A Thought Journey

Casual readers of this blog will notice the random themes, introspection, and commentary on events in business and finance. I have decided to channel this, but hopefully in a more meaningful way, into a series of essays. The themes are broad and the ideas random. This fits my personality and allows me to reflect and create. By posting this, I commit myself publicly to this work: a short book of essays.

That said, I will use this site to diffuse any finance-related theme I include in my writings. A note of warning or of jubilee: postings going forward will be more sporadic and less frequent than the past. Below is what I have so far. I'm halfway done with two of the essays. I welcome your comments and ideas.

Education:

i) Why I Write

ii) Types of Books

iii) Education

iv) Cultural Observations

Places:

v) The Real Mexico

vi) The Farm

People:

vii) Mr. Buffett

Misc:

viii) On Investing

ix) My Experience at Goldman Sachs

x) Our Sacred Stuff

xi) Running

xii) Skiing & Golf

xiii) The Buy Recommendation

Fees

Ebay's exit from the Skype debacle is a boon for financial helpers: fees for buying and then fees for divesting. Ain't life grand. It's not that advisers don't always earn their keep. But there are definitely misaligned incentives, when, from their perspective, the payout is: deal closes, big payout; deal fails, little money. Unless of course, you advise on both the acquisition and the divestiture. But I'd hope Ebay would have more sense than using the same helpers twice.

One Question

From its humble beginnings decades ago, Berkshire's annual meeting has morphed into a series of events known as the Woodstock for Capitalists. Rental car prices for that weekend attest to the popularity of the meeting; I can't find a car for less than $50.00 per day.

That said, this year's annual meeting offers a huge improvement over past years: the Q&A format will be half questions pre-screened by three journalists, and half awarded by drawing. Previous years were plagued with disputes about the ethics of hydroelectric dams and the conflict in Darfur (two important issues but not worthy of so much mic time in this type of setting).

And so, I offer my question, which I've emailed to one of the journalists mentioned in the 2008 shareholders' letter.


Messrs. Buffett and Munger:

Berkshire in the past has bought and sold interests in public companies. Could you comment on the orthodoxy of the till-judgment-day-do-us-part philosophy of Berkshire's operating companies?


Disclosure:
None

Credit-Default Swaps

If there's been one benefit of the financial crisis, it's the improvement in financial literacy. People are now paying attention to ratings, interest rates, and Fedspeak. Even credit-default swaps, at whatever level of understanding , are fair game for dinner-time conversation.

The recession has even brought into question the bedrock of finance theory: efficient markets, or the idea that market prices reflect all available information. One professor at the Solvay Brussels School of Economics confesses that the CDS market is "opaque, often illiquid, and prone to manipulation." This leads to share price pressure and a bundle of screwy signals to both rating agencies and short sellers. Alas, the markets are mostly efficient, and certain anomalies are worth exploiting. Just don't try to argue with your business school professor about this.

Oh the joys of TARP

The shotgun marriage between banks and government appears to be having some unintended consequences. While some firms, Goldman in particular, have talked about returning bailout cash, Washington has stalled such attempts saying it's not ready to get its money back. Weird.

Experiences financiers are now seeing today as a great time to jump ship. Punitive tax rates on already-distributed bonuses, further regulatory scrutiny, and a more risk averse balance sheet must have an effect on the most experienced bankers willingness to go to work in the morning.

Goldman offers a great example. Recently, Jon Winkleried, one of the top-3 at GS, decided to retire. Byron Trott, the rare banker (if not the only) to receive praise from Warren Buffett, is leaving to start his own merchant banking firm. And the co-heads of Global Alpha, Goldman's flagship hedge fund, are retiring to pursue other interests.

They'll be glad to be away from TARP.

AmEx: Reasonably Priced Plastic

The below is posted with a one day lag. (it was part of the application process for a freelance/contract writer position).

American Express

To participants of the capitalistic system American Express (“AmEx”) needs little introduction. The firm is a global payments, credit card, and travel company whose products are catered to well-heeled clients. AmEx runs one of the most prominent credit card networks in the world; unlike its largest rivals Visa and Mastercard, however, it profits from the entire economic cycle of issuing the card, swiping the plastic (via the merchant fees), other fees, and the spread on loans it provides. It is an economic powerhouse but is subject to greater volatility because of its risks of operating such a full cycle network.

As a somewhat mature company it “has sought to return at least 65% of the capital it generates to shareholders as a dividend or through the repurchase of common stock,” a goal it has since tempered as a result of the strings attached with money it has taken from Uncle Sam. A more muted target, though impressive nonetheless, of 20% return on equity, is now the company’s goal on account of higher charge-off rates and higher capital requirements.

In 2008 the company grew revenue 3% year-over-year to the impressive sum of $28 billion. This is possible through its boastful network of 92.4 million cards, an industry leading high-FICO-score client base, and ultra-low costs of funds of 3.63% for long-term debt and 2.11% for short-term borrowings.

My unofficial mentor, Warren Buffett—through Berkshire Hathaway—has maintained his position as the largest shareholder. That’s not to say the stock is without risk. A few of AmEx’s risks and uncertainties include: legislation on interest rates would adversely affect the company’s spread (interest charged vs. cost of funds); a really-bad-case-scenario in the macro environment would result in an even bigger spike in the charge-off rate (currently at 8.7%); a longer-than-expected turnaround in the securitization market would force liquidity issues.


Furthermore, at 407 pages, the 2008 10K is long enough to discourage even the most determined annual report aficionados. But the audit report looks clean and the numbers don’t look funny.

Valuation
So what is AmEx worth? Cash flow from operations has historically been 2-3x net income, largely due to the non-cash charge for the provision for losses. I use the more conservative net income as a base. The economy is in “shambles” as Buffett has stated, and a greater portion of the world’s citizens may continue their indifference towards paying their bills. Earnings multiples should be applied with caution since these are truly extraordinary times. Even with a 50% haircut off of last year’s net income, the stock trades at close to 12x earnings, or an 8% adjusted earnings yield (the inverse of P/E ratio)—it currently has a 5.9% dividend yield while paying out only 1/3 of earnings. This is a conservatively adjusted value and reflects the erosion of securitization income ($1bn in 2008) and a marked increase in the charge-off rate.

The Bottom Line
American Express has inched its way up to the 11th spot in CoreBrand’s brand ranking survey of 2008 and is 15th in BusinessWeek’s 2007 ranking. Translation to the card user: If you get charged $1000.00 for a breakfast at a café in Peru, you can trust that AmEx will fight to reverse the charges. It is the antithesis of the IRS. That business moat is hard to replicate. The company is positioned to profit from the long-term demographic trend towards a cashless society. That said, the brand value, and the attractive adjusted earnings multiple, provide an adequate margin of safety. I rate American Express a “buy.”




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P.S. 500 words (about the length of this piece) is a very short space to try to describe and dissect a business.

Disclosure:
The author has an AmEx card but pays off the balance every month. He also owns shares of AXP.

Performance Update

All stock-related sites should report an unbiased scorecard. The Faro portfolio puts itself up against the same test. The fund inception date correlates with the launch of this humble blog--estimates are in that there are 4-5 regular readers. The inception date is Oct 2007. If I had tried to "time" the start of such an auspicious task, well, I'm really bad at timing: stocks have lost half their value since then.

I still believe the case for stock investing stands. The transaction costs are almost nil (tell that to your real estate broker); they allow you to become part owners in pieces of potentially great businesses; owning strong companies over time is a great buffer to the loss of purchasing power (if the business can raise it's prices with inflation, it's returns should rise with general prices); historically, the returns for any one with a long-term horizon better any other asset class.

Since inception, the portfolio is down -17.8% vs. -49.40% for the S&P. It's worse than under you mattress but much better than most mutual funds.


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Full Disclosure: none

Company of the week

30 years ago, out of the wreckage of an imploding company, Leucadia National Corp (Ticker: LUK) was born. Ian Cumming and Joseph Steinberg have since transformed the firm from its early days of a shareholders' equity deficit of -7.7mn to +2.7bn. Albert Einstein's reverence of the miracle of compound interest has been at work: a $1,000 dollar investment in 1978 would be worth 1.98mn as of 12/31/08; that's a 28% annualized return. Book value has grown at a slightly more impressive rate.

The recent past has been less than stellar. From its zenith in May 2008 to Friday's market close price, the per share value has dropped 80% while the S&P 500 has declined 52%.

The source of the underperformance has to do with the nature of Leucadia. From the 10k we read: "In identifying possible acquisitions, the Company tends to seek assets and companies that are out of favor or troubled and, as a result, are selling substantially below the values the Company believes to be present.(1)" Unloved companies tend to underperform in spurts. By definition they have problems that others would rather avoid.

The company is a hodge podge of subsidiaries involved in timber, plastics, telecommunications, real estate, medical product development, wineries and others. The firm also owns a sizeable portfolio of publicly traded stocks ranging from mining, auto finance, Argentine agriculture, to Jeffries: an investment bank. In addition, Leucadia owns limited partnership interests in several asset management firms.

I'm still trying to grasp the estimated worth of the the company many call a "mini Berkshire." With such diverse companies, capital needs, and volatility of certain assets, estimated intrinsic value cannot be conveyed in a short blog post. But at a discount to book value, and with such an impressive track record and philosophy I mostly agree with, I decided a dip in the pool was worth it, even when I wasn't certain of crocs or the exact water temperature.

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Full Disclosure:
The author recently purchased a few shares of Leucadia. He also has a job interview with the company this Thursday.

Notes:
(1) 2008 form 10k

Buffett looks ahead after lousy year.

The much anticipated 2008 year-end Berkshire Hathaway Shareholders’ letter was released today. Buffett’s words are followed both for information on the direction of the conglomerate (highly weighted in insurance and utilities), as well as his thoughts and criticism of both business and politics.

It’s tone, wit, and substance is eaten up by media outlets. Stories are released within two hours after digesting the 20 page later. The headlines, of course, say a lot about how his words are interpreted, what the company’s results mean, and how this bodes for the economy as a whole.

So, I present to you how the most highly-regarded media sources and their spin on what he said. This does not substitute actually reading it, something I would encourage to anyone who either owns stocks or cares about politics or economics.

Here they are:

AP: Berkshire reports a 96 percent drop in 4Q profit

NYT: In Letter, Buffett Is Frank but Optimistic

WSJ: Berkshire Reports Worst Year Ever

Bloomberg 1: Buffett Says U.S. Economy Will Be `Shambles' in 2009, Likely `Well Beyond'

Bloomberg 2: Berkshire Profit Plunges 96% as Buffett Writes Down Derivatives Positions

Reuters: Berkshire net sinks; Buffett says economy in shambles

FT: Buffett’s Berkshire has worst results ever

I would have to cast my vote for the New York Times article, both for the headline and for its content.

As a Buffett devotee, I copied quotes and have lumped them together in this little collage:

“America’s best days lie ahead…economy will

be in shambles throughout 2009 – and, for that matter, probably well beyond…

Home purchases should involve an honest-to-God down payment

of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified... The investment world has gone from underpricing risk to overpricing it…The U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

What does this mean? The last two parts of the quotes are crucial for the individual investor. Buffett is predicting inflation; Bernanke is a scholar of the Great Depression and knows the perils of deflation. Inflation is currently not on the market’s mind, but as money is injected into the system prices and interest rates will rise—a death blow to bonds (prices and interest rates are inversely correlated). But, short-term bonds (little interest rate risk) in high quality corporations will do well—the “overpricing” of risk that he mentions means that some bonds are cheap. That’s why he’s pounced on fixed income in GE, Wrigley, Goldman, Harley Davidson, Tiffany, and others.

We’d be smart to look for similar bargains in high-quality companies’ debt.

JA

What to do with extra cash

The Economist has a great piece on the dilemma of today's prudent savers. It's hard to get excited about 1-2% yields on online savings accounts. And 5-yr treasuries yield only 2%.

There is hope in one end of the capital structure. High-grade corporate bonds that mature in the next 2-4 years offer compelling prospects (longer-term bonds have greater duration and therefore greater interest rate risk--think about possible medium-term inflation as we sell treasuries to Asia.) Spreads now are 400-600+ basis points above treasuries. Now, of course, this reflects perceived and actual risk, but with a little review of the underlying company's balance sheets and off-balance sheet stuff, you'll be rewarded by more than a few pennies.

Here are a few (non-callable bonds) worth considering as an alternative to idle cash:


Company | Rating | Maturity | Price | Coupon | Yield to Maturity | Current Yield

Alcoa BBB Jan/2012 87.88 6% 11.00% 6.83%

Kohls BBB Oct/2011 105.69 7.4% 5.02% 6.98%

Goldman A Feb/2012 99.30 5.3% 5.56% 5.4%

Nordies Reports

Prized by shopaholics and loathed by penny pinching husbands, today after market close, Nordstrom (JWN) reports 4th quarter financial results.

Two days ago, intra-day volume for 10.00 March put options spiked to 1,368 contracts (representing 1.37 million shares, or less than 1% of float); calls of the same strike price only attracted 2 contracts. Betting on short-term momentum has never appealed to my personal investment philosophy. Though JWN’s intrinsic value won’t change much regardless of whether the retailer misses by a penny, traders feel it’s worth betting that the earnings release will disappoint.

Amazingly, during the dotcom bubble, same store sales dropped only 1%. During our current market malaise, however, same store sales have fallen over 12%. There is a price at which I’d love to own such a great brand—the stock is 70% cheaper than the 52-week high. But given the economic headwind, I still wouldn’t now bet on $200.00 jeans.

I’d like to see management cut back on capital expenditures which have eaten into cash flow over the last year. The company should slice its 4.6% dividend yield in half, saving the Seattle-based retailer $70mn per year, which it could use to help trim down the $2.74bn in long-term debt (2x EBITDA).

A note

In a previous post on how the housing bubble grew, I mentioned two potential guilty parties: banks and individuals. I should have added the role of government to the equation. Uncle Sam was complicit through its drastic loosening of the fed funds rate in the post-dotcom bubble. The government, through friends Fannie and Freddie, also encouraged insane lending and scooped up over half the mortgages originated.

This will be written in history as one of the more memorable unintended consequences of government intervention.


Image source: http://www.princeton.edu/~pkrugman/fed-funds-rate.png

Baby Formula and Special Dividends

If you have children you've complained about the cost of baby formula. Today a baby formula maker had an IPO whose success is built on pricey fake mother's milk. Mead Johnson (MJN), leader in the pediatric nutrition market, sold 30M of 200M shares outstanding. Proceeds from the offering, a carve-out from Brisol-Myers Squibb (BMY), valued the company at over $4.8B.

It appears to be reasonably valued. The company is selling for 1.7x revenue, 10x earnings, has grown sales at 5-10% even in challenging economic times, and boasts of a 22% operating margin.

Now to the obligatory "use of proceeds" section. The $600M in net value the company received from the IPO will go to pay an inter-company note. However, $1.4B will still be left in debt since the parent company, surely through the advice of a strategic adviser, decided to "lever" MJN with $2B in debt prior to the carve-out. Not that this isn't manageable given Mead Johnson's level of profitability, but to put the stockholders' equity at a deficit of $800M to line the wallets of Bristol-Myers Squibb is wrong. BMS will use the $2B to pay a special dividend. That ain't so special a way for Mead to start as a public company, even if it can rest on high-priced milk.

On housing, lending, and advice for my grandkids

As all writers of anything finance-related, I feel compelled to comment on housing’s role in our current economic crisis and end with the clichéd "lessons learned" bit.

It’s tempting to say we all foresaw this. There is no doubt that housing was and is a critical part of our deep economic malaise. The seeds were sewn through low interests rates, poor lending practices, and the cultural notion that a house is more than just a roof over one's head. Though it can be more, speculative short-term gains in residential real estate should never drive a rational person’s decisions.

On the housing bubble, there are two predominate ideological camps: 1) it's the banks' fault; 2) it's the home buyers’ fault.

The first group feels the home buyers were unsuspecting victims, preyed upon by Mr. Burns-type lenders: greedy, cold, and with a profit-only code of ethics. (Not all bankers are like this, but it makes for good imagery). These bankers were eager to rush loan approvals to hasten the securitization process whereby ensuring private school tuition, vacations in Bora Bora, and early retirement. Bankers should be punished, regulated, and striped of the compensation that Croesus himself would envy.

Banks are greedy. Their fees are high, and certain aspects of their businesses need to be regulated (OTC options come to mind). But they do, however, provide a valuable service to the economy. Credit drives our economy. Anyone who’s been granted a loan will attest to that.

The other group believes the home buyers themselves are to blame. Stories of credit-less deadbeats buying multiple houses with the idea of flipping and becoming wealthy, draw the ire of penny pinchers. These reckless borrowers collectively failed to notice the bubble-level home price to median income (the PE ratio of homes) ratio. Somewhere down the road, it would have to correct. They deserved their prize; they too were greedy. The modern corporation does not hold a monopoly on unethical behavior. After all, this is capitalism, and individualism rules.

To mend the housing and credit problems there are no easy solutions. I have no idea which items of the current "stimulus bill" will have the greatest multiplier effect. I only hope that government behaves better than in times past.

Understanding this, however, isn’t the real issue from a personal learning point of view. Financial manias and asset bubbles will reappear. They are “Black Swan” events.

The real value in having lived through 2008 (and beyond) is not learning how we can personally predict (and prophetically time) any future crises, but to examine it from the most micro of human levels. What do these events tell me about how I should shape my behavior and views?

At the risk of being too prescriptive, something that I loath about most business books, I offer advice to my children and future grandchildren.

In anything in life, if there are no significant barriers to entry, it's not worth doing. Medicine requires smarts and time. Athletics begs time and talent. Business demands good ideas, execution, and drive. Anyone could set up a mortgage brokerage business and undercut the professional and legitimate players through lackadaisical lending standards. The barrier to doing it right is ethics, work, and patience. Most don’t have all three.

Lastly, (and not that there are only two, but because two are easier to remember) the further you separate the risk taker from the actual risk bearer, the more likely you are to face an unsavory result. A father, through no intermediary, should know and trust his future son-in-law. Bankers should know and trust borrowers.

Some thoughts on business analysis and macro forecasts.

Posting stock picks creates the obvious pressure: be right and you'll look smart; if you're wrong your sins are on display for all to see. Most either shy away from this or bombard the reader with innumerable "buys" so that it becomes impractical to work through the math to find out how valuable the advice really is.

Naturally, the reader must be weary of either of the two extremes. Outside politics, and in most environments where discussion of the stock market is heated, failure to take a definitive position shows lack of confidence, and an unwillingness to (justifiably) allow others' to criticize your ideas. Being overly sanguine about every idea, on the other hand, is reckless and dishonest.

Thus the logical responses when a stocks attractiveness is considered are: 1) I don't know, 2) It's probably a bad idea, and there are myriad reasons for this: it's too complicated; the business is lousy ; management is inept; My brother-in-law knows I guy who's an insider and he says it's going up. And finally, 3) It's worth owning, usually because the numbers look good and the business is solid--note the nebulous terms "good" and "solid"; I'm being purposefully vague since not all attractively priced stocks are a "buy" for the same reason. But, intrinsic business value rarely changes as much as many of the daily prices quotes would indicate, especially during market malaise.

These three answers may seem painfully simple. In a world of huge egos and image management, however, most are afraid to look like dummies and therefore feel obligated to have a strong opinion about every investment issue. "Oh oil, yeah, it's going up; there's just so much pent up demand." This is a monumental error. I turn to my unofficial and dead mentor Abe Lincoln for a quote that fits nicely with this fallacy: “Better to remain silent and be thought a fool than to speak out and remove all doubt.”

The cure for this vice is to embrace the 50th percentile. Just be average with some things. My answer is, I don't know where oil prices will be in six months. Please understand, however, that references to this are short-term forecasts. One can assume that certain long-term imbalances will lead to glaring macroeconomic consequences (e.g., America's entitlement programs). Also, there are some great macro-economists. But given my understanding of history, very, very few get both the timing and the event correct.

That is why I choose to be a business analyst and not an economist. And so, I move forward boldly, with the philosophy that good ideas are rare, simple, and should be put up to the scrutiny of the economics of the business against the market's perception. I publish ideas knowing what's on the line with the hope I'm right more often than not.