Wednesday, December 3, 2008

Mueller Water Arbitrage: Taking Candy from a Baby

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.

Wednesday, November 19, 2008

Valuations Don't Matter - In the Short Run

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 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.

Friday, October 17, 2008

Buffett Says "Buy American"

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

Thursday, October 2, 2008

One-Hour Interview: A Conversation with Warren Buffett

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

A Conversation with Warren Buffett

Sunday, September 28, 2008

Book Excerpt: THE SNOWBALL

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”.

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.”

Thursday, September 4, 2008

Wednesday, August 27, 2008

Longleaf Parnters 2008 Semi-Annual Shareholders Letter

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

Monday, August 18, 2008

The Security [Buffett] Liked Best in 1952

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.

Monday, July 28, 2008

PIMCO's Mohamed El-Erain

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.

Sunday, June 29, 2008

Excellent Seth Klarman Interview

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.

Monday, June 9, 2008

Buffett's Bet Against the Hedge Funds

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

Monday, June 2, 2008

Why Value Investing Always Wins - Numbers Don't Lie

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

Thursday, May 22, 2008

Value Investing Business School

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.

Tuesday, April 29, 2008

Where Many Investors Trip Up

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:

" 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.

Wednesday, April 16, 2008

Buffett Talks Business

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.'

Saturday, March 8, 2008

A Solid Bet: The Case For Ternium Steel

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.

Wednesday, March 5, 2008

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

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.

Tuesday, February 12, 2008

Berkshire's Bond Offer Is a REALLY BIG Deal

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.


Ajit Jain,

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

Thursday, February 7, 2008

Buffett Interview in Canada

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