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)