2008 Predictions

Predictions for the coming year are all the rage in financial journalism, especially among the more populist publications: BusinessWeek and Fortune. It seems the more intelligent people (read: The Deal, The Economist) understand flaws in seeking exactness and are much more cautious when asked about what the future will hold. Many journalists are publishing their stories of the year and their predictions for 2008. One would be wise to just gloss over these for the most part and ask one important question: how much of this year's 'credit crunch' is actually a crisis and how much of it is actually a return to historical risk premiums and reasonable mortgage lending standards--such as as actually proving income and not falling into the pits of esoteric neg-am loans. In theory, home values don't fall nationwide, but then in theory, financial journalists and economic 'experts' are the real experts.

Happy Investing,
Faro Research

Fallen Spinoff Tracker

Company Name	Ticker	Spin Date	Price	Current
Opnext	OPXT	2/14/2007	$15.00	$8.11
Babcock & Brown Air LTD	FLY	9/26/2007	$23.00	$19.35
Quest Energy Partners	QELP	11/8/2007	$18.00	$15.15
Encore Energy Partners	ENP	9/11/2007	$21.00	$19.26
Cal Dive International	DVR	12/13/2006	$13.00	$12.74
MF Global Ltd.	MF	7/18/2007	$30.00	$29.78

Virtues of Basic * Cash Flow Analysis

Since John Burr Williams' Theory of Investment Value in the 1930's clarified the idea of firm value, a discounted cash flow (DCF) analysis has been a pillar in finance theory and practice. Though simplicity is touted by using simple multiples, this does not eliminate the implied DCF of a financial asset. The value of any asset is the present value of all future cash generated.This raises some basic questions: when will I get my cash? How much will it be? How likely is it that I'll get it? What discount rate should I use for my estimate? Though this is far from science, and the model for analysis changes depending on the type of business (e.g., banks, manufacturers, et al.) in question, this forces one to question the future growth and profitability assumptions implied in an asset's price. Below are some key points to any simply DCF analysis:

Cost of Capital: risk-free rate + risk premium, or, opportunity cost of capital

Cash Flow Forecasting Period: long enough for the company’s top-line growth rate to be less than or equal to that of the economy.

Free Cash Flow: Operating Cash Flow – Capital Expenditures



*should be very basic and conservative

Arb Plays

This week's Barron's highlights the widening spreads of announced takeover deals. Two deals scheduled to close Jan 31st offer attrative spreads and could be a great place to put extra cash:

Clear Channel (CCU):
11/23 market close price - 33.68
1/31/2007 takeover price - 39.20
spread - 5.52 per share
potential holding period return - 16.4%

Harrah's (HET):
11/23 market close price - 87.14
1/31/2007 takeover price - 90.00
spread - 2.86 per share
potential holding period return - 3.3%

P/B and Earnings Index

A statistic that's grabbed my attention recently is the number of companies trading for less than book value--notwithstanding why this would justifiable occur. Per Yahoo Finance, as of market close 9/20, this number is 906.

Another number I've started to track is what I call the earnings index. This compares, on a pre-market market value-weighted basis, the earnings day closing price index of all companies that report earnings and compares this to the S&P 500. Results to be posted soon.

Banks and Financial Crisis: Segment of 1990 Bershire's letter to shareholders

"The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.

With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no genius," he said. "I'm smart in spots - but I stay around those spots.")

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.

Wells Fargo is big - it has $56 billion in assets - and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price, would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.

Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.

A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices"

---

13Fs

In the confusing world of 100-plus page documents, form 13F-HR is a very short SEC filing worth perusing. Any fund with $100M+ in assets must report their holdings within 45 days of quarter end. Well, this week puts us at the end of this time frame and should provide for some interesting looks at how your favorite investors changed their positions amidst the June-September period of market turmoil. These aren't filings I would blindly trade on; however, it does provide a pool of picks worth further research and consideration.

Spinoffs

These jewels usually occur when a parent company separates a subsidiary into an independent company via a stock dividend. According to a Penn State study covering 25 years of data* "stocks of spinoff companies outperformed their industry peers and the Standard & Poor's 500 by about 10% per year in their first three-years of independence.**"

Keys to look for when picking spinoffs:

• High insider ownership in new business
• Forced selling from institutions
• An uncovered great business

That said, here are two spinoffs that quietly happened last week:

Peabody Energy completes spinoff of Patriot Coal

Acuity Brands spins off chemical business

*Patrick J. Cusatis, et al., "Restructuring Through Spinoffs," Journal of Financial Economics 33 (1993)
**Joel Greenblatt, "You Can Be A Stock Market Genius" (1997)

The Long Case for Nordstrom (JWN)

JWN ($38.85) is a classic example of a great business at a fair price for the investor with a medium to long-term horizon and an appetite for a "heads, I win; tales, I don't lose too much" type scenario. Plagued by concerns of the credit crunch and housing downturn, JWN has fallen 35% since its 52-week high in February. Critical to most investors' minds is the uncertainty of this year's holiday season. Something worth noting: during '01-'02 downturn, Nordy's saw same-store-sales drop -2.9% in '01 and recover to +1.4% in '02. Nordstrom should weather the short-term market difficulties as it grows sales and easily sells off its holiday levels of inventory.

Thesis: better than expected holiday sales from higher-income shoppers less exposed to economic downturn; margin expansion; shareholder-aligned management; $1.5B share repurchase authorization (15% of company); profitable square footage growth of 4-5% through 2011, coupled with strong ROIC (21%); attractive valuation: EV/S: 1.22, EV/EBITDA: 7.4.


Disclosure: the author recently purchased shares of JWN

Daily Journal

Microsoft posts strong sales growth and 23% rise in profit; shares soar over 10% after hours

CFC reports results at 12:00 pm EDT

Insider sales: Why Wellcare's 63% skid doesn't tempt me

Motorola's net falls and Icahn insists on break up

Ahead of the tape

Small-stock focus

Daily Journal

Merrill falls 5.8% after $8.4 billion write-down and credit rating downgrade

Durable-goods orders forecast to rebound

Microsoft stake $240M, 1.6% stake in Facebook values the company at $15B ($490 per unique visitor--as of Sept 2007)

Under pressure, BofA to cut 3,000 jobs largely from global corporate and investment bank

Brazil Exchange's (Bovespa Holding SA) $3.2B IPO

Contrarian Screen

Daily Journal

SIV fund and earnings expectations

NYT bucks trend

Countrywide and option arm deliquencies

Ahead of the tape

Avaya to be dropped from S&P

Hilfiger IPO may be coming

Daily Journal

AMEX sets aside 44% more for loan losses

Ahead of the tape

Daily Journal

Credit Markets

Why firms are returning to their roots

Abreast of the market

Sulzberger and the NYT

Daily Journal

'7' and premium denim

Ahead of the tape

Daily Journal

The moral hazard

Morgan Stanley drops 7% stake in NYT

Ahead of the tape

Daily Journal

CPI expected to be tame

An interview with chief marketing officer of Motorola

Horton's sees cancellation rate rise to 48% in 4Q

Heard on the street

Ahead of the tape

Daily Journal

Mattel sees 1% drop in 3Q profit

Icahn at work: BEA Systems gets offer from Oracle

The $100B rescue

Daily Journal

Plan to 'rescue' banks from mortgages losses

Funeral homes profit squeeze

Boss Talk: Avon

Ahead of the tape

20 years ago

Daily Journal

The era of dogdy asset pricing is here

Retail sales report

Ahead of the tape

Countrywide lending plunges

Daily Journal

How widespread is 'subprime'?

As dollar falls, US trade gap narrows

middle-level skilled jobs see sagging in wages

Cadbury to spin off beverage unit by 2Q2008

Ahead of the tape

Progressive Corp's struggles with growth and brand

Pzena Investment sets IPO

Daily Journal

Miller and Molson Coors to merge US operations

The value and experience of older directors

Ahead of the tape

Sony Financial IPO

Daily Journal

Supreme Court: business vs. third parties

Tech and bubble indicators

St. Joe makes cuts

Illegal immigrants and mortgages

Heard on the street

Ahead of the tape

Daily Journal

New Fox Biz channel

Heard on the street

Ahead of the tape

Jobs data and rate cuts

New IPO offerings

Daily Journal

$100B deal for ABN Amro

Bill Gates on Health Care

VC goes big

Ahead of the Tape

Small Stocks

Daily Journal

Merrill cleans house

Big Bath?

Daily Journal

Front Page: Wal-Mart

Dean Foods struck by high commodity prices

The new store aisle

Power of the 'Loonie': Toronto-Dominion Bank buys Commerce Bancorp.

Ahead of the Tape

Stocks and mean reversion on profits

Daily Journal

Human Due Diligence

Heinz and its tomatoes

Ebay finally realizes they overpaid for Skype

Walgreen shares down 15% on slightly off quarter and lower guidance

Yahoo's new search engine

UBS and Citi take charges

Heard on the Street

Ahead of the Tape

Daily Journal

Dollar lifts exports

Interview with CEO of Molson, Coors

Ebay and Amazon

Ahead of the Tape

IPO market

Daily Journal 9/28/07

Grain prices

Airlines and mileage planes

Bond market and FDC's buyout

UAW's health care trust fund

Ahead of the tape

Small stocks: movers

IPO indexes gain appeal

Daily Journal 9/27/07

GM and health care

Timberland to close 40 stores

Rate cuts

Contrairian play: home builders

All-cash deals and acquisitions

Daily Journal 9/26/07

More on housing

Biz schools lose track of missions

EchoStar to acquite Sling Media Inc. for $380M

Moody's, S&P to confront critics

Speculation on Bed, Bath & Beyond

Merger-Arb spreads

Discover's net drops 16%; charge-off rate falls to 3.7%; shares fall

Daily Journal 9/25/07

Facebook

More on the housing slump

Treasury 'fails'

Daily Journal 9/24/07

There are too many lawyers

Another opinion article on CEO pay

Bausch shareholders approve takeover

Abreast of the market

Flight to safety: investors move to slump resistant picks

Ahead of the tape

Daily Journal 9/21/07

Jobless claims drop

Crude up. At what point will this have a meaningful drag on the economy?

FedEx warns on bumby road

Drug Ad restraints

Middle East scoops up stakes in exchanges

Corn

A lot left on the table: IPO soars 97%

Daily Journal 9/20/07

Impact of trade gap narrowing

The Moral Hazard

Consumer prices fall in August

Look out! China freezes prices amidst rising inflation

General Mills' battle with high prices

Romney on HilaryCare

On the Dollar and Oil

Ahead of the Tape

Daily Journal 9/19/07

When Google Finance lists the Fed rate cut with 2300 related stories, it's commodity news

I love shareholder activism

Cheney on Bush's economic record

Great for retailers: gift card business surges

Ahead of the Tape

Lehman results better than expected

Honestly from Coach execs on share sales

Dollar slides

WSJ Poll: was the Fed too aggressive?

What the rate cut means for us

Daily Journal 9/18/07

Also on the agenda for today: the discount rate

I agree with this, Why the Fed shouldn't cut interest rates

Buyers line up for Wendy's

Rove's solution for the health care mess

Yahoo acquires Zimbra

Debt underwriters retreat from buyout

Yield curve favors banks

Ahead of the Tape

Daily Journal 9/17/07

A lot of hope rests on the Fed's next move

Opinion article on the Fed

Change at Time Warner

Pricing the subprime related alchemy

Ahead of the Tape

Daily Journal 9/14/07

Yet another story on Countrywide

Robert Reich on CEO pay

'Scientific' studies and miscalculations

On the Thompson-Reuters deal

Investors anticipate Wall Street banks' financials

ABN Amro Deal

Ahead of the Tape: consumer spending

What to do with $350B of LBO debt

Global Alpha bleeds

Daily Journal 9/13/07

Not just for rednecks: An interview with Nascar's CEO

How PE firms make their money

Economists weigh in on the likelihood of a recession

Risk in Emerging Markets

Product recalls and the US' relationship with China

Destination clubs look to improve image

The bias of the Spanish news channels and the Hispanic vote

Daily Journal 9/12/07

Are homes getting smaller?

When activist investing pays

Small banks and credit ills

High gas prices and customers

Daily Journal 9/7/07

Can 25 sigma events happen day after day? More on the failure of algorithmic trading

A low calorie Gatorade

Rating firms under scrutiny for role in subprime collapse

Thoughts on the job market report

Daily Journal 9/6/07

Is the M&A boom winding down?

I think the $200 drop is price for the iPhone will be great for Apple

Don't know why, but the almond market fascinates me

More hedge funds in trouble: SIVs are the latest product

Ahead of the Tape

I love the energy drink market

Daily Journal 9/5/07

More housing market slump scary stories. My take is to let the market figure things out

The role of a CEO's personal life on stock performance

Countrywide and the downfall of #1

I love this side of brand development: a story on Nautica's upscale relaunch

A great commentary on undergrad "liberal" education

Libor takes sudden jump

Get ready! China Construction Bank prepares for IPO

Daily Journal 9/4/07

Credit-rating firms on the hot seat for their role in subprime mess

Gaz de France and Suez agree on €90 billion merger

Hats off toe P&G for their Gain brand and its clear divergence strategy.

Hedge Fund summer

$350B of LBO loans at stake

Airlines to change how they operate. Any time I hear that I jump for joy.

Daily Journal 8/31/07

'Investors' make up 21-32% of defaults on home loans in key growth states.

Finish Line in the news again over "merger-pact options"

Any time I hear about details on executive pay, my ears perk up.

I still love Eddie Lampert and Sears despite down quarter

Dollar edges higher as investors look for safety in Treasurys

Vulture fund looks for deals in sub-prime mess.

"Ahead of the Tape"

More stuff on Quant funds.

Daily Journal 8/30/07

3/4 of the world's oil is under the control of national oil companies: A good article on the rise of Petrobras

Estimate for GDP Growth Is Expected to Be Boosted

Bernanke breaks trend set by Greenspan

Altria to spinoff international unit to focus on growth overseas and to seperate co's for litigation purposes.

Much in line with the "Origin of Brands", Coors wisely seeks to create new category by creating a new high-end beer brand

More financial alchemy: lessons in conduits, esoteric off-balance-sheet items.

Again, questions about funding of KKR's big for First Data are in the news.

hedge funds: 30% of bond trading, wow!

Daily Journal 8/29/07

How Wendy's Faltered, Opening Way to Buyout

Hispanics' Hard Times Hit Wal-Mart

From Cheap Stand-In to Shelf Star

Don't Stop the Presses -- Sell the Building Instead

Ugg Is Solid Footing for Deckers

Billion-Dollar Question: How Will Street Titans Value Their Holdings?

Why Is Countrywide Sliding? It's Unclear, That's the Issue

Tight Course Lies Ahead For Bernanke

Daily Journal 8/22/07

A1
TD Ameritrade In Merger Talks With E*Trade

B1
Missouri case looks at cellphone taxes

B3
After 10 months YouTube unveils video advertising approach.

C1
The Journal interviews Peter Fisher formerly of the Federal Reserve Bank of NY

C7
Another outstanding year for Harvard’s endowment fund.

D1
The credit crunch spreads

D1
Car-sharing company eyes college kids

Daily Journal 8/21/07

A1
Yields on short-term treasurys see biggest drop in 19 years

A3
Sentinal braces for liquidity crunch

A11
Heelys: a one-trick-pony ? I think so.

B1
VCs push start-ups to use more online advertising

B3
A deal I think should get the green light.

C1
Buffett has warned about his name being thrown around

C3
The Yen carry trade loses steam.

Daily Journal 8/20/07

A1
How a Panicky Day Led the Fed to Act

Lessons of Past May Offer Clues To Market's Fate

A6
Countrywide Begins Staff Layoffs

Marketplace
Beauty, Prestige and Worry Lines

Money and Investing
Future Buyouts May Use Mold Of GE Plastics

Daily Journal 8/17/07

A1
Countrywide Airs Plan To Weather Credit Squeeze

A3
Whole Foods Wins Ruling on Wild Oats

B1
Wal-Mart Eyes Smaller And Higher-End Stores

Social-Climbing Samsonite Seeks More Elegant Image

B3
Darden Agrees to Buy Rare Hospitality

Money and Investing
New Villain in Market Drama: Commercial Paper

'Put' Scramble Could Ignite Volatility Index

Flight of the Merger 'Arbs': Risk-Takers Fear Dead Deals

Daily Journal 8/16/07

Page 1
Paulson Expects Markets to Slow, Not Stall, Growth

A3
Countrywide's Woes Multiply

Money and Investing
Dear Investors, We're...

'Multistrategy': A Fund Tack Worthy of Doubt

A Value Hunter's Desert

Daily Journal 8/15/07

Page 1
How Rating Firms' Calls Fueled Subprime Mess

A2
Wal-Mart Recovery Dealt a Blow

Money and Investing
Credit Tremors Crop Up in Cash Funds

LBO Shops Drove Debt Boom; Now, They Profit From Its Fall

Business Mood May Give Fed Leeway to Cut

Turmoil Roils (Many) IPOs

Personal Journal
How Merv Griffin Won His Jackpot