very reasonable terminal value of 10 times 2012 FCF ($1.6 billion) equates to $16 billion, or a present value of roughly $10 billion, for a total value intrinsic value of some $15 billion. With 200 million shares outstanding, this provides an intrinsic value of $75 a share. If cash flow grows at 15%, intrinsic value per share comes to around $92 per share. A 10% increase in shares outstanding would produce an intrinsic value of $68 to $83 a share.

Ternium is currently earning about $220 in EBITDA per ton of steel and is on track to sell some 10 million tons in 2007 (without IMSA) compared to 6,600 tons in 2005, a growth rate of nearly 24% a year. This equates into 2007 EBITDA of $2.2 billion. As I mentioned, IMSA adds 3 million tons of capacity, but with the sale of the U.S assets, capacity will be slightly reduced. In addition Ternium is undergoing its own capital expansion that should increase capacity by 2 million tons in three years. In five years, tons sold should easily approach 14 -15 million, or less than 10% growth a year. At an average EBITDA of $160 per ton, some 30% less than Ternium’s current level, this would produce an EBITDA of $2.24 to $2.4 billion. At 8x - 10x EBITDA, a very reasonable buyout multiple for any strategic buyer, Ternium would be worth between $17 and $24 billion, or $85 to $120 a share.

Buffett's New Elephant: Why Muni's Have Buffett So Exicted

2008-03-05T09:21:00.002-05:00

For years, Berkshire Hathaway's gigantic cash pile has been growing at a faster rate than attractive opporutnities available to Warren Buffett to invest in. Buffett has made it no secret that he would welcome a huge "elephant" type acquisition for Berkshire where he could deploy ten billion dollars or more of Berkshire's cash. Recently, Buffett has found pockets of opportunity to plunk down a few billion here and there – the Marmon deal for $4.5 billion and a few billion for nearly 20% of railroad operator Burlington Northern. Yet as Berkshire's size has mushroomed, the days when Buffett could chunk nearly 20% of Berkshire's book value into Coke are rare.

It turns that an elephant of an opportunity may lie in the same field that catapulted Buffett and Berkshire from the multi-million club to the multi-billion club – insurance. Late last year, Buffett announced that Berkshire Hathaway had agreed to deal terms with the state of New York to set up shop as a municipal bond insurer. Initially this was a small deal for Berkshire, but the hope was to gradually expand the newly set up Berkshire Hathaway Assurance Corp (BHAC) bond insurance operations across other states.

It didn't take long for Buffett to up the stakes, as he is apt to do when great opportunities exist. Earlier this week, Buffett announced that he had offered to assume liability of the municipal bond insurance operations of MBIA, Ambac and FGIC Corp. In a letter to MBIA, Ajit Jain, President of BH Reinsurance, stated that BHAC's capitalization would be increased to five billion dollars and that "we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years." Jain ended the letter by saying "We would be prepared to complete this transaction within the next five days." A closer look into the municipal bond industry reveals why Berkshire is so intrigued by this rare opportunity.

A. Huge Opportunity

According to a recent article published in the Wall Street Journal, the current municipal bond market is approximately $2.6 trillion. Roughly half of this amount is insured by MBIA, Ambac, FGIC, and a few other smaller names. The Wall Street Journal recently cited that in some cases, municipal issuers have paid as much as $2.3 billion a year in premiums to just insure their bonds. And Buffett's offer was on approximately $800 billion or so in municipal bonds. Even for Berkshire, this is serious money.

B. Virtually risk free instruments

Municipal bonds are issued to finance government infrastructure and are often collateralized by the tax revenues of the issuing entity. Since taxes are going away anytime soon, municipal bonds don't default much. According to the article, the state of California, one of largest issuers of municipal bonds, the state requires that tax dollars go first to education and second to pay off bond debt. To wrap your head around why default is unlikely, California's estimated $100 billion in annual tax revenues should do a good job of keeping them from default. Since 1970, municipal bonds rated double B have a cumulative average default rate of 1.74%. The equivalent default rate for double B corporate bonds is – 29.93%.

C. Favorable Economics

Before this current credit crisis, a state like California with its stable tax revenues would benefit very little from having bond insurance. Deciding whether or not to insure bonds is a simple exercise in cost benefit analysis. For example, if a state issuing municipal bonds is looking at paying 4% with insurance versus say 4.75% without insurance and the insurance premium is 50 basis points, then it makes sense to insure. The recent bond-insurer crisis has created a situation whereby even rock-solid municipal bonds are finding it increasingly expensive to fund much needed infrastructure projects. And not all states are sitting flush like California. Typically bond insurers were charging about 30% of the interest savings an issuer would get. So, if you could reduce your bond rate by 0.50% via insurance, the typical premium would be about 30% of that, or 0.15%. Those days are gone. Recently insurers are charging 80% to 90% of the savings. And with investors traumatized by the liquidity crunch, municipal issuers have to rely on bond insurance even with the higher rates. Enter Berkshire Hathaway to seize the day.

D. Competitive Advantage

Here, the case is glaringly obvious. Berkshire arguably boasts one of strongest balance sheets of any company in the world. Its triple-A credit rating is virtually assured. Any municipal issuer that decides to insure with BHAC will guarantee itself a triple-A. In today's rocky credit environment, that implicit guarantee is worth a lot – and Buffett knows it. As a result, BHAC will be able to command higher premiums. And if, as I suspect will be the case, Berkshire will be the insurer of choice in each state that it decides to enter. And since just about all other bond insurers are desperately seeking to raise additional capital, Berkshire will have virtually no initial competition.

So when you add A, B, C, and D, you find an investment opportunity that is vintage Buffett. This deal offers an excellent model for all investors, both individual and professional, to emulate. Look for companies that offer durable competitive advantages, long-term growth opportunities with minimal downside, and selling at very favorable prices. And then when you find them, don't hesitate to back up the truck and load up.

Berkshire's Bond Offer Is a REALLY BIG Deal

2008-02-12T16:25:00.000-05:00

For years, Buffett has been waiting for something to "move the needle" at Berkshire. The $4 billion stake in Iscar, the Israeli tool cutting business, should prove very meaningful to Berkshire over the years. Even the eventual total acquisition of Marmon, the industrial conglomerate, should cause some vibration....

Insuring municipal bonds on the other hand, could be a really really big deal. While this is a stretch of the imigination, if Berkshire were to insure municipal bonds in all 50 states, this business could have an effect on Berkshire Hathaway much the same way that GIECO did in the 1980's and 1990's.

A couple of months ago, Buffett committed about $150 million to the newly formed Berkshire Hathaway Assurance Corp., the newly formed entity created to insure municipal bonds in New York. This morning Buffett agreed to committ $5 billion to take over the municipal bond business of MBIA, Ambac,. etc. And he could do it in 5 days.

Below is the letter sent by Ajit Jain, President of BH Reinsurance to MBIA's Bankers at Lazard.

February 6, 2008

Mr. Gary Parr
Deputy Chairman, Lazard

Dear Gary:

As you know, many constituencies in the financial markets have been increasingly focused on the emerging issues in the financial guaranty industry for several weeks now. In fact, we ourselves have had several meetings with the New York Insurance Department to explore whether there is something we can do under the current circumstances that would be helpful in addressing the growing concerns in the financial marketplace. Unfortunately, the structured finance "side" of the business, with its many moving pieces and interdependent variables, has proven to be beyond our ability to adequately analyze. Nonetheless, we are ready and willing to lend our reinsurance support to the municipal side of the house, and in fact had set out in a letter to the New York Superintendent of Insurance a concept that we believe would address the needs and concerns of main street America's municipalities. The Superintendent has no objection to our approaching you with this proposal. We would like to meet with you and your client, MBIA, to discuss whether MBIA would have any interest in the proposal .

The key elements of the proposal we described to the Superintendent were: (1) we would raise the capital level in our monoline insurer, Berkshire Hathaway Assurance Corporation (BHAC), to $5 billion; (2) we would assume by reinsurance the muni bond portfolio of several of the monoline companies for a premium of 150% of the existing unearned premium reserves of the companies (with respect to two of the leading companies this would result in a combined unearned premium reserve of $6 billion, plus $3 billion for a total premium of $9 billion which, with the increased capital contribution to BHAC would result in approximately $14 billion of assets available to meet the combined $600 billion or so of total principal value of municipal bonds insured by these two companies); (3) we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years; and (4) we had furthermore proposed that, if the companies found a preferable solution during the first 30 days of our cover, they could have a no-questions-asked walk-away option in consideration of a break-up fee that would be paid to us.

The gist of our proposal to you is that we would reinsure MBIA's current municipal bond insurance portfolio in consideration of a premium payment to us of an amount equal to 150% of the existing unearned premium reserves. Like many potential reinsurance buyers, I recognize that your first reaction may be that this is an excessive premium, and I want to offer you upfront the thought processes that led me to conclude that this is in fact a fair proposal that achieves important objectives for both parties.

We priced this proposed reinsurance cover to reflect the significant opportunity cost from our perspective in providing this type of bulk reinsurance cover. In the current market environment, we are able to command premium levels double (or higher) your client's prior rates to insure the risks that in addition have the benefit of your client's AAA insurance cover. Given our conservative use of capital (for example, the capital ratios in our monoline insurer would be higher than other insurers and would not be subject to reduction by dividends, fees, etc. for a minimum of ten years under the concept we presented to the Department), by offering this cover we forgo these direct opportunities to wrap already wrapped bonds. Despite this, there is an obvious appeal to a bulk transaction like this given the low overhead costs which would be involved.

Taking all these factors into account, we came down in favor of making the proposal and are prepared to pursue it with you directly. It is efficient as both a bulk transaction and a transaction that we believe will help stabilize the currently unstable marketplace conditions for the municipal business. In that sense, this approach also has the appeal of serving the greater public good, not an unimportant consideration for us, both as a matter of principle and as a company with a vested interest in national economic conditions.

From your perspective, I would respectfully suggest that this proposal would allow MBIA to release substantial capital from the municipal bond side of the house that can be deployed to support other obligations. I would submit that our proposal at the pricing levels we require is actually a cheap way for MBIA to raise capital as compared to other alternatives and is therefore of great benefit to MBIA's owners and their municipal bond policyholders.

Should this proposal prove to be of interest to you, and I sincerely hope that it is, we would ask for the courtesy of a reply as soon as possible. We would be prepared to complete this transaction within the next five days.

Sincerely

Ajit Jain,
President

cc: The Honorable Eric Dinallo, Superintendent
New York Department of Insurance

Buffett Interview in Canada

2008-02-07T15:42:00.000-05:00

The Dow Jones [Industrial] Average started the 20th century at 66 and it ended at 11,400. That is not a bad train to be on. How could anybody lose money on something that went from 66 to 11,400? Well, a lot of people lost a lot of money in stocks because they come in at the wrong time, and they get out at the wrong time, and they buy the wrong things, and they get excited, and they get greedy when others get greedy, and fearful when others get fearful. I say you should get greedy when others are fearful and fearful when others are greedy, but that's hard for most people to do

It is much easier to buy and buy and buy little pieces of a wonderful group of American businesses, and you'll do fine over time and you'll keep your costs low. If you try to be a little bit smarter, you'll probably end up being a lot dumber.

Warren Buffet was in Canada attending the BusinessWire debut there. He spent some time with the Financial Post discussing his thoughts on investing, and the general state of affairs.

Both the written interview and video clip are provided below.

Video Interview

Interview Transcript

Earnings and Equity Returns

2007-12-21T09:14:00.000-05:00

Wall Street is fixated on the earnings number of a business. In the short run, stock prices are very sensitive to a company’s earning achievements.

Earnings Are Not Alone

While profits are essential, understanding how they fit into the value creation process is critical. This is where return on equity comes into play.

An initial yet meaningful way of looking at return on equity is similar to a coupon on a bond. A bond that earns a higher coupon yield than the prevailing rate of interest will trade at a premium, or above its par issued price. A bond that is issued paying ten percent a year will be worth more in the future if future rates on interest have declined. The reason is simple economics: no investor will pay the same price for an eight percent bond if he or she can buy a ten percent bond for the same price. So the price of the existing ten percent bonds will increase until its new market price represents an approximate eight percent effective yield. So if the bond had a face value of $1000 and initially paid $100 a year, its new price would be $1250 because at an annual payment of $100, the return is 8 percent.

Similar to a bond in a fundamental sense, businesses with sustained high returns on equity are usually followed by appreciating stock prices, but not for the same specific reasons as a bond. In the real world, of course, investors in stocks don't just buy and hold.

In the long-run, the rate of return of a stock should equal its return on equity. Consider Microsoft. Microsoft continues to deliver unbelievable returns on equity of over 40 percent and has done so for decades. Yet for years, Microsoft shares have not followed suit.

The times are different. In the beginning Microsoft had lots of space in the software market to deploy its capital. So when Microsoft was generating a ROE of say 40 percent, back then it was able to continue investing that excess capital and generate a similar rate of return. What this means is that Microsoft could take a million dollars, invest it in its operations, and earn $400,000. Microsoft could then take the excess capital and still earn that same 40 percent. Microsoft was able to do this with billions of dollars and this was happening years before the Internet boom.

It is no surprise then, that Microsoft stock rocketed for many years after its IPO and why early investors, Gates, and employees got so fantastically rich off the stock. The company was compounding existing and excess capital at a phenomenal clip. Anytime you can do this for a sustained amount of time, the intrinsic value of a business mushrooms and eventually so will the stock price.

Now What?

Microsoft still generates returns on equity of over 40 percent, yet the stock price sits still. Microsoft is so huge and has so much cash, that it is now only able to generate those returns only the capital needed to run he business. It can no longer take the excess capital and redeploy it at such a high rate of return. This is why it paid that huge dividend a few years back. It made more sense payout some of that excess capital to shareholders than to reinvest back in the business.

Concentrate Your Bets

Anytime you locate a company that offers the talent and ability to redeploy its existing and excess capital at above market rates of return for any sustainable period of time, odds are the stock price will follow suit. An ability to earn excess returns on equity signals that the company offers certain competitive advantages not easily reproduced by its competitors.

In the 1980's Warren Buffett bet over 20 percent of Berkshire’s book value on the Coca Cola Company. Buffett noticed, among other things, that Coke was earning excellent returns on its equity and deploy the excess capital into other infant markets. Berkshire Hathaway itself is a huge capital deployment vehicle. It takes the float from its insurance company and any excess cash from its operating subsidiaries and invests the excess capital very successfully. Berkshire has risen an amazing 7,000-fold since Buffett took control of the company in 1965.

Profits and earnings growth are vital. But what businesses are able to d0 to with those profits sets apart great businesses from good ones.

In 1978, Warren Buffett wrote an article for Fortune Magazine titled "How Inflation Swindles the Equity Investor" In it he noted that there are only five ways to improve return on equity:

1. Higher turnover, i.e. sales
2. Cheaper Leverage
3. More leverage
4. Lower taxes
5. Wider margins on sales

Companies have the least control over tax levels, although management can certainly use creative accounting to temporarily alter the tax rate. An investor is better suited to focus on the others, as the ability to spot improved sales, prudent use of leverage, or cost cutting initiatives can lead one to excellent businesses.

All else equal, sales increase should create an increase in profits. Of course the quality of sales should be carefully examined. As sales increase, accounts receivable level should naturally follow suit. However, if receivables are demonstrating a trend of growing much faster than sales future troubles may lie ahead when it’s time to collect. Additionally, inventory management is important. The application of LIFO or FIFO will affect the profit statement differently during inflationary or deflationary periods.

When used prudently and wisely the use of leverage can increase returns on equity. Similarly, if a business can lower its cost of debt, the corresponding effect is a higher return on equity. Today we are seeing exactly how the mismanagement of leverage has affected those businesses participating in the credit markets. The painful lesson is similar to buying stocks on margin. If you are levered five to one, a ten percent return on the levered portfolio equals a return on equity of 50 percent. The same corresponding loss occurs with negative returns. Unfortunately, most businesses (1) fail to use leverage appropriately and opportunistically; and (2) employ leverage at alarming multiples to equity. The results, as we can clearly see, have been disastrous.

Wider margins are created in one of two ways: increasing prices or decreasing costs. Very few companies can raise prices at will without incurring competition or meaningful declines in volume. Again, this is why Buffett bet so big on Coke. For decades Coke has been steadily increasing the price of its famous syrup with no meaningful loss in market share as a result. As Buffett once quipped, "Who's going to risk saving a nickel over a product they put in their mouth?" Wrigley's chewing gum offers a similar example.

Profits count, but it's what you can do with those profits over time that really matters.

Buffett Stays Steady and Buys $2B in TXU Bonds

2007-12-03T20:20:00.000-05:00

Buffett put $2 billion of Berkshire Hathaway's cash to work at the end of last week when the company purchased high-yielding bonds issued by Dallas-based power producer TXU Corp.

Berkshire bought into two issues by TXU. It purchased $1.1 billion of 10.25% bonds at 95 cents on the dollar to give Buffett an effective yield of 11.2%. And Berkshire bought $1 billion of 10.5% PIK-toggle bonds (bonds whose interest can be paid out in cash or more bonds) for 93 cents on the dollar, producing an effective yield of 11.8%.

See the full article here:

http://money.cnn.com/2007/12/02/news/companies/buffett.fortune/index.htm?postversion=2007120307

Working Paper on Berkshire Hathaway's Investment Returns

2007-11-16T13:22:00.000-05:00

Here's an interesting read...Imitation is indeed the sincerest form of flattery.

The link to the entire paper is below the abstract.

Abstract:

We analyze the performance of Berkshire Hathaway's equity portfolio and explore potential explanations for its superior performance. Contrary to popular belief we show Berkshire's investment style is best characterized as a large-cap growth. We examine whether Berkshire's investment performance is due to luck and find that beating the market in 28 out of 31 years places it in the 99.99 percentile; however, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely even after taking into account ex-post selection bias. After adjusting for risk we find that Berkshire's performance cannot be explained by assuming high risk. From 1976 to 2006 Berkshire's stock portfolio beats the S&P 500 Index by 14.65%, the value-weighted index of all stocks by 10.91%, and the Fama and French characteristic portfolio by 8.56% per year. The market also appears to under-react to the news of a Berkshire stock investment since a hypothetical portfolio that mimics Berkshire's investments created the month after they are publicly disclosed earns positive abnormal returns of 14.26% per year. Overall, the Berkshire Hathaway triumvirates of Warren Buffett, Charles Munger, and Lou Simpson posses' investment skill consistent with a number of recent papers that argue investment skill is more prevalent than earlier papers suggest.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1030485

ACTIVE VALUE INVESTING by Vitaliy Katsenelson - A Different Perspective

2007-11-04T08:22:00.000-05:00

Anyone fortunate enough to have invested during the bull market that began in 1982 will find easy to say "buy and hold forever." Indeed, for almost twenty years, the market had one general direction - up, and anyone who bought and forgot did well for nearly 18 years. Warren Buffett has described the bull market that began in 1982 as a period unlike any other for the markets and that it is highly unlikely or quite some time before the U.S. markets experience that again. And although Buffett is famous for his "our favorite holding period is forever" line, it wasn't until later in his investing career - when Berkshire's capital was enormous - that this approach really made the most sense for him and Berkshire Hathaway.

Consider that from 1983 until 1999, the average annual return on the S&P 500 was 15.7%, assuming the reinvestment of dividends. A similar return like this for the Dow Jones beginning in 2008 would mean that the Dow would be trading over 139,000 in 2024!

It is in this context that I found Active Value Investing: Making Money in Range Bound Markets by author and portfolio manager Vitaliy Katsenelson an interesting and insightful read on understanding the long mood swings of Mr. Market. One should not assume that the word "Active" in the title to suggest market timing - this is the last thing Vitaliy is concerned with. In fact he readily admits that trying to time the market is a fools game. Instead his focus on using fundamental valuation techniques - discounted cash flow analysis, price to earnings models, and margin of safety - to take advantage of range bound markets.

Any serious participant in the stock markets is well aware that markets trade in in ranges some periods longer than others. During the 16 year period beginning 1966 and ending in 1982, an investment in the Dow Jones index in 1966 would have been worth about the same sixteen years later. Hovering around 1000, the Dow remained around 1000 in 1982. Whatever dividends you earned were wiped out by inflation during that time. A simple buy and hold approach during that time would have produced an annual rate of return of zero percent. Yet during that sixteen year period occurred one of the most opportunistic buying opportunities in the U.S. Beginning in 1974, as Buffett so famously quipped, "I was selling at 3 times earnings to buy stocks at two times earnings."

Active Value Investing discusses how the prudent use of fundamental analysis allows to take advantage of such opportunistic times in the market. Focusing on the only three variables that really matter in a business - value, quality, and growth - investors can learn how intelligently exploit Mr. Market's mood swings. Unlike most great investing books that are focused on the buying process, Active Value Investing takes a very close examination of the selling process, something I find to be the most misunderstood area of investing. Make no mistake, if you can't buy at the right time, knowing when to sell won't mean much. Not only does Vitaliy walk you through his framework of knowing when to buy stocks, but he also takes a deep look at selling stocks, a topic not given enough discussion among value investors. Active Value Investing looks to change all of that.

We all realize that the markets are never a smooth ride and that market timing is mere folly. The key to taking advantage of the market's swings - buying on the stalls and selling on the surges - is to focus on valuation of individual securities. Indeed it is the price in which you buy that ultimately determines your return when you sell. Understanding what to look for in businesses and how to value them is an absolute must if you hope on succeeding in the markets for a meaningful period of time. Active Value Investing helps steer you in the right direction.

Public Pessimism Equals Opportunity for Value Investors

2007-10-26T19:49:00.000-04:00

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful." - Warren Buffett

Security Analysis was published over 70 years ago. To this day, the teachings of Ben Graham and David Dodd hold truer than ever. Graham used to love buying his famous “net-net” stocks, companies that were selling for less than the value of their current assets minus all liabilities. As more entrants came into the markets, these types of opportunities all but vanished. Nonetheless, the enterprising investor applying some serious effort can still uncover some gravely mis-priced securities.

Graham and Dodd’s core concept was to apply analytical effort in examining securities and purchase those selling below their intrinsic worth. The behavior of market participants over the long-term is quite predictable and if you follow the above advice from Buffett, you will do better than most investors. Buffett holds one of the best long term investment records ever, compounding money at over 20% for 40 years. Buffett made his money by exploiting market opportunities where there is a high degree of fear or pessimism.

Welcome Bear Markets

Bear present the most common market environment in which to locate temporarily mis-priced securities. In 1974, after a bull market spanning nearly two decades, the markets fell hard. Overcome by fear most people missed out on one of the century’s best buying opportunities. It was around this time that Buffett began scooping up shares in the Washington Post and Buffett's $10 million investment back then is worth over a billion today. Again in 2003, securities again were cheap, but everyone was afraid even though gap between value and price was wider than it had been in a decade. Investors who are overcome by emotion always disregard market fundamentals leading to the purchase of securities when one should be selling and vice versa.

The year 1987 presents a classic example of the folly demonstrated by most market participants. The year began with surge in share prices for about eight months and was followed by the crash in the October. Bill Ruane and Richard Cuniff of the hugely successful Sequoia Fund remarked,

”Disregarding for the moment whether the prevailing level of stock prices on January 1, 1987 was logical, we are certain that the value of American industry in the aggregate had not increased by 44% as of August 25. Similarly, it is highly unlikely that the value of American industry declined by 23% on a single day, October 19.”

October 20, 1987 would later represent one the best buying opportunities for stock investors.

Investing is "simple but not easy." The idea is simple: simply buy when Mr. Market is acting irrational, but not easy in that most people do the opposite of what they are supposed to be doing: buying on the way up and selling on the way down.

The 2007 Pabrai Funds Annual Meeting: Comments from a Buffett Disciple

2007-10-09T12:58:00.000-04:00

Mohnish Pabrai hosted his second leg of his annual meeting on September 27 in Chicago. Each year, Pabrai holds two meetings - one in Chicago and the other in Huntington Beach, CA to accommodate the geographic disbursement of his investor base.

The meeting began with Pabrai going over the past performance:

1. Since the 1999, the annualized return has been over 29% after fees.

According to data from Lipper, this performance ranks the Pabrai Investment Funds number 3 out of some 4,000 mutual funds during this eight year stretch.

The mutual fund comparison is appropriate because although Funds are legally structured as limited partnerships, consider that:

1. The Funds only take long positions in publicly traded securities - no shorting
2. No leverage (although in the past, a little margin was used during times of plenty at cheap prices)

Sitting Still Can Be Profitable

Buffett used to compare his investing to a baseball player at bat. Unlike baseball, in investing, you have no called strikes. You can wait and wait until the fat pitch comes to hit one out of the park.

Most market participants mistakenly assume that they will be penalized if they don't pull trigger and buy something (who wants to be sitting still when the Dow is up 400 points in a day?).

Let me now give you Sham's Theory on Investing (quite basic as I don't do well with complex situations):

There is no way that you will lose any money if you just sit still and do nothing. Wait for Mr. Market to serve you instead of guide you.

The above statement presents two takeaways:

1. The "price is what you pay/value is what get" concept. As Ben Graham alluded, every stock is a good investment at one price. One has to be patient and disciplined not to overpay. A good company (Google) is not necessarily a good investment ($500+ per share, over 40x P/E, etc.).

2. Be willing to watch your investment decline by 50% and sit still....or buy more. Buffett once remarked that you should be able to see your investment decline by half and have the conviction to buy more if your analysis and reasoning are right. (Remember that I am implying that nothing has occurred to change the intrinsic value - and that you would have caught such a deterioration way before such a drop).

Indeed the Pabrai Funds experienced such a situation and Mohnish discussed the issue at length:

Several years ago, Pabrai experienced a multi month time period during which the net asset values of his fund were down by more than 30%. Stocks he had bought were down by 40, 50 or more percent. According to Mohnish, this was not a hypothetical situation. There were some investors who literally entered his Fund right before the decline and they received statements indicating that their investments were down by over 30%.

There was no specific reason for the decline. The businesses were still intact. There was no direct correlation in the fund's holdings. There was no particular sector or industry weighting on the portfolio. Each company operated in a different industry, with a different set of economic considerations. What had happened was that the Dow Jones average had dropped from around 10,000 to 7,000.

Sometime during this situation, many investors would have gotten out at a decline of 10-15% giving no second thought to the fundamental soundness of the individual businesses.

Once the paper loss is realized, the investor is focused on recouping the loss quickly, an process that often ultimately leads to a less prudent investment approach.

Pabrai discussed the individual investments during that time, his cost, where they stood during the market decline, and ultimately where they stood when he exited.

In the end, the stocks recovered, some doubling and tripling the investment return.

As Mohnish responded to one question about his day to day activities:

"I consider myself a gentleman of leisure. I go into the office with no set goal of buying or selling. I just wait for something to grab my attention."

And that's all that needs to be said. The results speak for themselves.

The rest of the meeting Mohnish spent answering questions and as usual, there was no discussion on any current or potential investments.

Presentation in December

2007-09-13T10:18:00.000-04:00

I have been asked by a self-taught value investor Rishi Sondhi to give a short presentation/talk on investing.

Where: Chelmsford Public Library, Chlemsford, Massachusetts

When: December 13, 2007 at 7 pm

I've never been to Chelmsford, Massachusetts, but I've been told it's a short drive from Boston.

This is a free event open to the public.

I imagine my time will be about one hour. I am of the impression that one of the most valuable ways to give a talk is if I do very little talking and let the attendees ask questions. That way, they get the most out of their time.

My plan is to spend about 15-20 minutes discussing six attributes/characteristics/qualities that seem to be common threads amongst the most successful money managers - Buffett, Miller, Pabrai.

I will follow with a brief case study of a past investment that provides a good example to the business-like approach to investing.

Then I will answer questions for the remainder of time.

Feel free to stop by if you are in the area at the time!

Warm Regards,
Sham

How You Perform In Bear Markets Is What Counts

2007-08-30T13:21:00.000-04:00

By definition, a true value investor is primarily focused on the weathering the bear market storm and coming out relatively unscathed. In times of market advance, a lot of people get mistaken for investment geniuses when in fact it’s the rising tide that’s moving them up in the world.

Bear markets on the other hand, expose the intelligent investor from the fly by night speculator. My approach and the ultimate purpose of value investing is outperforming bear markets.

In his 1961 letter to partners, a thirty-one year old investor in Omaha named Warren Buffett told his partners that they should be judging him during times of turmoil and not times of jubilance.

Buffett told his partners

“I would consider a year in which we declined 15% and the [Dow Jones Industrial] Average 30%, to be much superior to a year when both we and the Average advanced 20%.”

Very early on in his career, Buffett was aware that performing well during market turmoil was the key to long-term success as an investor. During the 13 years that Buffett ran his partnership from 1956 to 1969, not only did he destroy the Dow Jones Average during both bull and bear markets, Buffett never had a down year. So while other investors have come along and produced records that better Buffett’s, its Buffett’s preservation of capital that has allowed him to compound money at such a staggering rate.

A simple illustration makes my point.

Consider two investors starting at the same point in time with the same initial capital. Over a two year period (assumed for simplicity) the investing climate is exposed to both a bear and bull market year. In year one, investor A suffers a 30% loss and investor B suffers a 10%. In year two, investor A enjoys a 50% and investor B enjoys a 30% return. After two years, investor A’s total capital has appreciated 5% and B has about a 17% overall return. Clearly the preservation of capital during the down market enables the enterprising investor to outperform over a satisfactory period of time.

There is a story that says when he was a 21 year old student at Columbia, Warren Buffett was in a classroom one day when he told his classmates to shut door so he could tell them how to get rich investing in the stock market. When he had their attention Buffett remarked,

“The key is to be greedy when others are fearful and fearful when others are greedy.”

If you think about it, what Buffett said is one of the most valuable pieces of advice in investing. The most difficult part is really putting it to use.

Back in the 1960’s Buffett bet big on American Express during the company’s involvement in the salad oil scandal. While everyone was running for the exits with fear, Buffett was being greedy and put 30% of his partnerships assets into that one stock. Similarly in 1971, Buffett began buying the Washington Post during a time when everyone fell out of love with media stocks. As the Post continued to decline, Buffett continued buy, investing close to $11 million. That stake is worth over $1 billion today.

The current market environment is shaping up to be rife with excellent companies at very attractive valuations. As always, the first goal is approach any potential investment very carefully in order to avoid mistaking a value trap for a bargain. But during these times of turmoil, making significant investments during times of maximum pessimism is one way value investors beat the crowd.

And here at Gad Capital, it is what I do each and every day for my partners - patiently waiting for Mr. Market to serve up wonderful businesses at significant discounts to intrinsic value.

Six Attributes to Intelligently Allocating Capital

2007-08-12T23:01:00.000-04:00

Market outperformance requires a disciplined and unemotional approach. Going left when the herd is going right is the most difficult process to undertake. It requires an unwavering conviction in your data and reasoning.

"You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right." - Ben Graham

Thus, in studying the greatest (Buffett, Schloss, Miller, Pabrai), I see six fundamental characteristics that they methodically practice.

Each and every day, I put these six principles to work for the Gad Partners Fund.

1. A Sound Investment Philosophy (Ben Graham, Value Investing)
2. A Good Search Strategy
3. Ability to value a business and assess the quality of management.
4. The discipline to say no.
5. Patience
6. Courage to make a significant investment at the maximum point of pessimism.

The Three Most UnderValued Words in Investing: MARGIN OF SAFETY

2007-07-29T22:46:00.000-04:00

Margin of Safety.

These words were officially brought to light in The Intelligent Investor by Ben Graham. And when you mention them to most money managers, they nod in approval and understanding. Yet, statistical performance results tell you another story. When 8 out of 10 mutual funds fail to be the benchmark, it means fund managers are simply over paying for businesses.

Only three types of investments exist -

1. under priced,
2. fairly priced, and
3. overpriced.

Value investors, by nature, engage in only three activities:

1. Buy the under priced assets
2. Hold or sell the fairly priced assets.
3. Avoid the over priced assets.

Yet finding under priced assets is not easy nor should it be. Further, an asset's intrinsic value is not an exact number but instead a value determined by several analytical inputs based on data and reasoning. Having a satisfactory margin of safety protects the intelligent investor from engaging in folly that results in a permanent loss of capital.

Ben Graham succinctly put it when he said,

"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

Whether or not money managers realize it, most "investments" are more often just mere speculative activities hinging upon the actions of management and the future results of the business. Of course in a bull market, speculation is mistaken for investing. Bull markets tend to disguise everyone as an investing genius. But we all know that a value investor is more focused on making it through bear market storms relatively unscathed.

Buffett said it best in his letter to his limited partners in 1961:

"I would consider a year in which we decline 15% and the [Dow Jones] average 30% to be much superior to a year when both we and the average advanced 20%."

Most investors don't fully grasp this investing approach, and the result is inferior long-term performance relative to the benchmarks. Value investors always demand a margin of safety. And a margin of safety can come in various forms, but its sole purpose is to diminish the probability of a permanent loss of capital. Most important, the margin of safety insulates the enterprising investor from the inevitable surprises that Mr. Market may have up his sleeve.

Finally, remember that the intrinsic value of a business changes over time, and therefore, so will the margin of safety. A 50% margin of safety one year may erode or widen the following year. If your assessment of intrinsic value changes, then so must your investment decision - to either buy more of a now more under priced assets with a greater margin of safety, or dispose of a 50 cent dollar that has now become a 90 cent dollar. Either way, all roads lead to one path in which you come out with minimal loss of capital.

Price is what you pay, value is what you get.

For more on margin of safety, check out my write up on at the Motley Fool:

http://www.fool.com/investing/value/2007/07/23/security-analysis-101-margin-of-safety.aspx?terms=margin+of+safety&vstest=search_042607_linkdefault

Some Valuable Comments

2007-07-24T16:50:00.000-04:00

I recently received the following comments from two readers:

1. "A few ideas, to be taken with a grain (or many grains) of salt: while it's good to talk about the articles you've written, I think most people don't like getting a detailed rundown of all of them. Perhaps writing a blog post that further expands on an article is better, that way you indirectly (thus subtle) point us blog readers in their direction...Also, perhaps posting more often? Sometimes you have really good, inspired posts. It'll probably be a challenge for you to post everyday, but even being consistent with posts every other day would help. Hey just some constructive ideas..."

These are indeed some very constructive ideas. I am sure that it would have been more informative to expand on the articles that are being written for the Fool, so I will keep this in mind. My ultimate goal was to really provide an "archive" link if you will, of my various other writings. I want this blog to be a central source for any other thoughts and ideas that I may cover outside of the blog.

The lack of consistency in the postings is something I have been aware of and I am glad someone mentioned it (hence why I took the easy way out and just gave you links to other articles). Beginning next month, my priority will naturally shift to running the Gad Partners Fund via Gad Capital Management. The blog will remain active, but it will certainly have to take a back seat. Nonetheless I will provide some new content as best I can.

I had one comment asking whether or not I would post the partnership letters on the blog. Unfortunately, because of the "hedge fund" like similarities of the partnership with respect to its legal formation, I can not advertise the partnership like a mutual fund. While posting the letters might not be considered "advertising," I feel better playing in the center of the court rather than around the edges.

2. "Congrats on getting GCM off the ground. Do you still plan on writing for fool.com and the blog once you’ve started GCM? Thanks for the blog it has helped lead me in the right direction for my investing education."

I don't deserve this compliment. There are plenty of wonderful value investors out there that have allowed me to make this blog a possibility. I am glad I can be of some help.

With regards to my future writing commitments, let me post my response to this comment:

"Yes, I still plan to continue writing for the blog, the Motley Fool, etc. I feel that the written word is very helpful to an investor. Putting my reasoning on paper is a great mental exercise for me. For example, last week I was wanting to understand the fine points of the securitization process.

As I begin to mentally gather ideas, it occurred to me that it would be very helpful to me to write down the process. The end result was an article. I wish I could say that I would contribute on a regular basis, but with the start of the partnership, the rate of postings will be a little slower, at least initially."

Three Visits with the World's Best Value Investors

2007-07-19T23:09:00.001-04:00

When I started this blog last year, my goal was to provide the value investing perpsectives taken from the world's best investors. As we all know, a common theme amongst investors is the willingness to teach. Investing is after all, a continuous education; a game that never ends. It is these two facets of investing that really keep me going - there is always something to learn in order to expand your circle of competence, and the intelligent investor's goal is to use his knowledge to evaluate businesses and come to independent rational decisions on why he should invest. More often than not, the best investments will occur at the point of maximum pessimism, and you have to trust your reasoning when everyone around you is taking you to task.

Over the past year, I have been extremely lucky to have personally met some of the best investors on the planet.

First in January of this year, I met Warren Buffett. After my mother and father, Buffett is without question the greatest influence and inspiration in my life. Without Buffett's teachings and writings, I can guarantee that I would not be the person I am today. Aside from being the greatest investor in the history of mankind, Buffett's leads a life that sets an example for all to follow. When I asked Buffett about what the most important advice he had for me, he quickly remarked, "Do what you love and make sure your kids love you." The two day visit I had with Mr. Buffett is an opportunity I will always be grateful to him for.

Secondly, this past spring, I visited with Mohnish Pabrai. I first met Mohnish last November at the Value Investing Congress in NYC. On the last day of the event, Mohnish sat next to me during breakfast. Since then, I am very proud to call Mohnish a friend. Already, Mohnish's investment record is legendary and he has decades to go. One day the world will be very grateful that Mohnish is doing what he is doing. I am grateful to call him a friend.

Thirdly, I had an opportunity to visit and spend time with Mason Hawkins. Mason Hawkins is quite simply the most underrated money manager in the business. The accomplishments he has achieved operating under the regulatory framework of the mutual fund industry is impossible to accomplish unless you're Mason Hawkins. True to his form, Mason does what he does because he loves it. As far as I'm concerned, any investor in the Longleaf Funds should name their first born child Mason. As a steward of capital, Mason Hawkins sets the standard all should follow.

In less than six months, I had the honor to spend time with three phenomenal human beings and individuals that I look up to not only for thier impeccable investing ability, but also for the example they set each day. All three were gracious with their knowledge about the world and business and most importantly, thier time. Time to give to someone like me and everyone else who's just as passionate about investing.

Some of you may be wondering why the postings on this blog have been more and more infrequent. Gad Capital Management will begin operations in about a month. GCM will be running the Gad Partners Fund, a value-centric investment partnership deeply rooted in the teachings of Graham, Buffett, Hawkins, and Pabrai. Some really terrific individuals and families have decided to join the partnership. I am very lucky to call them partners.

Value Investing Articles at The Motley Fool

2007-07-16T09:21:00.001-04:00

Some of you may know that I was offerred a great opportunity to post articles and other value investing musings on the Motley Fool. Below are some links to the articles.

"The Intelligent Investor's Investment"

http://www.fool.com/investing/value/2007/06/27/the-intelligent-investors-investment.aspx?vstest=search_042607_linkdefault

Buffett and Pabrai Break Bread

http://www.fool.com/investing/general/2007/07/02/buffett-and-pabrai-break-bread.aspx?vstest=search_042607_linkdefault

Investing Lessons From Benjamin Graham

http://www.fool.com/investing/small-cap/2007/06/12/investing-lessons-from-benjamin-graham.aspx?vstest=search_042607_linkdefault

Long-Term Riches on Tap

http://www.fool.com/investing/small-cap/2007/06/05/long-term-riches-on-tap.aspx?vstest=search_042607_linkdefault

The Skinny on Sub-Prime

http://www.fool.com/investing/value/2007/07/10/the-skinny-on-subprime.aspx?vstest=search_042607_linkdefault

Pabrai Wins Bid to Lunch with Warren Buffett

2007-07-03T18:03:00.000-04:00

Mohnish Pabrai recently bid $650,100 to have lunch with Warren Buffett. According to Mohnish, his winning bid was a overdue "tuition payment" to the man who has taught so many.

Lest you think that this was a ridiculous sum of money to fork over for lunch with anyone, I would like to invite you to read my following article at the Motley Fool:

http://www.fool.com/investing/general/2007/07/02/buffett-and-pabrai-break-bread.aspx

By looking at this lunch from several angles, you begin to realize that this lunch bid was a typical Pabrain value play.

This morning, CNBC interviewed Mohnish about his winning bid. (Thanks to Lincoln Minor for graciously sharing valuable information on all things value investing)

http://www.cnbc.com/id/15840232?video=408046817&play=1

Interview Clips with Mohnish Pabrai

2007-06-21T11:18:00.000-04:00

Mohnish Pabrai was interviewed on Bloomberg on June 19, 2007.

Thanks to Lincoln Minor for sharing these wonderful video clips:

Part 1 http://wpi.clipsyndicate.com/publish/index/339725

Part 2 http://wpi.clipsyndicate.com/publish/index/339737

The Principle of [Value] Investing

2007-06-05T00:15:00.000-04:00

I often hear the term "value investing," too much to the point where I begin asking myself two fundamental questions:

1. What do people really mean when they say that they are value investing?

2. What makes a value investor?

Let's be clear from the start. Ben Graham was an investor. Warren Buffett is an investor. Mason Hawkins is an investor. The term value investing was given to their style simply to define what they do best: finding valuable--companies worth more than their current market price--investments.

In my opinion, the best definition of an investment was given by Ben Graham in Security Analysis:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

So there it is. A simple, yet elegant definition of what investing ought to be. If you want to call it value investing, be prepared to explain what that really means. When Charlie Munger remarked "all intelligent investing is value investing," he knew exactly what he was saying. If you say you are a value investor, then without exception, you should be applying the three qualifications that Ben Graham laid down over seventy years ago. Each investment should be made only after a detailed assessment of the facts, a compelling valuation that provides a margin of safety, and a return that is better than other viable options adjusted for risk. I would be willing to wager that at least 75% of so called value investors don't come close to passing the test. You can forget about the majority of mutual funds with the name "Value" in them, as they define their investment operation as low P/E, low P/B stock picking.

Charlie Munger said it best when he remarked:

"Our investment style has been given a name - focus investing - which implies ten holdings, not one hundred or four hundred. The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obvious idea. But 98% of the investment world does not think this way. It's been good for us."

The number one key to a intelligent investing approach is discipline. Discipline is what prevents you from losing money. Preservation of capital is name of the game. I am glad I got a [relatively] early start in investing my own money, because when I look back at my approach, it wasn't truly the prudent approach outlined by Graham. It worked, but the great thing about this game is that if you stay disciplined you are going to learn a lot over time.

The key to remember is that a value investor does not exist in bull markets. Just about any approach during bull markets will make you money. As Seth Klarman aptly put it "Bull markets have of way making everyone look like a genius." A true value investing based approach is designed for bear markets. A value investor's approach is one that can weather the storm during the bear markets and come out with a minimal loss of capital. A successful investing record should be measured in bear markets alone. Earning 90% in a year when the overall market is up 25% tells me zilch about your abilities as an investor. Just look at how many Internet funds were up over 100% per year during their heyday. Losing 10% when the market has tanked 25% on the other hand shows me that an intelligent and disciplined approach was used in making investment decisions.

As Warren Buffet said "Investing is simple, but not easy." There are only three types of stocks: undervalued, overvalued, and fairly valued. What determines the category is simply the price you pay. The worst business in the world can still be undervalued at the right price. So based on the price you pay, the business will either be overvalued, fairly valued, or undervalued. One simply must sell the first, ignore the second, and buy the third without any deviation in approach. This is intelligent investing.

Links to Charlie Rose Interviews with Warren Buffett

2007-05-22T01:16:00.000-04:00

Visit the link below and you can watch the PBS series of Warrren Buffett interviewed by Charlie Rose.

I also very strongly recommned watching the interview with Kevin Clayton of Clayton Homes.

Enjoy them at:

http://video.google.com/videoplay?docid=-6298731715532653073&hl=en

Meeting with Mason Hawkins

2007-05-15T08:27:00.000-04:00

I just returned from Memphis were I had the good fortune to attend my very first Longleaf Partners Annual Meeting of Shareholders. Although only an hour and a half in length, I was baffled at why I had waited so long to attend. I have been reading about Mason since I was 20 or so but it never occurred to me to attend a annual meeting of a mutual fund. I do not invest in Longleaf--although it would be wise to do so--but Mr. Hawkins, true to his character, was gracious enough to invite me to the meeting and get this--the private dinner for the senior members of the Longleaf team. There is no other mutual fund group, to my knowledge, that offers a more candid communication with thier shareholders.

Because Mason Hawkins runs a mutual fund, I sometimes think that he is not given the ultimate credit that ought to be afforded to someone with his achievements. In retrospect, I think the record at Longleaf is all the more spectacular given the operating regulations beholden to mutual fund managers. Mason opened the meeting by citing six principles than any true investor must have in order to succeed in the long-term:

1. You need a sound philosophy
2. Good Search Strategy
3. Ability to value businesses and assess management quality
4. Discipline to say no.
5. Patience
6. Courage to make a significant investment at the point of maximum pessimism

It is easy to see that not many people can truly admit that they adhere to these principles. Admittedly when I first started investing my money at 21, I can easily say that I was still in the early stages of developing a sound discplined approach. Having said that, I know now, seven years later, that because of my somewhat "early" start, and my steadfast belief in the principles set forth in The Intelligent Investor, I am very aware of the attributes needed to ensure a successful long-term investment operation. Understand however, that it's the true application over time that shapes the development of these principles. Charlie Munger remarked at the 2007 Berkshire Annual Meeting that "Warren has gotten better over the years." One needs to really think about Munger's statement. Berkshire shareholders have been fablously rewarded because that they have had the good fortune to have the same guy at the helm who has gotten better over time. The point is that over time the investment philosophy will become more sound, your search strategy will improve, the ability to value a business will expand, and your experience should keep you disciplined. If you are not patient, then odds are that you will not do well over time.

If you are among the minority that can truly say they mentally grasp the first five principles, and your reasoning and data are right, back up the truck and make a substaintail investment. Forget all the EMT non-sense about diversification. A well-chosen, carefully selected portfolio of 7-10 securities is all you need to have a market beating portfolio. You have to be able to eliminate all the noise and accept the fact that most superior investments will be made at the exact time all the "smart" people want nothing to do with it. In the 1960's Buffett put over 30% of his partnership's assets into American Express amidst a scandal. In 2006, Mohnish Pabrai loaded up on Pinnacle Airlines when everyone thought the airline industry was the worst investment ever.

The key to all of this can be summed up in one word: rationality.

Success in investing has nothing to do with your IQ level and everything to do with your ability to be rational in your thinking and being able to eliminate all the excess noise. A good investment can usually be explained by three or four fundamental reasons as to why it is underpriced relative to intrinsic value. To draw an analogy, consider the great chess masters Kasprov, Spasky, etc. Chess masters have developed very specific patterns on how to approach a match. While certain adjustments may need to be made, the overall pattern remains the same each time. The same approach and discipline is required in investing. Mohnish Pabrai told me once "that I can eliminate most companies in 10 minutes or less." Why? Because he has his pattern and knows what to look for in a business in order to pursue it further. At Longleaf, and with any sound investment operation, the approach should be both qualitative and quantitative. The key is buy cheap, not what is down in price. On the quantitative side, a margin of safety requirement demands one to look for businesses that are trading at significant discounts to intrinsic values - at Longleaf, they want at least 60%. There also must be qualitative elements as well in the business like shareholder oriented management, a competitive advantage and so forth or otherwise you really don't have a intelligent investment. Mason Hawkins read The Intelligent Investor as a senior in high school. At the meeting he told the partners that the most fundamental concepts to investing are summed up in two Chapters: 8 and 20--Invest with a margin of safety and look at every investment as part ownership in a business.

Asked about private equity and all the froth in the industry, Mason replied,

"Capitalism has a way of turning a good idea at a low price into a bad idea at a high price. It makes sense to buy at 6x operating cash flow, but at 14x operating cash flow it is very problematic and harmful to do so using massive leverage."

I would like to share another quote of Mason's that he shared to business students a few months ago that I feel sums up the whole idea,

"If you are not willing to look stupid in the short run, you are not likely to be a successful investor in the long-run."

Afterwards, I had the great fortune to have dinner with Mason and the wonderful people at Longleaf after the meeting. I met some really wonderful people, both successful in business and their personal lives. I found this combination to be the rule and not the exception at Longleaf as this is the culture that Mason has created. As impressive as Mason has been managing money, he is even more so with his efforts in his community and hometown. You wouldn't know this because like all great individuals, Mason refuses to take any personal credit for his philanthropy and prefers anonymity

The 2007 Berkshire Hathway Annual Meeting

2007-05-08T00:28:00.000-04:00

Well, it was an interesting AGM this year to say the least. Rather than try to pick through it all, I thought I would provide you with a rather complete transcript of the session. Here is a friend's version. Based on what I heard, this is a fairly accurate transcript.

http://boards.fool.com/message.asp?mid=25469398

I will add this: it is clear that Buffett is looking beyond North America more and more. He made some very subtle, yet valuable comments alluding as much. According to Buffett, Berkshire has two stakes in German companies. Buffett also indicated that Berkshire is involved in a currency transaction that he will get into next year. "You won't believe it" says Buffett.

It's important to realize a couple of things about Berkshire and its forays into foreign investments. First, Buffett hates it when his buying becomes public knowledge. In Germany, for example, laws dictate that upon a 3% accumulation of shares, one must make a public filing. Thus if Berkshire finds an attractive $30 billion company, after accumulating $900 million worth, the word gets out and Berkshire is unable to quietly continue adding to the position at its preferred price. This just one example, but it serves to illustrate that Buffett's "minimal" participation in the global markets doesn't necessarily equate to not having attractive valuations overseas. Buffett has said time and time again, Berkshire's size is such that its performance CAN NOT come close to what is was in the past. Berkshire's need to find investments that can move the needle simply preclude a lot of attractive opportunities domestic and foreign.

Buffett is looking very closely at South Africa and has been presented with some very attractive businesses.

Berkshire Annual Meeting

2007-05-03T15:33:00.000-04:00

Looking forward to a great weekend in Omaha. I hope to see all of you there!

I will be at the Yellow BRKers gathering on Friday at the Double Tree Hotel.

Find out more about at www.YellowBRKers.com

Please introduce yourself if you are there as I am looking forward to meeting everyone who has visited this site.

Thanks,

Sham

Visit with Mohnish Pabrai

2007-04-26T21:24:00.000-04:00

I just returned from a two day trip to L.A. where I had the great fortune to visit with Mohnish Pabrai, agruably one of the most successful investors today.

In 1999 Mohnish set up shop with $1 million. Today he manages $500 million and has an annualized rate of return of 29.1%. And just to be sure, this is after he takes his cut (as Mohnish eloquently says, "after my outrageous fees".)

I enjoyed the opportunity to hear Mohnish speak to a group of business school students at USC, chat with him privately, and have dinner with him. Most of what Mohnish had to say he gives to you in his newest book, The Dhandho! Investor, a must read for any true investor.

Nonetheless, it pays to listen very carefully to Mohnish as one will take home some pearls of wisdom.

On becoming a successful investor,

"All the great investors have given you their methods. Read everything Buffett has to say...he tells you how to succeed in investing. Joel Greenblatt, wrote the The Little Book that Beats the Market for his young daughters. In the book he tells you how beat the market. His website, http://www.magicformulainvesting.com/ screens for the best stocks. Find the best ones and you will beat the market. Patience is the key"

With regards to his investments,

"When I buy a stock, two things ALWAYS happen: immediately after I buy, the stock tanks and once I sell the stock, it really takes off"

If you're asking yourself how this is possible alongside with 29.1%, pay attention to this,

"When I invest in a business I have a very good idea about the intrinsic value of the business. I never have an exact figure, but I know the business well enough to arrive at a very comfortable range with a high degree of probability. If in invest in a business, I now wait three years before I sell if the price has gone down as long the present intrinsic value has not deteriorated.

This routine comes from Mohnish's investment in USAP, which I won't go into great detail here. Basicailly, he bought the stock, after which it proceeded to go down by two thirds. After a reassessment of the underlying economics of the business, Mohnish concluded that the intrinsic value has actually gone up. This continued to be the case over the next two years and the stock remained dormant. Sure enough, the market caught on and USAP climbed to a point where Mohnish had more than a 100% unrealized gain. Now, the security is up over 200% from his investment point and Mohnish has since exited with only a very minor position.

The takeaways you should have from this are simply:

1. Understand your investment well and make sure you have a thesis that clearly explains your reasoning for investment. This should be no more than 3-4 lines.

2. Approximately 80% of a stocks price movement occurs during 10% of time. Timing the market is a fools game. Exercise patience.

Dinner with Mohnish, was very entertaining to say the least. He's full of humor and witty wisdom...much like a guy in Omaha.

Mohnish was kind enough to keep a copy of my Letter to Potential Limited Partners regarding the formation of the Gad Investment Partnership. I only asked him to take look and he was very kind enough to do so. As we all know Mohnish eats his own cooking and invests all his money in the Pabrai Investment Funds. Nonetheless he was impressed with what he saw and I hope to someday catch up with his phenomenal pace.

On that note, I am happy to report that the formation of the Gad Investment Partnership is moving right along. I appreciate everyone's interest. I have been studying business, and specificially the workings of Graham and Buffett since I was 15. My setup will be very much like the original Buffett Partnerships of the 1950's and the Pabrai Fund in 1999.

Accredited investors should contact me directly regarding investment interest.

Buffett: 1956-2007

2007-04-17T00:06:00.000-04:00

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."-

Warren Buffett on June 25, 1999 (Business Week)

By now most of us our familiar with this statement from Warren Buffett or have heard something similar. Well, it was this quote that got everyone so curious about how Buffett would be able to generate such a outstanding performance today.

In order to really understand what Buffett had in mind when making this remark, you need to know this: Buffett is not the same investor in 2007 as he was during the 1950's and 60's.

Let's go back and look at Buffett's early years compared to today.

During the 1950's, Buffett's returns exceeded 50%

His investment strategy was concentrated into three categories:

workouts,
undervalued securities, and
control situations.

Workouts essentially constituted of investments which were dependent on a specific corporate action for their profits rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs came about through sales, mergers, liquidations, tenders, etc. This is arbitrage in the purest sense. With work-outs the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally.

Control situations involved an investment stake substantial enough in which Buffett was able to take part in corporate decisions. At times these positions could make up to 20-30% of the capital under Buffett's management. An example of such a situation was the purchase of the common stock of the Commonwealth Trust Co. of Union City, New Jersey in 1957. Buffett concluded that the stock, priced at $50 per share, had an intrinsic value of about $125 on a conservative basis. Buffett accumulated 12% of the stock before it reached a price of $65 in which case he neither bought or sold. By the following year, he had negotiated a private transaction and sold the shares for $80, with the current market price quoted at 20% lower than his sale price. The most famous control situation, of course, was Berkshire Hathaway.

The 50's and 60's was a good period for these types of investment situations and Buffett took advantage by committing large portions of his partnerships capital. He was concentrating his portfolio in the best ideas regardless of market environment. While Buffet is indeed an extraordinary stock picker, he was a brilliant businessman, and his track record of the 1950's and 60's lay evidence to that.

With only millions to invest, the opportunities for workouts and control situations were easier to exploit. With tens of billions to invest today, Buffett simply cannot employ the same investment strategy. To be sure, he always sees hidden value in his investments, but you have to remember one important thing: Berkshire is so huge and well diversified that Buffett's investment decisions are now about keeping the company going in line with economy as opposed to beating the pants of the Dow Jones. Over a third of Berkshire is ultimately going to the Bill and Melinda gates foundation, so Buffett needs to really make long-term stable investments and not necessarily workouts situations. One might argue that USG is a workout situation, but the corporate action --emerging from bankruptcy-- has already occurred. USG is simply a fantastic business that is waiting for the next cyclical demand boon in wallboard (an economic event). Berkshire's investments in Posco and most recently, Burlington attest to this.

In end all this means is that Buffett is still the greatest capital allocator in the history of mankind. He has a unique ability to shift gears when the situation calls for it. There a lot of other points I skipped over, like Munger's influence on Buffett's investment philosophy with the purchase of See's candies in the 1970's. My goal here was to simply show evidence that one can not and should not analyze Buffett's investments of today with the same parameters of Buffett's investments during the early years.

Buffett buys Railroads

2007-04-09T14:46:00.000-04:00

By now, I am sure everyone is aware of Buffett's 10.9% stake in Burlington Northern Sante Fe Corporation. Like typical Buffett, he is buying railroads just at the exact moment when the industry is predicted weaker growth. Purchased at around $81.40 per share, Berkshire now holds about 39 million shares. Plus Berkshire is supposedly buying shares in other yet to be disclosed railroads.

Here is the link to the Berkshire disclosure filing:

http://www.sec.gov/Archives/edgar/data/109694/000118143107024383/xslF345X02/rrd154090.xml

Consider that Burlington hauls enough low sulfur coal to produce about 11% of the country's electricity needs. If you have any long-term favorable outlook for U.S. energy demand, then Burlington makes perfect sense. We know Buffett does, as years ago he publicly stated that Berkshire can be expected to make "substantial" investments in the electric/utility industry.

Pabrai's Perspectives on Investing, Part 2

2007-02-26T10:05:00.000-05:00

Here's Motley Fool contributor Emil Lee's second half of his interview with superinvestor Mohnish Pabrai. Click http://shamgad.blogspot.com/2007/02/mohnish-pabrais-perspectives-on.html for Part 1.

Emil Lee: How do you do your due diligence? Do you generally stick to industries you are already familiar with? How in-depth do you get, in terms of studying a company, its industry, and its competitors? Do you talk to a lot of people in the industry?

Mohnish Pabrai: I don't call or meet with management or company insiders. I do rely, from time to time, on the investors in Pabrai Funds. I am blessed to have a large contingent of CEOs and entrepreneurs as investors. Many of these folks know their industry cold. So, if I'm looking at something in real estate, there are [a] few real estate experts in my circle. I read up on the business, try to honestly assess whether it is within my circle of competence, and then send my thesis to the investors with domain knowledge and get their perspective.

Lee: You don't use Excel models. How do you keep track of all the moving parts (i.e. unit costs, discounted cash flow)? Are the economics of your investment ideas so compelling/simplistic that they can be done on the back of an envelope?

Pabrai: Usually two to three variables control most of the outcome. The rest is noise. If you can handicap how those key variables are approximately likely to play out, then you have a basis to do something. Things that are approximate and probabilistic don't lend themselves too well to Excel modeling. For me, if I find myself reaching for Excel, it is a very strong sign to take a pass. The thesis ought to be painfully simple in your head.

Lee: There's a ton of books about value investing, but very few about "special situation" or "event driven" investments -- do you recommend any books/magazines? Do you recommend any other business publications/trade magazines? Also, you mentioned Timothy Rick in Altucher's book -- I couldn't find anything on him (was it supposed to be Timothy Vick?) -- can you point me in the right direction?

Pabrai: Yes, it's Tim Vick. Buffett has spoken and written a lot about special situations. One should read up on the Buffett Partnership letters and Shareholder letters, as well as the annual meeting transcripts printed in OID. Tim talks about it in his book as well. Finova was a recent Buffett Special Situation, as were his adventures with Level 3 (Nasdaq: LVLT) Bonds, Korean stocks, American Express (NYSE: AXP) in the 1960s, etc.

Lee: What do you hope to accomplish with your new book? Is there a message or point you'd like readers to pay particular attention to?

Pabrai: The best way to learn is to teach. Writing the book was tremendously helpful for me to systematize the framework that I had in my head. I enjoyed writing it. I wrote it for the intelligent individual investor. And I wrote it for the great-grandkids that I'll probably never meet. If it improves the investing results of a few humans, I'd consider it a success.

Lee: Do you have any additional advice that would be helpful to people like me, who are trying to learn as much as possible about investing?

Pabrai: Pursue your passion, whatever it is. If you pursue what you love, you're pretty much assured of doing well at it. If investing is your passion, then study the best intently. The best investor is Warren Buffett and he's an open book. I'd suggest spending all one's energies getting to understand Buffett's modus operandi. To the extent that it's consistent with your temperament, adopt it.

Mason Hawkins on 2006

2007-02-25T01:17:00.005-05:00

A couple of months ago, I wrote an article on this blog about Mason Hawkins and his deep commitment in running his three funds at Longleaf as a true partnership between the managers and investors. Let me re-post the first two Guiding Principles of Longleaf:

1. "We will treat your investment...as if it were our own."

2. "We will remain significant investors with you..."

Mason Hawkin's Annual Letter to Partners has just come and I wanted to share some highlights. (read the whole thing at http://www.longleafpartners.com/pdfs/06_q4.pdf. It's a wonderful document and truly reflects how managers should communicate with their investors)

Here's Mr. Hawkins take on 2006 and the investing climate in general:

We have no view on what markets will do, but this environment presents a challenge as we enter 2007. There are few available bargains as we look for new opportunities to strengthen the foundation for compounding over the next five years. The domestic “on deck” list of potential investments is relatively small, but we are buying several new international companies.

Spoken like a true creator of long-term value.

Our long term success has emanated from several core principles:

Buy a business with expected value growth
Parnter with capable, honorable management
Pay a signifcant discount for stocks
Invest with a minimum five year horizon, deferring taxes and minimizing transaction costs
Charge reasonable fees

What has all of this done for Longleaf under the tutelege of Mason Hawkins? I will let the numbers speak for themselves (results are 10 year annualized returns)

Longleaf Partners Fund - 12.8% vs. 8.4% for S&P 500

Longleaf Small Cap - 14.5% vs. 9.4% for Russell 2000

Longleaf Int'l - 15.5% vs. 8.0% for EAFE

Mohnish Pabrai's Perspectives on Investing

2007-02-23T10:53:00.000-05:00

Emil Lee from the Motley Fool recently had a chance to sit with Mohnish Pabrai and discuss his investment philosophy, his similarity to Warren Buffet, and his amazing track record. Here are excerpts from the first part of the interview:

Emil Lee: You've modeled your partnership after the Buffett Partnership -- do you mind providing any detail on how that's going? Are you on track in terms of performance, assets under management, etc.?

Mohnish Pabrai: It has gone far better than I would have forecasted. Mr. Buffett deserves all the credit. I am just a shameless cloner. A $100,000 investment in Pabrai Funds at inception (on July 1, 1999) was worth $659,700 on Dec. 31, 2006. That's seven and a half years. The annualized return is 28.6% -- after my outrageous fees and all expenses. Assets under management are over $400 million -- up from $1 million at inception. On all fronts, Pabrai Funds has done vastly better than my best-case expectations.
Going forward, I expect we'll continue to beat the major indices, but with just a small average annualized outperformance.

Lee: You clearly believe in having a broad latticework of knowledge from different educational disciplines from which to draw upon when judging investment ideas. Can you describe how you spend your day? Do you devote a general percentage of your time to reading "non-investment" material versus 10-Ks, etc.?

Pabrai: My calendar is mostly empty. I try to have no more than one meeting a week. Beyond that, the way the day is spent is quite open. If I'm in the midst of drilling down on a stock, I might spend a few days just focused on reading documents related to that one business. Other times, I'm usually in the midst of some book, and part of the day goes to keeping up with correspondence -- mostly email.
I take a nap nearly every afternoon. There is a separate room with a bed in our offices. And I usually stay up late. So some reading, etc., is at night.

Lee: In Trade Like Warren Buffett, you mention that you let investment ideas come to you by reading a lot, and also monitoring familiar names on the NYSE. Can you describe your process of generating investment ideas -- is it simply just reading a lot? Do you do anything else to actively seek out ideas?

Pabrai: The No. 1 skill that a successful investor needs is patience. You need to let the game come to you. My steady-state modus operandi is to assume that I'm just a gentleman of leisure, and that I'm not in the investment business. If something looks so compelling that it screams out at me, saying "Buy me!!," I then do a drill-down. Otherwise, I'm just reading for reading's sake. So, I scan a few sources and usually can find something scream out at me a few times a year. These sources (in no particular order) are:

1. 52-Week Lows on the NYSE (published daily in The Wall Street Journal and weekly in Barron's)
2. Value Line (look at their various "bottoms lists" weekly)
3. Outstanding Investor Digest (www.oid.com)
4. Value Investor Insight (www.valueinvestorinsight.com)
5. Portfolio Reports (from the folks who put out OID)
6. The Wall Street Journal
7. Financial Times
8. Barron's
9. Forbes
10. Fortune
11. BusinessWeek
12. The Sunday New York Times
13. The Value Investors' Club (www.valueinvestorsclub.com)
14. Magic Formula (www.magicformulainvesting.com)
15. Guru Focus (www.gurufocus.com)

Between all of the above, I have historically found at least three to four good ideas every year. Sometimes I make a mistake, and a good idea turns out to be not so good.

Lee: A big part of investing is knowing what to pay attention to and what not to [focus on]. How do you sift through the thousands of investment ideas? Often, bargains are bargains because they're unrecognizable -- how do you spot the needles in the haystack, and how do you avoid the value traps?
Pabrai: I wait to hear the scream. "Buy me!" It needs to be really loud, as I'm a bit hard of hearing.

Lee: Would it be fair to say you are more balance sheet-oriented, versus income/cash flow statement-oriented? If so, how do you get comfortable with the asset values (i.e., Frontline, death care)?

Pabrai: John Burr Williams was the first to define intrinsic value in his The Theory of Investment Value, published in 1938. Per Williams, the intrinsic value of any business is determined by the cash inflows and outflows -- discounted at an appropriate interest rate -- that can be expected to occur during the remaining life of the business. The definition is painfully simple. So, cash can be gotten out of a business in a liquidation or by cash the business generates year after year. It is all a question of what is the likelihood of each. If future cash flows are easy to figure out and are high-probability events, then liquidation value can be set aside. On the other hand, sometimes the only thing that is a high probability of value is liquidation value. Both work. Depends on the situation. But you first need to hear a scream ...

Permanent Value: The Messages of Warren Buffet

2007-01-28T22:50:00.000-05:00

For complete highlights of my class visit with Buffett, please visit:

www.buffettspeaks.blogspot.com

Buffett Speaks

2007-01-22T17:40:00.000-05:00

I just returned from a two day visit to Omaha, Nebraska to visit with Warren Buffett at Berkshire Hathaway. I took along 50 of my fellow MBA classmates. As expected, the Sage of Omaha was full of humor while dispensing his unique, masterful thoughts on business and life.

Unlike most student visits to Omaha, this one was unique in that we had extensive access to Mr. Buffett...nearly seven hours over the course of two days. Most schools consider it a major coup to score 2 hours with him and others spend tens of thousands of dollars for a two hour lunch with Buffett (see eBay for future lunch dates).

The time was priceless...we spoke of the early years with Buffett working for Ben Graham, the formation of the legendary partnership in 1956, his remarkable gift to the Bill and Melinda Gates foundation, and of course, investing.

The notes of this trip will be available on this blog shortly. For now, I will share some highlights of the meeting.

I asked Buffett about the state of the securities markets in the U.S. going forward and how they will compare to the period in which he operated and how he could make 50% or more per year...

Buffett: "It's a structural issue...yes, with a small sum like a million dollars, I could make 50% or more a year. The key is rationality. There are always going to be times when humans act irrational and this is time to make your money. I've made a career of cashing in when people act irrational."

If you consider some of Buffett's most successful investments--American Express, the Washington Post Company, and Gieco--they were all made during the absolute worst times for these companies. Times when nobody wanted anything to do with them.

Buffett then picked up a copy of the 2004 Citigroup Investment Guide to Korean stocks and began flipping through the pages,

Buffett: "A couple of years ago I got this investment guide on Korean stocks. I began looking through. It felt like it was 1974 all over again. Look here at this company...Dehan, I don't know how you pronounce it, Flour Company. It earned 12,879 won previously. It currently had a book value of 200,000 won and was earning 18,000 won. It had traded as high as 43,000 and as low as 35,000 won. At the time, the current price was 40,000 or 2 times earnings. In 4 hours I had found 2o companies like this."

What Buffett said next is critical,

Referring to having found 2o or so companies like Dehan Flour Buffett remarks,

"When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses."

It's critical to understand the mental model Buffett has going into these investments in Korea. A portfolio of carefully selected stocks in understandable businesses trading at very attractive valuations generate abnormal returns. While I don't have Buffett's personal investment record, I am certain he was making 40-50% returns in Korea simply by choosing a portfolio of stocks with strong earnings records trading at very low multiples to earnings. Ironically, this model is not new...it was actually revealed by efficient market advocates Fama and French in there three-factor model. Over time, low P/E, low book, small companies tend to outperform. Apply a little more intensity, as Buffett is famous for doing, and you can make lots of money.

One of Buffett's most successful international investments was PetroChina, China's largest oil producer.

Buffett: "The whole company was selling for $35 billion. It was selling for one-fourth of the price of Exxon, but was making profits equal to 80% of Exxon. I was reading the annual report one day and in it I saw a message from the Chairman saying that the company would pay out 45% of its profits as dividends. This was much more than any company like this, and I liked the reserves."

The Chinese government owns 90% of PetroChina, so only 10% was available to outside investors. Even with this lopsided ownership, Buffett liked the company enough to buy 13% (actually 1.3% of 10%, but Buffett likes to joke that the company is owned by him and the Chinese gov't)

"I was considering buying this company, but I was also looking at Yukos in Russia. This was cheap, too. I decided I’d rather be in China than Russia. I liked the investment climate better in China. In July, the owner of Yukos, Mikhail Khodorkovsky (at that time, the richest man in Russia) had breakfast with me and was asking for my consultation if they should expand into New York and if this was too onerous considering the SEC regs. Four months later, Khodorkovsky was in prison. Putin put him in. He took on Putin and lost. His decision on geopolitical thinking was wrong and now the company is finished. Petro China was the superior investment choice. 45% was a crazy amount of dividends to offer but China kept its word. I am never quite as happy as I am in the US, because the laws are more uncertain elsewhere, but the point is to buy things cheap."

Once again, "the point is to buy things cheap." Because the company is not in the U.S., Buffett applies more filters before committing capital.

"So we own 1.3% of this company and it cost us around $400 million. Now it's worth $3 billion."

Look closer and you can see the real value in this investment...the dividend payout. When Buffett made his investment, PetroChina was paying a dividend of close to 9-10% (I know because I bought some shares the minute I heard of Buffett's stake and about 5 minutes of my own research.) At the time the stock price was about $30 per ADR, but Buffett purchased H shares directly in China at a lower price. The stock currently trades at about $125 per ADR and yields 5%...you do the math...about $6 per share on a $30 cost basis or even lower...margin of safety?

Buffett also had a copy of the 1951 Moody's Banking and Insurance Manual.

"There were four Moody's manuals at the time. I went through them all, page by page, over 10,000 pages. On page 1433, I found Western Insurance Securities. Its earnings per share were as follows: 1949 - $21.66, 1950 - $29.09. In 1951, the low-high share price was $3 - $13. Ten pages later, on page 1443, I found National American Fire Insurance (“This book really got hot towards the end!”) NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. This company was located right here in Omaha, right around the corner from I was working as a broker. None of the brokers knew about it. This book made me rich."

Sham Gad can be reached at shamgad@gmail.com

The Warren Buffett of Mutual Fund Investing?

2006-12-25T16:06:00.000-05:00

No, I am not talking about Peter Lynch, although Mr. Lynch is arguably one of the best mutual fund managers and investors of his era. Nope, the gentleman I am referring to runs a mutual fund company that is quite simply unique amongst its peers. Consider the firm's statement of principles found on the first page of the prospectus:

1. "We will treat your investment...as if it were our own."

2. "We will remain significant investors with you..."

Sound familiar? Buffett and Munger subscribe to the same principles at Berkshire Hathaway by "eating our own cooking." Mutual funds are not exactly known for their high insider ownership, although a few diamonds in the rough can be found.

The fellow I am referring to is none other than Mason Hawkins, investment guru extraordinaire and chairman of Longleaf Partners, a value oriented mutual fund family. The word partner in the company name is richly deserved...each investor in Longleaf is viewed as a long term partner.

I must admit, I have known of Mr. Hawkins for some time now, but it was only recently that I discovered where Mr. Hawkins earned his MBA...the University of Georgia. As a current MBA candidate at UGA, I was euphoric that UGA boasts as an alumnus one of the greatest money managers of our time....who adheres to the value principles espoused by Ben Graham. Needless to say, my recent discovery sent me on a search to learn as much as I could about Mr. Hawkins and the his wonderful canvas, Longleaf.

To really appreciate Mr. Hawkin's partnership approach with his investors, all you need to do is consider how Longleaf came to be. Longleaf was basically started by Mr. Hawkins in 1987 when he introduced it to Southeastern Asset Management. Since 1975, SAM was a respected value oriented firm. Longleaf was created so Mr. Hawkins could essentially pool his money alongside his clients without creating the conflict of interest that can arise when money managers buy and sell for their own accounts. Mr. Hawkins bought all the same securities held by SAM and then put all his and his colleagues money into it. If that ain't eating your own cooking, I don't know what is. Mr. Hawkins went even further when he prohibited Southeastern's employees from investing in any of their bonuses and profits outside of Longleaf...talk about a true partnership with your clients.

I recently uncovered a gem of a paper written a few years back about Longleaf and Mr. Hawkins that really illustrates the viewpoints of Longleaf and its founders:

When Mr. Hawkins was a high school senior, he read Graham's "The Intelligent Investor" and remarked,

"The single thing that Graham talks about that allows for success is establishing firmly what a company is worth. Only if you've done rigorous analytical work that has a high probability of being right can you control your emotions and act against the collective mind-set of the moment."

Staley Cates, a colleague at Longleaf aptly says,

"We believe risk goes down when you put your money only in the investments you understand very well."

The folks at Longleaf have been compounding money in excess of thier respective benchmarks for a long time. With a track record like that, Longleaf would have no problem attracting funds. Instead Longleaf decided to close out two of its funds several years ago and forgo all those lucrative asset management fees. When Mr. Hawkins decided to close the funds to new investors, he was doing so at peak performance and could have attracted capital at the snap of a finger. Instead, as all true intelligent investors do, he chose not to.

"If we'd kept the Funds open, we could have maximized our fee income but we would have damaged our record and impaired our ability to compound our own capital as well as our customers'. So we closed them."

Mr. Hawkins will only reopen the funds when the economics are right to put more assets to work....in other words when stocks are cheap. Indeed since 1995 when Mr. Hawkins closed the Partners Fund to new investments and in 1997 when he closed the Small Cap, Mr. Market has created pockets of opportunities to reopen them and as a result, both new and existing partners have been handsomely enriched. While there are several mutual fund outfits that align their interests with those of outside shareholders, I haven't come across any that are as methodical about it as Longleaf.

It's really important to consider that Mr. Hawkins and his team could have gotten very rich a lot quicker by running their funds geared at maximizing short term profits, but instead they choose to get rich slowly alongside their partners. According to Charlie Munger, "why should it be easy to get rich?" And that is exactly how it should be.

Each year Longleaf hosts a annual shareholder meeting that gives their investor's a chance to get their questions answered. Like Berkshire, Longleaf strives to treat their shareholders fairly and in the process, Mason Hawkins, like Warren Buffett, is beating the pants off mutual fund managers.

The Art of Deep Value Investing

2006-12-14T02:03:00.000-05:00

Charlie Munger said it best when he remarked that, "All intelligent investing is value investing." Quite simply, value investing can be defined by two fundamental metrics:

1. Look for a business trading below its intrinsic value.

2. Invest with a margin of safety.

In other words, pay attention to price. A fantastic business is not a fantastic investment if the price is wrong. In my obsessive pursuit of understanding the true mechanics of Grahamian value investing, I went looking for some insights into the complex art of deep value investing. I found some wonderful words of wisdom from Seth Klarman, value investor extraordinaire and founder of The Baupost Group, a value driven hedge fund. Mr. Klarman has been compounding money at over a 23% clip for the past two decades. At a recent talk at the Columbia Business School, Mr. Klarman shared his thoughts....

“If only one word is to be used to describe what Baupost does, that word should be: ‘Mispricing’. We look for mispricing due to over-reaction,”

Markets are never completely efficient. There will be times when Mr. Market goes crazy and offers to sell dollar bills for fifty cents. Taking advantage of these opportunities can generate enormous returns. But to do so, you have to constantly be working and working and working...why should it be easy to get rich?

“Investors can not predict when business values will rise or fall. Valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value and other methods.”

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world,”

Consider the Washington Post Company in the early1970's. At one point, the market cap of the Post was around $80 million yet the media and publishing assets of the company could have easily fetched $400 million in a fire sale liquidation. Eighty cents for four dollars sounds like a pretty good margin of safety. Valuation is not an exact science...an adequate margin of safety, usually 50%, helps cushion against "volatility" and "bad luck."

Look at investments as "fractional ownerships."

How else should you look at buying shares in a business?

Ultimately, investments generate profits in three ways:

1. From the free cash flow generated by the underlying business, which will eventually be reflected in a higher share price or distributed as dividends.

2. From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price.

3. Or by closing the gap between share price and underlying business value.

So how do you find profitable investments?

"Value investing requires a great deal of hard work, unusually strict discipline and a long-term investment horizon"

Seth Klarman wrote a book, Margin of Safety, that is a blueprint for a sound investment approach. Unfortunately, the book is out of print and last time I checked, a copy was fetching over $1300 on eBay. However, most university libraries ought to have a copy or should be able to be able to point you in the right direction.

A Thought On Investing

2006-12-01T23:18:00.000-05:00

Author's note: I orginally wrote this article several years ago in response to the puzzled looks I got when I was telling my friends (I was 22 at the time) about value investing and this guy in Omaha, Nebraska that was beating the pants off Wall Street practicing it.

Fact: Between 1984 and 1999, a great bull market in America, 90 percent of mutual fund managers underperformed the Wilshire 5000 Index, a relatively low bar to beat.

Ninety percent. Think about this for a moment. Only one out of ten “expert” mutual fund managers generated a return higher than that of the overall general market. Why does this happen? How is it that an overwhelming majority of intelligent professionals fail to produce a par result for their investors? The answer is two-fold: First, mutual fund managers tend to focus on short-term results and second, they tend to follow the herd. Mutual fund managers define their investment strategy with particular styles such as “small-cap value” or “small cap growth” to isolate the parameters that guide their portfolio selections. Any business that does not fit into the particular investment focus of the fund is screened out, regardless of its suitability for investment. The reason mutual-fund managers limit themselves to a particular class of equities is doing so appears rational and is therefore seen as the safest option. Who wants to ever appear irrational? This rationality (or lack thereof) is how mutual fund managers are able to justify their performance to their investors.

Investors, wanting evidence that a mutual-fund manager’s decisions are reasonable, compare his decisions and performance with his peers. Mutual fund managers, knowing this investor behavior and anxious to protect their jobs, simply mimic their peers. This mimicking destroys whatever informational advantage they had leading to a shortage in investment possibilities and any informational advantage they had to begin with. As John Maynard Keynes wrote in The General Theory of Employment, Interest and Money, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” What does all this say about mutual fund managers? That, in their goal of wanting to do what seems to be safest, they follow the crowd, resulting in performance below that of the general market by sticking to the same investments as their peer groups.

Fortunately for investors, they have some options: Two options are index funds and what legendary investor Warren Buffett terms “super investors.” While the focus of this article is on the latter, a simple word on the former. Index funds are a great way to mimic the market without the necessary (sometimes outrageous) fees of a mutual fund. These low cost passively managed funds are, in general, far superior investments to mutual funds in many asset classes. However it is possible to have consistent marketing beating returns—by a healthy margin at that. When you think about trouncing the market, names such as Bill Ruane of the famed Sequoia Fund, Warren Buffett of Berkshire Hathaway, Peter Lynch of Fidelity, Walter Schloss, and Rick Guevin come to mind. Mr. Guevin never attended business school; Mr. Schloss never even went to college (I am not suggesting avoiding an education, something this author values tremendously, but merely to suggest that a pedigree MBA does not necessarily give you an advantage). Some of these names stand out more than others, but all of them and dozens like them have amassed equally astonishing performances year after year through bull and bear markets. And they did it in their own way. Walter Schloss owned stocks that Bill Ruane did not own that Peter Lynch did not own and so forth. The common thread amongst these super investors is their relentless pursuit for quality investments at attractive prices, otherwise known as value investing. Warren Buffet beautifully illustrates this idea as “buying dollar bills for fifty cents.” This discipline, coupled with patience and total lack of emotion from the daily market swings, has served these investors amazingly over decades.

Ben Graham, the dean of value investing and a mentor to the some of the greatest investors, has said “investing is most prudent when it is most business-like.” A simple concept, but one that very few mutual fund managers practice. When you purchase a home, you hunt for a good price, safety, and a quality neighborhood and neighbors. You do your research and then purchase the most attractive home giving strong consideration to these factors. Investing and investment managers must be the same way, so as not to be mistaken for speculation. You want a bargain, safety, and a quality business and management. While I certainly cannot expect all investors to manage their own money—I would have no job or livelihood if that were the case—investors must demand market-beating performances from their financial gatekeepers if they are to justify the fees that they pay them to manage their money. Thankfully for us, we are fortunate to have some money managers and investors who don’t follow the herd.

Sham Gad, a 2007 MBA candidate, is currently working to establish Gad Investment Partners, an investment partnership inspired by the work of Graham and Buffett. I welcome all comments and suggestions to shamgad@gmail.com.

Mohnish Pabrai's Words of Wisdom: Excerpts from the 2006 Value Investor Congress

2006-11-20T14:47:00.000-05:00

Mohnish Pabrai, Managing Partner of Pabrai Investments, gave an illuminating presentation at this year's 2nd Annual VIC in New York City. Titled, "Dhandho! Low Risk+High Uncertainty = Ultra High Rewards," Mohnish brilliantly illustrates the rise of the Patels in the U.S hotel industry.

Coming as refugees from East Africa, the Patels were filled with entrepreneurial spirit and nothing to lose. By buying small motels, living in the motels, and staffing the motel with family members, the Patels were able to reduce overhead costs down to the bare minimum (low risk).

This low cost structure gave the Patels one of the most prized attributes in all of business: a sustainable competitive advantage. Patels had no idea how their model would work out (high uncertainty), but they did know that they had no downside (the hotels were highly leveraged).

Mohnish referred to this as The Patel Motel Dhandho model (clever choice of words).

So how did this model turn out? Collectively, Patels own over 33% of all U.S hotels (about 20,000) or so worth over $40 billion.

Essentially what Mr. Pabrai is illustrating is the arbitrage spread that exists due to a gap that start ups step in to fill. In the Patel case, because they were able to operate with the lowest costs, they were able to provide the lowest prices and so they generated super sized returns.

Like all arbitrage opportunities, however, over time the gap diminishes. As Patels applied their model on a larger scale, the profits eroded and the gap diminished. In this situation the gap persisted long enough for a lot of Patels to make a lot of money.

I found Mohnish's talk to be brilliantly refreshing. Before his discussion, I was puzzled with the title of his topic, but as I have come to discover about Mr. Pabrai, give him a few minutes and he will explain his thoughts in such a way that you taken by thier combination of simplicity and potency (I am often reminded of Warren Buffett's responses to shareholder at annual meetings in much the same way)

This talk contained valuable nuggets of information that are essential to any long-term investment philosophy: seek out companies with sustainable advantages and you don't need to take on higher risk to generate higher returns.

Mohnish's Dhandho model is a powerful frame work for all equity investors to use.

Long Term Value

2006-11-18T10:28:00.000-05:00

Welcome to Sham Gad on Value Investing: Inspirations from Ben Graham, Warren Buffett, and Mohnish Pabrai. This is my blank canvas. My goal is to periodically paint strokes on this canvas as I pursue my lifetime goal of running Gad Investment Partners, a private investment partnership modeled after the original Buffett partnerships that begin in 1956.

According to Warren Buffett, the most important skill an investor needs to possess is temperament. Charlie Munger has said that "all intelligent investing is value investing." I first heard about Warren Buffett in 1994 when I was 15. After reading Roger Lowenstein's biography on Buffett and Graham's "The Intelligent Investor," I became a student of value investing almost religiously. I say almost because I encountered a few slip ups early in my investing endeavors. Fortunately for me, these mistakes occurred early in my life with the little savings I had.

Sometimes the best investment strategy is to have no strategy at all. Valuable lessons can be learned from observing successful long-term investors. This group includes the original master craftsmen (this is certainly not a complete list), Buffett, Munger, Bill Ruane, Christopher Brown, Walther Schloss and their disciples: Joel Greenblatt, Mohnish Pabrai, Bruce Berkowitz and Eddie Lampert.

Sincerely,

Sham Gad