Faro Researc*

A Thought Journey

2009-04-17T22:19:00.001-07:00

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

2009-04-14T19:36:00.000-07:00

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

2009-04-12T23:06:00.001-07:00

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

2009-04-06T21:22:00.000-07:00

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

2009-03-31T20:26:00.000-07:00

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

2009-03-24T21:34:00.000-07:00

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

2009-03-15T22:28:00.000-07:00

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

2009-03-08T22:16:00.000-07:00

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.

2009-02-28T23:22:00.000-08:00

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.

What to do with extra cash

2009-02-26T23:42:00.000-08:00

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

2009-02-23T01:10:00.000-08:00

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

2009-02-22T17:13:00.000-08:00

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

2009-02-11T21:44:00.000-08:00

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

2009-02-08T01:00:00.000-08:00

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.

2009-01-25T23:59:00.000-08:00

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.

What's the most meaningful way to measure investment returns?

2008-12-21T23:28:00.000-08:00

It's being called the biggest investment scam ever. The Economist suggested, partly tongue-in-cheek, that the "Ponzi" scheme be rebranded the "Madoff" scheme due to its size and scope. Newspapers and blogs are humming about the institutions and country club members who fell for Bernie's years of lies. Obviously, especially in retrospect, the flags were crimson. A three-person audit firm was one. The supposedly consistent 10-12% annualized returns was perhaps the biggest; the open interest in the S&P 100 options used to run the split-strike strategy was too low to support $17B of activity.

Even if the volume of options wasn't a deal killer, how would you further critique the steady investment results? This is a problem the investment management business has yet to solve, or at least speak honestly about. What's the most meaningful way to measure investment returns?

Leverage and luck are two culprits. Pile on loads of debt either through margin or options and if things go your way, your returns are juiced. If you're wrong, your bad returns are amplified. Luck can be indistinguishable from skill in the short-term. So track records should count for something.

Naturally, hedge funds and other investment vehicles breed opacity. If they divulged everything than others would simple mimic their strategies and trades and therefore "crowd out" that corner of the investment world and dry up the excess returns. But investors now will demand greater transparency, or at least know that such a way of making money is feasible.

Oddly, most investment managers treat the quality of the return as ancillary--quality in the sense of risk and in probable future results. Since their incentives are to make the coveted 2/20 fees, high risk and high returns go hand in hand. Their traditional tools of return calculation use either beta (the covariance between the asset return and the market return) or the standard deviation of the portfolio, in some relation to returns generated. Again, they're not clear as to how the returns were made, only the final number. They also use a flawed definition of risk, but that's worthy of a separate posting.

Unlevered (equity only), market beating, long-term transparent strategies are the best way to measure investment returns; the final return measured against last year's price movement deviations is not enough. It's fair to ask how a manager justifies his fees and the scorecard that should be used to decide whether he should still have a job. Managers owe their clients restful sleep.

For a group that demands, clarity, loose regulations, detailed financial footnotes, and management candor, the investment management industry needs to come clean on how it measures returns. It would help doctors, teachers, and janitors to know that not everyone that manages money is like Bernie Madoff; some of them actually "add value."

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Disclosure: none
Image: http://www.yu.edu/uploadedImages/Sy_Syms/Dinner_2008/madoff_web.jpg

A Carnival Quiz

2008-11-26T22:48:00.000-08:00

I easily get excited about new businesses and what makes them tick. The industry on my mind over the last several days has been the cruise industry. And after having recently finished my first cruise, I thought this little cruise quiz would be a fun test of your cruise business intuition. Questions of this sort were on my mind between meals and while relaxing by the pool. Enjoy. Answers are posted at the end.

1. Which of the following cruise company does Carnival not own?

A) Princess
B) Holland America
C) Celebrity
D) Seaborn

2. The percentage of worldwide cruise passengers sourced from North America is....

A) 40%
B) 50%
C) 60%
D) 70%

3. Cruises have the well-deserved reputation as places to overeat. What percentage of total passenger ticket sales does Carnival spend of food for its chubby guests?

A) 8%
B) 16%
C) 24%
D) 31%

4. A great (and consistent) source of revenue is derived from other income (alcohol, casinos, souvenirs, land excursions, photos, etc.) True or false, this makes up 50% of total revenue?

5. ALBD means what in cruise economics?

6. Carnival and its publicly-traded rival Royal Caribbean have sales/debt ratios of:

A) between 20% and 49%
B) between 50% and 60%
C) between 61% and 90%
D) greater than 100%

7. What corporate action did the industry's cruise operators recently announce?

A) A near-term discontinuance of stock dividends
B) A huge drop in asset-backed securitizations
C) An increase in the share repurchase program
D) A move in corporate offices from Spokane to Atlanta.

Answer Key: 1) A, 2) D, 3) B, 4) False. It's closer to 25% of sales. 5) Costs per available lower berth day "ALBD". ALBDs assume that each cabin offered for sale accommodates two passengers and is computed by multiplying passenger capacity by revenue-producing ship operating days in the period. 6) C, 7) A.

A few words on public vs. private

2008-11-07T20:49:00.000-08:00

After balance sheet concerns and the overall lackluster macro economic environment, the decision to be a public or private company must now keep executives wondering. Is it worth it to be a pubic company?

Most public companies have a culture of benchmarking and short-sided metrics. They are faced with quarterly grillings at the hands of mostly out-of-touch analysts who are more concerned about modeling next quarter's capital expenditures and whether earnings are off by a penny. I'm not just being cynical either. If you've listened to quarterly calls you get my point. Though some notable CEOs have the mettle to withstand the institutional imperative, most do not. A study by McKinsey & Co. shows that 50% of execs would forgo a positive NPV project rather than miss next quarter's numbers. My guess is if all were truthful it'd be even higher.

Public companies almost universally decide to grant top employees stock options. However, though these carry a tax benefit, the compliance savings of not having to abide by Sarbanes-Oxley (private co's don't have to follow this), would more than offset the tax advantage for most companies. An alternative to public stock options: a combination of cash incentives and private stock offerings. The only issue is they can't bail and sell with the ease of the the public markets. But who wants a short-term marriage anyway?

I would prefer to own a private business. I don't need to know my net worth every day. I'm in it for the long haul and I'd rather sacrifice next year's numbers for a long-term strategy that makes sense. If you're a company that needs constant access to the capital markets, a daily performace scorecard, and thinks high doses of liquid shares should be granted to top talent, stick with the public model. As for me, I prefer my privacy.

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Disclosure: I still think some public companies are awesome.
Image: http://act.psy.cmu.edu/awpt/pictures/graph.gif

The Covered Call

2008-10-26T20:50:00.000-07:00

The credit bubble has made fools out of many people. Economists assumed housing prices couldn't systematically drop. Banks didn't care about the underlying credit worthiness of the home owners since they quickly repackaged the loans and sold them to Fannie, Freddie, or Bear Stearns. Economics has lived up to its reputation of being a backward looking study whose predictive ability stinks. Financial risk cannot be measured based on distributions of historical returns since history does not repeat itself. This time is, and will continue to be different than '29, '73, '87, or '01. Stockpickers, this site included, have made gutsy bets on downtrodden stocks only to see their market prices plummet further.

VIX

With the CBOE volatity index (VIX), "fear index" at all-time highs, options are steeply priced due to implied near-term volatility. A high VIX index, if you're a contrarian, is a bullish signal since markets tend to place too much emphasis on the recent past.

A short call

This particular strategy is an alternative to the 1.27% yield of a 6-month T-bill or could be a long-term investment with capped upside and limited downside. Here's the play: Find a stock whose fundamentals you aren't too afraid of. Simultaneously buy shares and sell a deep-in-the-money call option. I've selected Discover Financial, a previous long only recommendation.

DFS

Discover Financial (DFS) issues credit cards and processes payments. Charge-offs are rising but Discover has over $10B in cash, only 1.85B in debt, a mere 30M in mortgage-related securities, and $1B in loan loss provisions for those who are indifferent about poor credit records. Loans, like with American Express are securitized and are therefore off-balance-sheet. Lack of willing buyers of receivables is the most serious near-term concern. Yesterday Visa and MasterCard announced a $2.75B settlement with Discover over anti-competitive practices. That adds more of a cash cushion. This is a good business at a good price (not a great business at a fantastic price--these situations are obviously rare).

The possible payoff

A 7.50 Nov 2008 call sells for 2.55/2.95 (bid/ask). If you buy 100 shares at 9.68 + .05 per share commission and collect the 2.51 (2.55 - 4.00 commission) from the short call option you face a 74% loss if the stock goes to zero, a breakeven scenario at 7.27 and a maximum profit of 2.88% if the stock finishes above 7.50. The stock could drop a further 22% from the current price and you'd still make 2.88% (including commission). This could be compared to picking up nickles in front of a steam roller. I think the downside protection is sufficient to justify a short-term alternative for idle cash.

_____________________

Disclosure:
Faro has recently made this trade. Do this with only a small portion of your available cash. Don't get too greedy and only invest in a company whose fundamentals you believe to be sound. If I were long-only one credit card company it would be AXP (a similar covered position could be made with a slightly higher investment and a lower maximum payoff).

Image: http://blog.sellsiusrealestate.com/wp-content/credit-bubble.gif

For Sale?

2008-10-11T23:19:00.001-07:00

After the worst week ever for the Dow, the recent drop-off is now worthy of wikipedia. At cocktail parties and dinner tables the topic du jour is the market and the effect on investors' retirement accounts. We love to put the stock market in the simplest of terms, and in an odd retrospective view. The stock market is merely a place where businesses are bought and sold. Contrary to popular opinion, it is never universally wrong or right to buy or sell. But we should at least think about why we're buying or selling a piece of a business.

Cash flows

According to finance theory (and sometimes reality) the value of any asset is equal to the present value of all future expected cash flows. And with some stocks down 80% +, their very existence is now questioned, even without the toxic balance sheets of banks. Peak to trough the market has fallen over 46%, well into what economists consider bear market territory.

So if you have some cash on the sidelines, here's what to look for in companies and in strategies:

A super clean balance sheet: since credit is a huge part of the problem, debt is now a sin. We have yet to see the coming wave of corporate debt defaults. The 10%+ spread of non-investment grade debt to US Treasuries is a testament to risk and uncertainty.

Tiny market caps: these are thinly traded and have little or no analyst coverage; their price swings can be the biggest and their pricing the most inefficient.

A large cash pile: this serves as a further cushion, or margin of safety, against a greater collapse.

A business: a product or service that is needed or wanted in any economic environment.

Options: covered calls (if you'd like to lower your effective cost basis but cap your upside, consider this) or married puts (to protect the downside).

And?

Faro is finding extreme value in global mining, Brazilian poultry, and Chinese education. Timing the market bottom is a fool's errand. However, I wouldn't bet (long at least) on banks or the American consumer (70% of GDP). Shrinking retirement accounts, falling home prices, and tightened credit must eventually bring even the most spendthrift of consumers to question whether to fork out $40.00 for dinner or drop $200.00 for jeans. Though the recent plunge reflects this, the enhanced awareness may likely lead to a self-fulfilling prophesy: an even bigger drop for companies that sell stuff people only think they need.

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Note: Though readers may note the poor record (along with the market) of previous stock recommendations on this site, Faro is happy to report a flat last two weeks due to a short position in a domestic retailer.

Image: http://www.biojobblog.com/for_sale_sign(1).jpg

A Letter to Williams-Sonoma Management

2008-09-28T23:38:00.000-07:00

Corporate excess is nothing new. The below is a letter that will be sent today to executives of Williams-Sonoma regarding the firm's use of a leased jet.

---------------------------------

September 29, 2008

W. Howard Lester
3250 Van Ness Avenue
San Francisco, CA 94109

Dear Mr. Lester:

Williams-Sonoma, Inc. has a storied past of brand equity and profitable growth. From its humble beginning in 1956, to its coveted Oprah endorsements of recent years, the company has pushed forward with winning strategies and has an impressive base of loyal customers. This, coupled with an attractively-valued stock, is what led us recently to become part owners (shareholders) of Williams-Sonoma (WSM).

We know things are tough. As shareholders, we salute the company's efforts to maximize returns on advertising by trimming the length of the catalogs and by tweaking both circulation numbers and catalog recipients. To say the market is challenging is an understatement. Home prices are correcting (falling). According to futures on the S&P/Case-Shiller Home Price Index this is likely to continue through the next several quarters.

Though systematic risk is unavoidable, certain expenses are well within management's control. Our concern is the company's use of a leased corporate jet. The related-party nature of this arrangement also raises eyebrows. As you read this, a jet is parked, or is perhaps soaring through the air, at the cost of over $12,328.78 per day (plus use-related expenses). Williams-Sonoma's likely future dealmaking and travel convenience needs do not warrant such lavish travel perks, independent Board approval aside. What could possibly justify such an expense?

We are cheerful about the long-term prospects of the company, and as shareholders, are compelled by its rock-bottom equity valuation. However, saying no to corporate waste and conspicuous luxuries is an important cost-cutting measure in any macro environment. Cruising in style in an owned or leased jet should not be part of the corporate ethos. It costs four cents per share and no measurable value can be expected from it. That money would be better spent increasing the share repurchase program. Now is the time to reverse this misappropriation of shareholder funds.

We welcome your comments.

---------------------------------

Brink's Home Security

2008-09-25T22:58:00.000-07:00

A Breakup

Companies are always in flux: acquiring, divesting, buying back stock, retiring debt, borrowing money, managing investments, dealing with macro concerns (housing, joblessness, markets), and appeasing customers. Divestitures, often times, are part of the "creative destruction" of capitalism, and serve as chances to break up crappy businesses that a company's overpaid for, or to truly separate units that don't share common "synergies."

This can help boost returns. Spinoffs fall into this category. Unloved, unwanted, or companies in the better-off-on-their-own category soon break free and relish their independence as new entities. They're now let loose of the parent company's TPS reports and fading memories of clashes over uses of capital. Parents are relieved and can now truly focus on how to appeal to shareholders' complaints. Ain't the life of a public company grand?

Independence can ironically be the most synergistic. Brink's Home Security (BHS) sells monitored security services in a highly fragmented market to over one million North American customers. Activist investors Steel Partners and MMI Investments have encouraged a divorce of BHS from Brink's, a provider of armored transport and cash services. The company is set to break free from its parent by the end of October via a tax-free spinoff. Shareholders will receive one share of BHS for every share of Brink's (the parent). BHS will emerge with a spotless debt-free balance sheet and will be allowed to use Brink's name for three years. Then, a rebranding campaign will ensue. That sounds like a perfect opportunity to be acquired.

Revenues are largely recurring and costs fairly consistent. Operating margins have stood at an enviable 25-26% over the last couple years. Returns on capital, a sign of business strength, run close to 18%. Business is good. Revenues are up 8% year-over-year. Amidst the bursting of the real estate and credit bubbles, homeowners seem to still worry about strangers breaking in.

The Competition

ADT is probably the biggest name in the game. It is 15x BHS' size in sales but has nearly twice the attrition rate (12.7% vs. 7%) and less than half the operating margin. ADT, a division of Tyco, would love to gobble up a smaller but better run competitor.

The Breakup Fee

From the most recent form 10Q:

"Year-to-date expenses related to our strategic review, proxy matters and the spin totaled about $9 million. We’ll probably spend another $8 million to $11 million on this effort, so total expenses for these matters should be in the range of $17 million to $20 million for the year."

And....

To spend close to 50% of last year's operating income on strategic review, proxy stuff and other legal and accounting bills is a gutsy move. As future details surface, namely executive comp and insider ownership, BHS appears to be a strong, easy to understand, and predictable business. At 15x EBIT I'd consider a deeper look into this soon-to-be-public subsidiary.

---------------
Disclosure: none

Rambling on crunches, herds, lies, and bankers

2008-09-14T22:21:00.001-07:00

The most impressionable thing with the current economic correction (most often called credit crunch) is not about the magnitude Lehman's chapter 11 filing, Merrill's sale to BofA, or AIG's balance sheet problems. It is what otherwise extremely intelligent people will do when led by greed and herd-like behavior. Nevermind the liquidity crisis, market dislocation, sharp selloff, or whatever bullshit terms rich managers use to justify their behavior and poor risk management, finance needs more straight talkers. "I made a mistake. I foolishly benchmarked my decisions against my peer group and I lost your money. I'm sorry." Failing to acknowledge the truth is both dangerous and detrimental to learning.

Bad lending and falling home prices

I daringly call it a correction (not a credit crunch) because it is leading to return of old-fashioned lending standards, the four C's: character, collateral, capital, capacity. Banks, for fear of future losses if anything, are returning to this standard (1). Housing prices in the short- to near-term will feel the affect. The Case-Shiller Home Prices futures index seems to agree prices will decline through 2010 (2). This bodes ill for most. Banks especially will suffer as a significant portion of real estate will continue to fall in value. Sometimes getting kicked in the nuts is the only way to learn.

A pain in the ARS

Auction-rate securities (ARS) are not cash equivalents (3) and everyone knows that. The maturity is greater than 90 days and they were never in the same seemingly "risk-free" category as T-bills. Banks sold them because of the commissions they made and failed to support the market when people stopped showing up for the auctions. Investors were left with discounted illiquid securities and firms only capitulated on making the investors' whole when regulators levied fines and warnings of great legal headaches. Their behavior has been nothing short of deplorable.

Securitizations and cheap money led to lackadaisical lending standards as banks tried to outshine other banks in their quest to chase yield. Banking once was about making a reasonable spread on interest paid on deposits vs. interest earned in long-term investments. We should learn a lesson from the less enviable traits of human nature.

--------------------
Disclosure: None

Notes:
(1) "Banks to toughen lending standards into 2009"
(2) "Composite 10 city U.S. Futures Market"
(3) According to SFAS-95, cash and cash equivalents are: risk-free assets with original maturities of 90 days or less.
(4) Image

The Rembrandt Question

2008-09-07T21:40:00.000-07:00

Williams-Sonoma

It's usually a bad idea to buy the stock of a company only because you like their product. Clearly, however, there must be a service or product behind the business that: 1) is needed or desired, 2) has pricing power (ability to raise prices ahead of inflation, and 3) trades at a reasonable price (more like a bond than a Rembrandt painting). In the end, business models and economics are critical.

In addition to these points, there are a couple questions I often ask myself when I consider owning a piece of a public company (buying a stock). Could I LBO (leverage buyout) the company? Is there any Rembrandt premium? Stocks are valued partly like bonds (discounted expected future cash flow) and partly like Rembrandt paintings (1). If stock picking is presumed to be a worthwhile exercise then this statement is critical. I only wish I had been the first to say it in those words.

A brief overview

Williams-Sonoma is "a specialty retailer of products for the home." That wins the award for the simplest opening line of a business description section of a 10K. The company operates 600 stores, primarily Williams-Sonoma (WSM) and Pottery Barn. WSM sells really nice kitchen-related items while Pottery Barn sells furniture and other housewares. 58% of sales are made in retail stores. 42% are direct-to-customer sales (catalogs and online). WSM has felt the downturn of the housing market. Same-store-sales numbers have dropped over 10% while shares have fallen over 50% from last year's high. But are they worth a look today? Two important questions follow.

Could I LBO Williams-Sonoma?

Assuming a 30% premium, the historical average for buyouts, and 60% debt and 40% equity at a 6.5% pretax cost of debt, would put the interest coverage ratio (EBITDA/interest) at 4.5x. This would likely fall in the BBB debt rating, the last notch of investment grade. Would bankers loan under such a structure? Maybe in today's market. Very likely in tomorrow's. It kind of passes the LBO check.

What is the Rembrandt premium?

A Rembrandt premium is most obvious when the bulk of the discounted future earnings is out 5 years plus. Capitalism works its magic when numbers look super good; returns revert to the mean and creative destruction runs its course in most cases. I've recently had this theory of shorting any company that's on the cover of Fortune or Forbes. Since journalists are generally backward-looking, I think this might make sense.

WSM now sells for 7x cash flow, or a 14% cash flow yield. Given the relative strength of its yuppie customer base, and the current valuation, it is not selling for a Rembrandt premium. I don't lose sleep about owning a portion of Williams-Sonoma. The current credit environment has reinforced my belief in understanding not only a company's potential future earnings, but also its balance sheet. The balance sheet has no net debt and the company sells for 2x current assets.

Though I've never bought $40.00 pumpkin loaf tins from Williams-Sonoma, as a shareholder I'm glad thirtysomething white people do.

----------------------

Notes

(1) Charlie Munger
(2) 2007 10K

Disclosure The author has a covered call position in WSM.

And Then There Were Five: IAC/InterActiveCorp's Spin-off

2008-08-21T07:14:00.000-07:00

After feeling the heat from disgruntled investors, Barry Diller has now succeeded at splitting IAC into five publicly traded companies. The parent IAC, until the spin, was an amalgamation of internet sites, cable networks, travel services, and mortgage lending. These groups had little in common (not a lot of 'synergies').

The split finalized today after nearly a year of paying high adviser (lawyers and bankers) fees.
The hope is that the svelter IAC will put the $1.3B in cash it extracted out of its other business to work.

However, Moody's slashed its corporate rating to junk due to "the significant reduction in IAC's scale and business diversity with the spin-off of approximately 78% of its revenue and approximately 73% of segment EBITDA." No matter. With a huge pile of cash and less side businesses to worry about, IAC just might fare well. Investors seem to think so: shares traded up over 8% today.

But what of the other four?

TicketMaster (TKTM) received very little detail in past IAC SEC filings. Independence will be great for a seemingly neglected company. Hopefully, the new company will fight Live Nation, a former customer (14% of revenue).

Tree.com (Lendingtree.com) is still an attractive site for consumers to shop for mortgage loans. Lack of company financials makes it too early to say.

HSN (Home Shopping Network): there are few things in today's economic environment that worry me more than strapped customers' willingness to sit and watch a channel (or surf the website) to buy blenders and gold-plated wrist watches.

ILG (Interval Leisure Group): this is a timeshare company. At just over 2x sales and with recurring revenue from gullible consumers, ILG's valuation looks decent.

The greatest joy is the absence of historical line-by-line economics, especially for the four subsidiaries. Bank analysts love to extrapolate these items into the future to justify their "target prices." Lack of such detail, coupled with forced selling (some institutions will have to sell shares of the smaller companies), and the relatively new entrepreneurial zeal of the new bosses, should create some potential buying opportunities. You won't see that on the Home Shopping Network.

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Disclosure: None
Image: http://aplasticcentral.com/images/then%20there%20were%205.jpg

An earnings followup

2008-08-10T23:25:00.001-07:00

Orbitz

The bookings question: overall, bookings rose to $3B, or 4%. This was a tale of two stories: international jumped 41% to $476M; domestic remained basically flat at -1% growth, or $2.6B. The air side of the bookings did less well, down 13% due to a decline in U.S. volume.

This segment of the travel business is tough: margins are negative, returns on equity capital are decreasing and I'm not sure what edge they have over the competition.

Would I like to run the business over the next five years? No. What would I do as a competitor to erode Orbiz' business, I'm not sure. I'd take a pass on this company though fundamentally it doesn't look like a bubble stock.

Cowen

The company is trading at close to cash because of the deterioration of its model. The future of the super-small boutique firm is looking not so hot as panicked companies and investors seek the comfort of larger and more established banks (though their blunders as of late have been huge). At an industry high employee compensation-to-revenue ratio of 60% +, any reduction of business (investment banking is down 32%), cash on hand will get eaten up as the Cowen continues to operate as a going concern. If I were management, I'd look for a bigger player to buy me.

Papa John's

Wheat and cheese prices are rising fast (100%+ and 26% year-over-year). 35-40% of Papa's cost is cheese. The pizza world is too competitive to pass those price increases on to customers. This will pressure margins. Look for the cheapest (Little Caesar's) and the highest-end niche players (The Pie Pizza where I live) to do less poorly. I love pizza. I'm not to keen on pizza economics.

Perini

It's growing somewhere, oddly enough in Cali. and Vegas. That's saying something in today's environment. Revenue is up 21% and its backlog book of construction business is at $6.8B. With an enterprise value of $400M and $5B in sales, coupled with a pristine balance sheet and $460M in cash in the bank, it may be time to say hello to construction.

Beazer

It's adjusted balance sheet is still a mystery. If you're looking at placing a bet with a home builder, try DR Horton or NVR. Both are in better financial shape and run businesses I'd rather operate. They're also the builders I'd be least enthusiastic about competing against.

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Disclosure: None

Earnings Time

2008-08-03T22:02:00.001-07:00

Corporate executives are great salesmen. Many have climbed the ladder through actually sales talent, or by selling themselves. One of their preferred pitches once they reach the top is the case for their stock: it's always undervalued by the market.

Quarterly earnings releases are important market signals since a company has to earn real money (either now or in the future) to be worth something. But earnings reports can also be rife with overly optimistic management speak and fuzzy accounting assumptions. Management will border on dishonesty to prove their case. That's why, with no significant research budget, Faro relies on basic economics, common sense, and financials as the foundation for investment decisions.

So when analyzing the earnings releases, look for companies with potential economic signals (Are people eating out less? Do moviegoers habits change in a bad economy? Are people paying their credit card bills?) True, these are lagging economic indicators, but econ is not known for its predictive value. Since learning is cumulative, even if management is full of it, you'll be able to take away useful bits of info. And, you'll be able to hang this on your problem solving matrix framework (PSMF). I just made that up.

As we're in the middle of "earnings season," each day of this week there's a call which is probably worth paying attention to.

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Monday

Orbitz (online travel). How bad are leisure and business travel bookings?

Tuesday

Cowen (boutique investment bank). Why is this company trading at close to cash? 116M net cash vs. 122M market cap.

Wednesday

Papa John's (pizzas). How are commodity costs affecting margins?

Thursday

Perini (general contracting and construction management). What's changed in the last 12 months?

Friday

Beazer (home builder). What would its adjusted balance sheet really look like?

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Enjoy.

$1 Trillion

2008-07-24T12:30:00.000-07:00

This article, written by famed bond guru Bill Gross of PIMCO, paints a bleak picture of the current financial environment.

In my opinion, banking, at least over the next generation, will be drastically different:

1) gone are the days of no-doc teaser home loans.
2) banks are now much more risk averse (less willing to lend to anyone with just a pulse).
3) many more banks will fail.

What America needs is the Leave-it-to-Beaver era of thrift, honesty and a 20% down payment. I would not lend to someone who didn't pass that filter. I don't have much faith in people not wanting to keep up with the Joneses.

Sadly, however, this crisis means Uncle Sam's place in our lives just got bigger. America will live with much of this. Remember, some of the most odious Acts and Laws were passed several decades ago (e.g., Social Security). So be leery of any measures to 'save' homeowners. Few find it politically expedient to speak the truth: the banks lied; the borrowers lied; the mortgage lenders lied. That's a scary combination. But all should pay the price before the taxpayer carries the burden.

As Buffett said: "Be greedy when others are fearful and fearful when others are greedy." There's blood in the streets now, but expect more. Nevertheless, I am optimistic about the long-term ingenuity of America's creative engines.

On Timeshares and Psychology

2008-07-13T21:11:00.000-07:00

There's something about mostly tan, thin, vacation-theme clothed, and universally happy sales people that breeds distrust. This past weekend, my wife and I sat through our third timeshare presentation in as many years. We're not interested, but companies now dangle bigger rewards as incentives to come sit for 90 minutes; sales presentations can also be a great education in psychological persuasion and in how to see through fuzzy math. It was a 4th of July weekend well spent at a Worldmark office, a subsidiary of Wyndam (Ticker: WYN).

The picture

4.4 million US households own vacation ownership interests (a euphemism for timeshares). For Worldmark, The average age is 52 and the median household income is $74,000; this is the middle class, the I-can-feel-retirement-coming crowd. Again, this is the median number so half are older and have are younger. All are bad at math, however.

We were probably referred by a friend or acquaintance (they offer extra perks for referrals). The sales building was located in a typical office park but in an upper-middle class area of town. The parking area was newly paved and partially shaded with immature trees. The entrance was simple yet attractive and on 95 degree day, the cool office air felt almost too cold. The facilities had the disadvantage of being located off-site. There was no personal tour to entice would-be buyers with extra big jet tubs and high thread count sheets (or whatever they have). On-site tours account for 90% of Wyndam's timeshare sales though only 80% of sales close on-site.

Once settled in the office our sales rep (a twentysomething mother of two) offered us cookies and soda--an odd and unsatisfying menu given the mid-morning hour of our appointment. 10-15 couples of middle and young family age, joined us in what I'll call "why everyone needs to buy a Worldmark timeshare."

The Economics

Worldmark should make a profit, but it's how they present that bothers me.

The direct cost to the consumer are: 1) a lump sum payment, generally 10% down; financing is pre-approved at 17.9% (a stratospheric rate) though the average interest rate on 277,000 loans ($3.3 billion in total loans) is 12.5% (source: 2007 10K). This is still extremely high; 2) Maintenance fees* of $500-1,000 per year depending on the number of vacation credits (these are exchanged for days at any one of the company's 67 resorts.)

The numbers presented to us were vacation credits roughly equivalent to ten days per year for 55 years. The one time fee was $31,340 with an annual maintenance fee of $947.00, or $94.70 per day. The key factors in doing the math are the estimated average room rate increases over the next 55 years and the assumed alternative rate of return (the opportunity cost of capital) of the lump sum payment. Opportunity cost is one of the most important principles of any economics class.

Wordmark's assumed room rate inflation is 7.6% and is based on past 30 years. This number seems high and unlikely to continue. This is economic red flag number one in the presentation. Room rate inflation, according to form 10K, over the last 8 years has been closer to 4%. I make the assumption of an opportunity cost of capital based on the stock market (S&P 500) recent 30 year compounded annual growth rate of approximately 9%. 7-8% would probably be more appropriate.

In the pitch, she told us room rates averaged $150.00+; a higher hotel room rate makes it more appealing to lock in the rate today; it's also very dishonest. This is economic red flag number two. With a base room rate of $108 (the average daily hotel room rate for 2007 was $103.00 per 2007 10K) and 7.6% room rate inflation over 55 years at 10 days per year you will have paid $725k for hotel rooms assuming you 'vacation' as they say you should.

But what would you have given up (what's the opportunity cost for saying yes)? If you invested the $31,340 lump sum payment in the S&P 500 over the course of the same 55 year period, with an assumed return of just over 9% you'd have over $3.1 millions dollars. Add the yearly fixed maintenance fees of 947.00 and you'd have another $1.3 million.

The pitch compared future dollars to present dollars (the lump sum payment you'll make up front)--an apples to soggy watermelon comparison. This is economic red flag number three. Clearly $725k in future hotel bills looks cheap next to the $4.4 million opportunity cost. (This assumes the $31k lump sump payment is made in cash; to finance 90% of this and to add the 12.5% rate financing to equation would look even less favorable from the consumers perspective.

Securitizations

After too many cokes, the opaque math and bombardment of vacation imagery, a middle age couple decides to go for it. Of a motley group of 15-20 or so couples, they are perhaps the only to buy. The others will either sleep on it (rarely a bad policy), or just say it's too much money.

A check for 10% down is cut, the contract is signed and the couple walks with gifts equal to some reimbursement of their time. The salesman smiles looking for approval from his now content supervisor, while other sales reps curse that others were too cautious and rational.

When a deal is closed the firm sells the loan within 30-90 days as part of a receivables securitization (loans packaged and sold to investors). With a spread of 7.1% (WYN borrows at 5.4%--per 2007 10K--and lends at 12.5% for vacation ownership loans) over the standard 10-15 year period for such a loan, banking becomes the bread and butter of the business.

The present value of such a loan is worth 33% more than if the lending were done at 3.00% above borrowing costs (more reasonable given the credit of timeshare owners).

Over the last three years, securitization of customer receivables has generated $1.5 billion in gains for Wyndam, the parent company. The pursuit of profit is hardly shady, but free cash flow (what the company makes from it's core business of hotels, vacation rentals, and timeshares) over the sames period has netted a mere $148 million. To sell pools of loans is 10 times as profitable as the company's general operations. This helps to understand the motivation of receivables financing.

The psychology

So why would someone buy a timeshare if the numbers look so bad for the consumer and so great for the company?

As we proceeded through the sales pitch, I took down mental notes of some of the principles touched on in Cialdini's book, Influence: The Psychology of Persuasion. I also jotted down numbers, as the sales rep nervously observed, since this drives the rationale for accepting or rejecting decisions of this kind.

Every sales experience is deeply rooted in human psychology. Cialdini's book is so influential that upon reading it, Charlie Munger of Berkshire Hathaway, gifted the author one Berkshire Class A share. I've recommended this book to no fewer than 10 people. I've outlined some key points used in the timeshare sales-pitch.

Social Proof

Everyone is doing it. A common refrain from high school, this is ubiquitous in the world. When I said that this didn't make economic sense, she replied: "If this didn't make sense, we wouldn't be in business."

Reciprocation

There's a powerful example from the book: In a WWI battle situation, a German surprised an enemy soldier in no-man's land while the enemy was eating a sandwich. The enemy soldier surprisingly reached out and gave the German some of his food. The stunned German soldier, under command to bring back any captors for interrogating, returned alone to face the wrath of his superiors

Worldmark offers free cookies, coke, two or three nights in a resort, gas cards, and $100.00 restaurant gift card: the least you could do is become a "vacation ownership" member as a return for all these favors.

Scarcity

We received a call the day before wanting to push back our time 2 hrs. When we declined they offered us a $50.00 gas card. We kept our original reservation. They tried to create the aura of scarcity. Panicky financial decisions are rarely good ones.

Liking

We like others like us. Timeshare pitchers are young, attractive, tan, and tend to favor Hawaiian shirts over more traditional dress since we all like the idea of worry-free vacationing.

Authority

Worldmark uses AAA as the authority source for future room rate inflation. But you should ask: Is this authority truly an expert? And, are these statistics misstated or cherry picked?

How can we say no?

The easiest was to say no is avoidance. If that's not an option, then we must accept offers only for what they fundamentally are. Hence, the focus on the economics. Timeshares at best are a ripoff, at worst, sales associates (or sales executives as they may be called to inflate the importance of their jobs) present a skewed view of the world through contemptibly misleading numbers.

--------

Disclosure:

None

Notes:
*"These fees generally are used to renovate and replace furnishings, pay operating, maintenance and cleaning costs, pay management fees and expenses, and cover taxes (in some states), insurance and other related costs. Wyndham Vacation Resorts, as the owner of unsold inventory at resorts, also pays maintenance fees to property owners’ associations in accordance with the legal requirements of the states or jurisdictions in which the resorts are located. In addition, at certain newly developed resorts, Wyndham Vacation Resorts enters into subsidy agreements with the property owners’ associations to cover costs that otherwise would be covered by annual maintenance fees payable with respect to vacation ownership interests that have not yet been sold."

Some thoughts concerning timeshares

2008-07-05T17:13:00.000-07:00

There's something about mostly tan, thin, vacation-themed clothed, and universally happy sales people that breeds distrust. This weekend, my wife and I sat through our third timeshare presentation--not because we're interested, but because companies dangle bigger carrots as incentives to come sit for 90 minutes, and it can be a great education.

I'm compiling some industry and company specific figures on the economics of timeshares to share with friends, family, and eager readers. Results will post within a few days.

The verdict: don't buy one (this shouldn't be a giveaway for most).

Executive Writing

2008-06-26T20:20:00.000-07:00

Nothing in the business world draws more ire than "high" executive pay. Ask a doctor what they think and they'll most likely declare: "I save lives. What do execs do?" Faro discussed management pay in a previous post and argued in favor of rational, shareholder-friendly payouts for top talent. Like a good exercise program, the advice is rarely heeded.

How executives get their jobs is worth pondering. In addition to talent (for most) and energy, much of the rung-climbing success is due to politicking and affability. Companies understandably gravitate to likable people. Though being a nice guy shouldn't be as big of a part of the equation. Clear communication and honesty should be near the top of the list.

You don't want a CEO who's just a consensus builder and good golfer. But that's how many do it. Too many, perhaps, come from smooth talking sales backgrounds. These are 'yes' people.

You have to wonder, why these 'yes' people want to be CEO of a big company. Is it the power, the money, the ego? The lifestyle and the lavish houses, however, are appealing. In an interview with Fortune, a famous rich guy named Warren said he'd rather be a paperboy than be the CEO of GE. Whether he meant this post- or pre-billionaire status is kind of irrelevant. People should place a high value on their time.

Well, what do CEOs do? They lead the strategy of the company. They motivate. They make sure all the pieces of the puzzle fit and that, ideally, the value of the firm increases over time. They attend meetings. They have secretaries who arrange their schedules. They golf. They attend fancy dinners. They hire and fire. They are scapegoats. They put in long hours (however productive they may be). They also should write the annual shareholders' letter. This seemingly easy task is, more often than not, plagued with ambiguity and buzzwords.

Below is the Fresh Del Monte 2007 letter to shareholders. Cleaning this up would be messy. The astute reader should be leery when only GAAP figures are mentioned, but also skeptical of language like "excluding", "other charges", "accretive" (though this term is not used below, it is very common when justifying a potential acquisition), etc. This doesn't mean the business is poor; the presentation is just bad. The poor writing also reflects unclear thinking. It doesn't have to be poetry, but it should be better than MBA-level "strategic" writing. But maybe strategic is what Wallstreet is looking for.

Areas of concern in the letter are in red. Faro's comments are bolded and in brackets.

__________

"Two thousand and seven was one of the best years in the history of Fresh Del Monte Produce. During this period, we benefited from the many improvements we made in all of our business lines, which restored Fresh Del Monte’s track record of creating enhanced shareholder value [I'd mention the 2007 stock performance of +125%. That's impressive.] To achieve this goal, we continued to streamline our fresh and fresh cut businesses, eliminating unprofitable products in our fresh-cut line, while maximizing production and driving efficiencies in our logistics networks. In addition, we improved banana contract pricing in North America, countering higher production and logistics costs. We expanded our global customer base, and we began to serve a number of new markets [I like numbers].

We also continued to leverage the power of the Del Monte® brand to create new inroads in fast-growing Middle East markets. Much of our success in these and other markets is due to enduring consumer confidence in our 115-year-old brand, which symbolizes quality, freshness and reliability. In addition, we aggressively repositioned our prepared food business by streamlining production and distribution [how? don't give away your secrets, but how].As a result of our solid operating achievements in 2007, we were able to deliver substantially improved performance across a range of financial metrics. Earnings per diluted share climbed to $3.22, compared with $0.10 per diluted share for the year ended 2006, excluding asset impairment, restructuring and other charges [i.e., exluding the bad stuff]. Net sales for the year increased to $3.4 billion, compared with $3.2 billion in 2006. Gross profit for the year rose to $364.9 million, compared with $189.4 million in the prior year. Net income for the year increased to $179.8 million, compared with a net loss of $142.2 million in 2006.

We are justifiably proud of our performance in 2007, particularly as the prior year had been one of the most difficult we had ever endured. In 2006, we faced a number of hurdles, including higher energy and production costs [you state it later in the 10k, why not mention impact of energy costs in $. What about foreign currency? That's on my mind too] . The fact that we were able to overcome the lingering effects of those factors in 2007 is a testament to the expertise and commitment of our management team and the dedication of our 35,000 employees around the world. It is also a powerful endorsement of our business model. Our mission is centered on increasing shareholder value [who's isn't]. To fulfill this mission, we set out each day focused on offering products and services that meet the needs of our customers and enable us to improve profitability. While this mission requires disciplined implementation, it also calls for flexibility and resilience—two inherent qualities that we demonstrated yet again in 2007, when in spite of continuing cost pressures, we delivered some of the strongest financial results in our history [examples would be great].

As we advance through 2008, we are optimistic about our future. Fresh Del Monte Produce continues to perform well around the world, in part because of our concerted efforts to improve our operating efficiencies and reduce costs. These efforts continue, and we remain vigilant about meeting the continuing challenges of fluctuating costs related to production, transportation, fuel and packaging. We also remain firmly committed to prudently growing the Company, improving our operations, expanding in new geographic areas and developing new products to meet consumer demand. As we steadily pursue these measures, we warmly thank all of our shareholders—including those of you who took a first-time stake in our Company in 2007—for your continued support."

__________

Source: http://library.corporate-ir.net/library/10/108/108461/items/285073/FDP07AR.pdf

Disclosure: none

The Problem with Being Active

2008-06-17T23:09:00.000-07:00

This site was originally spinofftracker.blogspot.com. Spinoffs are still a great place to dig. Though I'm sure one of the rules of a successful blog is focus, this site meanders from the rare company analysis to random musings on markets and human nature. The principle reason is fear of activity. In most situations in life, the scorecard is based on how busy we look, not on how productive we are.

Society supports and rewards activity. Only in times past it was harder to fake. If you lived in the Great Rift Valley, it was impossible to pretend to hunt. Today we have IM and meetings to mask our slacking.

In the online financial world, sites that give advice, particularly stock advice, bore the reader with mundane lists and yesterday's news. They try to hard to be active. The Motley Fool is an example of a site with an occasional standout story or opinion piece. The rest is mediocre. (Important note: I did interview unsuccessfully--by some measures--with The Fool.) Their analysts try too hard to create the next big headline: "Why you need to buy these 5 stocks today", "3 mistakes Buffett made." Those headlines are not real. But most articles are overly hedged, obvious, or too promotional.

Hyperactivity is a great argument against subscribing to a stock newsletter. I'd guess that most newsletters are marketed to individuals not institutions. Institutions have research departments and sophisticated TPS reports.

A person, we'll call him Bill, is 45 years old and enjoys a modest income. Bill occasionally listens and cares about what Ben Bernanke says. He peruses the business section of the paper. He knows what LIBOR means, that the S&P is a market-weighted index, and that nobody really understands credit default swap exposure. He's ahead of the pack.

Most stock newsletters publish monthly picks of 1-2 stocks. You can imagine if Bill subscribes to just one letter, over the course of five years--the minimum time frame to establish a solid track record--that he'll have seen 60-120 recommendations. And surely he's not puting all his extra cash in one newsletter's picks. He'll pay 200-300 dollars per year for the letter and he'll cherry pick stocks he's familiar with. His performance will be very different from the letter's reported numbers.

Far superior to the newsletter model is money management. The idea of being a mere observer and learner and reaping the huge paydays is probably diverting many geniuses from cancer research and mentoring. That's not to say funds don't justify their "work" in some way. Nerds create algorithms, and fancy charts with Greek letters attempt to validate the lucrative 2 and 20 (2% of assets and 20% of returns) fees.

The ideal model is simpler. It would be a team of one or two. An ambitious unpaid intern could be of use in filtering and going through boring SEC filings. Office space would have to be free at the start, run out of an apartment or house. There'd be no company car, perks, or "strategic lunches." Portfolio turnover would be minimal, leverage nil, and picks rare (maybe 3-5 stocks in most years) but uncommonly good. 1.5% of hedge fund s (loosely regulated investment firms) manage less than $100M. The fund would be small, have a one-time 100 basis point fee, and a performance fee of 20%, but only after profits of 5%. Size would be an advantage as the investment universe would be tilted toward $10-500M companies (too small for the big boys). The majority of the founder's net worth will be married to the fund.

Productivity, as measured by long-term returns, is the key. Bull shit activity is the curse of the modern corporation. A lot of big dumb problems can be avoided if we continually learn and work intelligently. Who cares if someone wears a nicer tie and walks faster than you.

Disclosure: see statement at bottom of screen.
Image: http://www.vtt.fi/kuvat/cluster1_tieto_ja_viestintatekniikka_elektroniikka/sw_testing_kuva_big.jpg

Life as a balance sheet

2008-06-04T21:24:00.000-07:00

Albert Einstein famously referred to compound interest as the 8th wonder of the world. Double-entry book keeping arguably deserves a spot in the top 10.

Developed by Luca Pacioli, an Italian monk and mathematician, double-entry book keeping is the foundation of accounting. Pacioli established any transaction as a set of two transactions. If you're not yet bored, keep reading. This is a basic T-account, a favorite for accountants.

On the left of the T is the debit, on the right is the credit. Note: debit is not universally negative as many use it. A debit increases an asset; a debit decreases a liability and owners' equity. A = L + OE, to remember, think of the cold green gel that cools sunburned skin. Assets = Liabilities + Owners' Equity.

Assets are defined by SFAC 6 (Statement of Financial Accounting Concepts) as "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events." A liability is "probable future sacrifices of economic benefits arising from present obligations or a particular entity to transfer assets or to provide services to other entities in the future as a result of past transactions or events." This seems fun enough. An asset is usually good; a liability is usually bad. We'll spare the accounting details here.

Owners' equity, we'll just call it equity for our purposes, is the net of assets and liabilities. This is simple. The goal of companies is to consistently increase the equity piece of the pie, and the market value of the stock (again, we'll spare the accounting lesson of book value and market value details). Berkshire Hathaway has increased it's equity per share (book value per share) from single digits to tens of thousands. A compound annual growth rate north of 20%.

The personal finance jungle

Financial planning advice, outside estate and tax issues, is usually pretty bad. So though this is more qualitative in it's approach, Faro ventures to be one of the few to add valuable personal financial advice: treat your life as a balance sheet.

It goes something like this. And you can break this down however you'd like. Every period, be it a day or a month, has a series of debit and credit transactions. I'm getting into accounting terms; don't be too scared. Good sleep is a debit to assets--it has a positive future benefit. It also increases the equity in the long-term health account. Smoking would do just the opposite.

Time, and how it is spent, is a trickier one to estimate. Rest and fun are good, but in excess are a liability and decrease the equity in your quality of life account. Don't get lost with this.

How we spend our time becomes critical to our equity account. And anyone with competing interests--families, "careers", hobbies, reality TV schedules, and others--knows this. If in a day, you take out the uncontrollable factors, (sleep, work, etc) your time to have a material impact on your equity account is limited. It may be as few as 4-6 hours per day. So if you spend most of your time worrying about how cool your car is, what to watch on TV tonight, or planning the next credit-funded vacation, you'll discover your equity account is small.

The average American who watches four hours per day of television should feel this. The difficulty is in realizing and changing this. But treating your life as a balance sheet is a great way to open your eyes. It also helps establish the mindset for analyzing companies' decisions.

Useful Calls

2008-05-27T19:31:00.001-07:00

Finance is prone to problems and complaints. There's too much regulation, then not enough. There's the politically valuable common man (the "working class") and there's Mr. Burns. Financial information is abundant; there's too much. Jim Cramer should annoy most sane people.

So when you open floodgates of financial media, you either have to ignore most noise, or only rarely but deeply pay attention. Faro prefers the former. Selecting what is newsworthy is hard given the prevalence of financial data: CPI, Case-Shiller, employment, level of the Dow vs eight days ago (who really cares?), oil, commodities, trade imbalances, inflation, etc.

These all have value. But meaningful short-term economic forecasting is extremely difficult. There is, however, a great source of data that come direct from companies (though you should be selective since most CEOs are salesman). Only pay close attention to companies whose business models you admire or that have a compelling special situation scenario--real "change" in the works.

This site is following three companies during this week's earnings calls: Borders, Costco and Tiffany & Co. All are household names and operate in the easy-to-understand worlds of books, food and electronics, and high-end jewelry.

All should add insight to investors on commodity costs, consumer behavior, and luxury consumers. Borders is in the news as a potential acquisition target for Barnes & Noble. A combination would have 30% of the book market. Costco brought in 1.3B in membership fees, curiously close ((1.2x) to its reported FY2007 profits. That's a fair trade-off for good food, a 90-day return policy, and tasty Saturday samples. Tiffany seems immune to the current economic woes. Drop in USD will be interesting in results, as will expansion plans.

Grab a pen, pay attention and ignore the buzzwords.

Wednesday: Borders

Thursday: Costco

Friday: Tiffany & Co.

Disclosure: None

Image: http://www.bradleygoughdiamonds.com/pictures/diamond.jpg

On Restaurants

2008-05-18T22:43:00.000-07:00

Restaurants largely deserve their reputation as poor businesses. Any business with low barriers to entry will never make much more than its cost of capital*. It's capitalism 101. You don't need to read strategy guru Michael Porter to know that.

Long waits and good food don't equal a buy signal. The Cheesecake Factory, other than its bad name, is famous for it's dairy desserts and long waits. I wouldn't salivate over the stock, however. All capital expenditures, in excess of actual cash generated, are understandable plowed back into growing store count. But the incremental returns on capital are mediocre 13% / 8% (levered to unlevered).

Costs across restaurants are fairly consistent: about 1/3 of sales is food, 1/3 labor, 25-30% SG&A and other, and the other 5 cents flow to the bottom line.

Ticker ROE (ttm) ROE (w/o debt) Profit Margin

CAKE 13.0% 8.4% 4.51%
DRI 28.6% 12.6% 5.83%
EAT 24.7% 12.6% 4.71%
MCD 16.7% 10.0% 10.86%
RUTH 20.4% 9.1% 4.76%

Problems

higher wages: minimum wages will jump 12% in some states this summer.
low barriers to entry
exposure to fluctuations of commodity costs while unable to pass on costs.
consumer fundamentals: there were 524,286 eating and drinking places in the U.S. in 2006 -- a 45% increase from 1990, according to the National Restaurant Association. The U.S. population rose 20% during that period, according to census figures.**"
People aren't eating out more frequently than 10-15 years ago.
The solution: crimp on extras, cut hours, or offer specials.

The thought of a smaller burger patty brought by a disgruntled waiter annoys me.

In business, just like airline seats, the middle sucks. The low-cost fast food restaurant (e.g., McDonald's) or the high-end (Ruth's Chris) will be most likely to succeed in the long-term. A restaurant that can earn barely in excess of it's cost of capital is a wonderful restaurant, not a wonderful business.

Notes:
*return a firm would earn on an investment of similar risk
**Wall Street Journal
Image: http://www.shyiam.com/wp-content/uploads/2007/06/cheesecake.jpg

Hyping Stocks

2008-05-11T22:27:00.000-07:00

Anyone who pretends to give stock tips should report transparent performance. Faro holds itself to that standard. Below is a brief update of all companies recommended on this site, with an unbiased view of how the three stocks have done. There's no massaging the numbers, no justifications or excuses; it's just the performance based on the adjusted closing price as of 5/9/08. All positions are still held in the Faro portfolio with no plans of selling. Additional shares of LOJN were purchased after the stock dropped 25%.

Nordstrom (JWN)
April same-store sales figures came in at -3.8%. That's a bigger decline than the '01-'02 downturn. There could be more shoes to drop. The Nordstrom name and franchise, however, is strong. JWN trades at a forward multiple of 12x earnings, 6.7x ebitda, .85x sales; it earns an enviable return on equity of 43%; Interest coverage ratio is 15x.

-10.8% vs. S&P -8.6%
Recommended: 10/27/07

Discover Financial Services (DFS)
In the current economic environment, few companies--outside mortgage originators, "greedy" banks, and brothels--get more flak than does DFS. Households continue to worry about expenses. Credit card issuers are often the scapegoats for America's vast financial illiteracy. A key indicator of the firm's business, the net charge-off rate, stood at 3.84% for fiscal 2007. Discover is priced at 11x forward earnings, 2x sales, and has 17.29 in cash per share.

39.3% vs. S&P 5.9%
Recommended: 1/20/08

LoJack (LOJN)
People keep stealing cars. Revenue for LoJack, however, fell 15%. The company faces a challenging near-term outlook as cash-strapped consumers delay big-ticket purchases. Car dealers are focused on clearing out sales lots and less on the added revenue from LoJack units.
Shares are at 10x forward earnings and .83x sales. The company earns a slight excess of its cost of capital: return on equity is about 14%.

-28.7% vs. S&P 1.7%
Recommended: 2/23/08

Is this site worth reading? You decide.

Image http://www.edmunds.com/pictures/VEHICLE/1993/Ford/7227/1993.ford.tempo.3624-396x249.jpg

Beyond The Klamath

2008-05-04T20:11:00.000-07:00

If it were any other time of year, you'd wonder why 31,000+ went to Nebraska for a single event. This weekend, however, thousands converged on the surprisingly pleasant city of Omaha for the Berkshire Hathaway shareholders' meeting. Most came to hear from Warren. A handful came to protest. The protests did impact the mood.

The event continued. Despite efforts by the misguided few to protest the Klamath river hydroelectric dams of Pacificorp, a Berkshire-owned regulated utility. Capitalism and modernity never please all parties.

The trip to Omaha is a yearly journey thousands make in hopes of hearing the next piece of investment wisdom, thoughts on the economy, and political opinion. Many learn. Most of us, however, listen and forget. Advice, when truly needed, is seldom heeded. To paraphrase Munger's past comments on this, when people ask for advice, they often mean: spoon-feed me advice so I can be rich, only more quickly.

It is valuable time for friends and investment advisors to reflect on the past year and to consider their next capital allocation decisions.

The questions, however, were surprisingly poor given the financial hurdles of ownership and the intellectual make-up of the party-goers. Most of what was asked is found in past annual reports, books, or public comments. The true gems stemmed from the inspiration of the simple economic truths of Buffett's approach of analyzing people and businesses.

Below is a summary of a few points Buffett and Munger (Co-Chairman) made that I pondered both on Saturday, and on the return flight.

Noise

We ignore 99.9% of what we see in the market (stocks)

Communication

Communication--written and oral--is enormously valuable and under-taught.

What determines dividend policy

Whether you can earn more than $1 of market value per $1 of retained earnings.

Integrity

When we make a deal, there are no special clauses.....Whether Ben Bernanke runs off to Brazil with Paris Hilton, or if a nuclear bomb explodes over NYC, the deal will go through.

It's refreshing to hear such simple advice from a candid, smart, but imperfect man. Hopefully we listen. And hopefully we learn when, where, and to whom we protest.

Disclosure: none

What the real experts say

2008-04-26T11:30:00.001-07:00

Anyone who reads the business section is probably sick of the terms "subprime" and "credit crunch." Google "credit crunch" and you'll get 4.2M results. The repricing of risk, the bursting of the housing bubble, the health of companies' balance sheets, inflation, and the impact on the consumer's ability to keep buying stuff, however, keep both politicians and breadwinners up at night.

We should be worried. But we should also ignore most of what we hear. In the stock market--especially stock picking--whose opinion matters? Jim Cramer is good at generating hype; though he is very bright, the Mad Money Jim Cramer persona annoys me. Most news exists not to report accurate and meaningful news, but to report what sells. Panic, greed, and Britney sell. The best source for news is rational economists, reputable business leaders, and other smart independent minds. This site tries to be relevant.

Fortunately, many intelligent independent leaders, et al., have recently made headline comments and observations on the current economic environment.

On U.S. shipping

Scott Davis (CEO, UPS)

UPS's first quarter results illustrate the dramatic slowing in the U.S. economy. At our investor conference on March 12th, we told you that volume growth in January had been up 3%. But in the six weeks prior to the conference, it had been negative. We also said if these trends persisted through March, we would not achieve the earnings guidance we had provided for the quarter. [The] trends did continue. Many have become sharply more negative in the last two months. ... The great unknowns are the severity and the duration of the current economic slowdown. Many of our customers have tightened their belts resulting in a shift away from our premium air products to ground shipments. [Emphasis added]

On housing

April 22, 2008, 2:50 pm

Source: wsj.com

Yale University economist Robert Shiller, pioneer of Standard & Poor's/Case-Shiller home-price index, said there's a good chance housing prices will fall further than the 30% drop in the historic depression of the 1930s. Home prices nationwide already have dropped 15% since their peak in 2006, he said.

"I think there is a scenario that they could be down substantially more," Mr. Shiller said during a speech at the New Haven Lawn Club. [Emphasis added]

On lattes

Slowdown filters through to Starbucks

By Jonathan Birchall in New York

Wednesday Apr 23 2008 18:50

Starbucks (NASDAQ:SBUX) , the coffee house chain, on Wednesday blamed a "sharp weakening" in the consumer economy for an unexpected decline in its US sales, sending its shares plunging more than 10 per cent in after-hours trading.

Howard Schultz, who returned to the role of chief executive in January, said "the current economic environment is the weakest in our company's history", citing the housing slump and rising energy and food costs.

The company said conditions were particularly bad in California and Florida, which account for 32 per cent of its retail revenues and have been hard hit by the slump in the US housing market. [Emphasis added]

What does Greenspan think?

NEW YORK (CNNMoney.com) -- Today's economic condition could likely be seen as "the most wrenching since the end of the second world war," wrote former Federal Reserve chairman Alan Greenspan in the Financial Times on Monday.

And Buffett?

FORTUNE 4/14/2008

Q: The scenario you're describing suggests we're a long way from turning a corner.

A: "I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that."

In the end...

Only in hindsight does "buy low, sell high" mean anything. To actually do that presupposes a contrarian strategy. So when the press talks about the death of equities and new strategies for winning big, ignore most of it. Or even better, short it.

Image: http://conductr.com/assets/2007/8/14/refi-ad.png

Disclosure: none

Books

2008-04-20T20:18:00.000-07:00

Have you read Adam Smith? I don't know anyone who really has. Most just lie about it. "Yeah, I read The Wealth of Nations, well, kind of." Many are familiar with comparative advantage, the pin factory (the values of the specialization of labor), and the invisible hand--all of which are important principles. The rest of the book, however, is terribly boring and difficult to read. I've tried reading it at least three times.

This all has a point. Anyone serious about the pursuit of a lifelong personal education is constantly reading and learning. And there are several ways to maximize reading output: learn to read faster; skim more; spend much more time doing it; find a way to live without sleep; and, the method I prefer: always read and learn new things but don't obsess about it. It should be natural.

That said, below is an attempt to list categories of books. This should make it easier to decide what is really worth reading.

1) wikipedia knowledge (e.g., Seven Habits--if you care)
2) historically significant well-written books
3) books to avoid (self-help books and most popular business books)
4) books for information and/or vocation
5) pleasure reading
6) other (haven't figured out what this is yet)

Be selective about what you read. But be balanced. You'll become a better investor. And don't worry if you've never read Adam Smith, most honest people have not.

Image: http://www.library.hbs.edu/hc/collections/kress/kress_img/adam_smith2.jpg

Management Pay

2008-04-13T21:48:00.000-07:00

When Michael Jordan retired in 1998, the NBA, was doing well: sell-out crowds dominated, sales of licensed goods soared and companies anxiously sought endorsement deals with basketball's newest superstars. Fans paid the salaries. Jordan commanded $30M per year deals. Few if any complained about his pay--though he arguably deserved more.

The public today is up in arms about the "egregious" practices of executive compensation, and understandably so. In a typical illustration of Wall Street's excesses, under pressure from board members and shareholders, Bob Nardelli last year jumped from an ailing plane called Home Depot with his clichéd "golden parachute." How was his landing? He walked with a cool $210M. Was he worth it? During his six-year tenure as chief executive he received $123.7M while the stock fell 5.6%. Meanwhile, rival Lowe's saw it's stock triple.

A nauseating look into a past Home Depot 10K exposes an 8400-word mess of legal jargon, colossal promises, and the root of his staggering severance. His December 2000 pay contract reveals a convoluted pay structure of millions of options, a $10M loan, accelerated vesting of stock options upon "resignation with good reason," and even a part that states: "Nothing contained herein shall prevent the committee from paying an annual bonus in excess of the maximum amount." The contract is devoid of operating improvement incentives, talk of long-term share price increases, and reasonable limits to the size of his severance package. It's little wonder he jumped when he did.

This example of corporate gluttony is worthy of scrutiny. There were too many guarantees for thumb sucking. Nardelli received a Grasso-like package to destroy value.

Few gripe, however, when high pay is commensurate with strong stock performance. In response to concerns about Gillette's James Kilts' options grant worth about $150M for a one year post-acquisition contract with P&G, Warren Buffett, a staunch voice against high executive pay said, "Jim quickly instilled fiscal discipline, tightened operations and energized marketing. Jim was paid very well—but he earned every penny." Even Buffett approves of the stratospheric compensation for those who can create substantial shareholder value by deftly navigating treacherous competitive waters.

That said, egalitarians lament the increasing disparity in top-level and "everyman" pay. Higher taxes, more regulation, and capped salaries are proposed tools to bridge the pay gap. Though their intentions may be good, such measures would likely be detrimental. Top talent would gravitate to higher pay and less regulated arenas such as hedge funds and private equity. According to a study by Steven Kaplan of the University of Chicago, for every $1000 in excess public corporation profits, management keeps $3. For private equity deals, the numbers are more lucrative - $63 dollars on every thousand in excess profit. In essence, public shareholders are getting a deal.

What does "excess" mean and who should make that determination? It's often quoted as excess when it meets a certain multiple of average worker pay (30x is ok; 1000x is not so good--or so it goes). Ultimately, it's in the hands of market forces. Aflac is set to become the first US company to allow shareholders to have a direct say on executive pay starting in 2009. But could draconian pay restructuring at the hands of investors alienate management? This is possible. According to a survey by Ira Kay, of Watson Wyatt, a consultancy, 90% of institutional investors feel management is "dramatically overpaid." Shareholder input could be harsh and speed the exodus of talented managers into private firms Conversely, one could argue that institutional investors are sophisticated (read: smart) enough to realize the downside of dramatic pay restructuring.

High executive pay largely represents the value the market places on ingenuity and value creation. I prefer to see management as business owners, not short-term joy riders. To align management with the interests of shareholders, effective tools are: executives' stock option vesting periods to be no shorter than a 5-7 year range; a separation of market uncontrollables (e.g., high oil prices in the case an oil company) from the compensation equation.

In addition, short-term operating objectives such as inventory management, cost controls, and divestment of value-destroying projects should figure into the compensation formula. Established hurdles based on top-line organic revenue growth would encourage companies to honestly evaluate the supposed synergies and operating efficiencies of a potential acquiree; long-term stock price appreciation would be the reward for the well-executed merger or acquisition.

A portion of the pay should be determined by an ex-post independent board. Board independence with cogent short-term operating metrics and lucrative long-term stock option plans based on value-creation, i.e., increase in stock price, would limit the possibility of Nardellisms. This would piss fewer people off and help public companies find and keep the next Jordan of corporate superstars.

Disclosure: none

MSCI: it's the valuation, stupid

2008-04-06T08:31:00.001-07:00

Most people can name a great business. Coke is one. Disney is awesome too. Defining exactly what makes it great, in business terms, is more difficult. Often this involves ugly buzzwords. Intuitively, however, most people can name some traits of greatness. This may include: a product or service that is highly desired or needed (diamonds, gasoline); one with an advantage due to scale, patents, or brand (Wal-mart, Pfizer, Coke); a business that makes a lot of money while investing little back into it (MSCI. NOT Delta Airlines). We keep things simple.

Not all fabulous businesses are good stocks. Why not? Price.

The high free cash flow generated by MSCI (MXB) through its international investment indices is what makes this business great. If you buy an emerging market index, a bit of the fees you pay goes to MSCI. MXB produces indices and risk and return portfolio analytics for ~3,000 clients with "over 100,000 indices calculated daily and over 3 trillion USD of assets globally benchmarked(1)" to the company's indices. The firm's clients are geographically diverse: 53% of clients in the Americas; 33% Europe, the Middle East and Africa (EMEA); 8% Japan, 6% Asia-Pacific.

It derives just over half of sales through fees tied to investment indices; the other half comes from portfolio analytics--this includes portfolio modeling tools used mostly by institutions. Growth has two stories: the passive index side is growing at 20% plus year-over-year (yoy) while the analytics side is at ~9% yoy.

The business model is compelling given its 90%+ retention rate and a sales model based largely on recurring annual subscriptions. But, what is is worth?

Valuation: what's it worth?

At it's current valuation of $3.3B, MXB is trading at close to 9x sales, 25x forward earnings and 16x book value. Is it worth it? Let us turn to a simply 10-year discounted cash flow (DCF) model.

Let's optimistically include management's mid-teens revenue growth goal coupled with recent FCF yield of 29%. A multiple of 15x cash flow at the end of the forecast period plus the cash flows of years 1-10 discounted at 10% per year, reveal a per share value of $24--a 27% discount to the current price. This of course is an estimate.

Key concerns

share dilution: 6% increase in share count in 2007

margin expansion: current free cash flow yield (FCFY) of 29% is almost unheard of; mean reversion would have significant impact on valuation: FCFY of 20% would reduce the per share value by over 30%

portfolio analytics business (50% of sales) is less protected from competition

Some thoughts on management
The use of EBITDA (earnings before interest, taxes, depreciation and amortization) multiples is classic managementspeak (2). Charlie Munger refers to EBITDA as "bullshit earnings". Interest and taxes are a reality. They should not be excluded. Nor should depreciation and amortization (where appropriate). An emphasis on real cash flow, both for reporting and compensation purposes, would be more useful. Avoid bullshit.

Last July MXB paid a special dividend of $973M with $325M of cash, and the rest, you guessed it, was borrowed. With no significant capital expenditures and the operating leverage (ex: sales rise 10%, costs rise by less than 10%) of the business, a dividend is understandable but only if the company can't put that cash to work for a higher return elsewhere. The flexibility of a cleaner balance sheet would be welcomed. Borrowing money in this case was a mistake.

Gold star: the company does not provide quarterly guidance. It's refreshing to see people avoid this bad habit.

So what?
At the current price, MSCI is a great business whose valuation more than fully reflects the quality of the business. It's the valuation, stupid.

Quick Overview
Pricing power: average
Oligopoly: yes
Recurring revenue: yes
Brand strength: strong
ROIC > Cost of capital: yes
Balance sheet: average
Valuation: not attractive, yet.

Notes: (1) MSCI Q4 2007 Earnings Conference Call; (2) MD&A section of 2007 10K
Dislosure: No position in MSCI. If you believe markets are efficient, please disregard this post and invest passively, and in regular increments, into index funds.
Image: http://www.midwestcheerexpo.com/images/clipart/money%20machine.bmp

MSCI: A Spinoff Story

2008-03-30T20:00:00.000-07:00

Spinoffs can be a fertile place for investment ideas. The idea is simple. A stock's price, usually, is an unbiased representation of all expected future cash flows of a company from now till judgment day. Understandably, information and transparency drive this estimate of value.

Charlie Munger amusingly stated that stocks are "valued partly like bonds, based on roughly rational projections of use value in producing future cash. But they are also valued partly like Rembrandt paintings." Well said. Don't pay the Rembrandt premium.

Spinoffs are situations where there is often new information, factors not related to economics (e.g., forced selling by institutions due to lack of index membership of the spun-off company), periods of uncertainty regarding the new spun-off company, and an opaque picture of the recent past--often a guide for forecasting. This implies the market is less efficient; that is, there's a greater liklihood the market's estimate of the company's value deviates from its intrinsic value.

Faro is always on the hunt for these types of investments. In November, Morgan Stanley spun-off its MSCI subsidiary, a purveyor of investment indices and risk and return porfolio analytics. Since November, the stock is up 74% (usually spinoffs go down following initial independence). Why is this up so much and is it still a buy? Revenues grew 19% year-over-year while costs grew less rapidly. Below is a snapshot of the firm.

This is largely an emerging market play to be highlighted more in detail in next week's post. Stay tuned, this could be the 7th best investment you've ever made.

Quick Overview
Pricing power: average
Oligopoly: yes
Recurring revenue: yes
Brand strength: strong
ROIC > Cost of capital: yes
Balance sheet: average
Valuation (buy/sell): TBD

Disclosure: I don't knit.
Image: http://www.icelandicsheep.com/Made-with-TRF-wool-photos/Spin-off.jpg

Temperament like Pre

2008-03-22T18:16:00.000-07:00

Buffett and Steve Prefontaine share a common trait. It's not the runner's physique. It's their even temperament.

Steve Prefontaine (Pre), was a former holder of five American track records (2,000 meters to 10,000 meters), made distance running "cool," and is an example of the even temperament found in many who enjoy running.

Proper temperament is paramount for success in both investing and running. Though Buffett is clearly not a runner, he understands the temperament side. To paraphrase The Oracle of Omaha, intelligent investing requires two traits: Ordinary intelligence and and an even temperament. That sounds like an easy recipe for success; the combination is rare, however, and is often accompanied by man's money-making gene.

Intelligence leads to the creation of a simple investment thesis. Temperament helps you avoid the siren songs of the market. And, the money-making gene, is the obsession (in whatever form) with the investment process.

What is temperament?

According to Wikipedia, "temperament is defined as that part of the personality that is genetically based." Dictionary.com defines it as "the combination of mental, physical, and emotional traits of a person; natural predisposition."

So how would one describe the temperament of a runner and how does this temperament potentially limit errors in the investing process? Distance running, especially under intense pain or stress, requires mental, physical and emotional stamina. It requires independence; it is usually a battle with one's self. Running also forces one to ignore exogenous variables and to focus on the few things that count: breathing, form, and pacing. This focus and avoidance of noise is invaluable when making buy/sell decisions.

There are many habits and hobbies that reflect one's temperament. Running is just a painful one that often manifests even temperament; that's half of Buffett's equation for investment success.

Disclosure: I think Pre was awesome
Image: http://www.thefinalsprint.com

How formulaic should stock picking be?

2008-03-15T16:32:00.000-07:00

Ratios, numbers, forecasts, and data points are abundant in the financial world. You can't peruse a financial site or catch a business publication without titles like "5 Stocks to own today." There are obvious problems with that headline: why just five? How do you know what my financial needs are to recommend five nifty stocks?

Some articles are gimmicky, others have merit. On whether to use rough rules such as low P/E, Price-to-Book, or Price-to-Sales screeners, the answers is painfully simple: If you're investing your own money in individual stocks and are comfortable with the gyrations of Mr. Market, and, if you understand (and care) what deferred revenue is, you should consider the question. This understandable excludes most people.

For those who dare to brave the waters of the financial markets, and individual stock selection, two ideas make sense: 1) formulaic & broad screeners that slowing lead to investments in 30+ stocks without care for company specifics (in this case, diversification protects you from stupid picks), 2) in-depth and concentrated (5-8 positions) selection based on a) favorable long-term economics, b) the desire to run the business, if it were possible, for a period of about 5 years, c) a reasonable price tag).

I'd prefer the second option of looking at stocks, though it doesn't create great newspaper headlines.

Disclosure: none
Other: Joel Greenblatt's book "Magic Formula Investing" is a great option if you'd prefer the formulaic approach.

Rethinking Margin of Safety

2008-03-08T20:56:00.000-08:00

"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, Margin of Safety."
-- Benjamin Graham

They've been called the three most important words in investing: margin of safety. For security analysis purposes, it describes the gap between intrinsic value and market value. There's an out-of-print book by renowned value-guru Seth Klarman titled after it that sells for over $1000.00.

Margin of safety serves two purposes: 1) to render "unnecessary an accurate estimate of the future." and 2) to guarantee "....a better chance for profit than for loss--not that loss is impossible."

Of course, this is an absurdity to adherents to the semi- and strong-form efficient market hypotheses, since all information is reflected in the stock price and no advantage can be gained through fundamental analysis. However, it is doctrine to savvy investors who believe the market is occasionally inefficient.

In a rebuttal to the wide acceptance of the efficient market hypothesis, Warren Buffett makes the following distinction: "Observing correctly that the market is frequently efficient, they went on to conclude incorrectly that it is always efficient. The difference between these propositions is night and day."

Does that mean that the margin of safety used by many is frequently illusory since markets are mostly efficient? If that's the case, are we often wishing for a margin of safety with the assumptions we use, and then unwisely believing those assumptions?

This idea can be extremely dangerous as investors make quick judgments about a company's worth and compare it to the value quoted in the stock market and say: "Eureka, I've found a bargain!" Even bright "value" investors, obsessive about correcting psychological errors, developing latticeworks of mental models, and avoiding the "herd" mentality, can fall prey to this. Imagine that. Demosthenes was dead on with these words: "The easiest thing of all is to deceive one's self; for what a man wishes, he generally believes to be true." If what at first glance appears to be a margin of safety, try to disprove yourself first.

Too good to be true?
A non-subprime-related company is trading at close to 20% of book value with all expectations to continue as a going concern. The balance sheet contains minimal goodwill and debt net of cash of $94M with a market cap of $113M and book value of $498M. One could say, we'll as long as they don't loose money year after year, there's a cushion, or margin of safety. But even property carried on the balance sheet for over $300M can't relieve the company of $3.6B in long-term leases. Unless the company improves its profit margin of (1.05%) and/or finds a way to renegotiate its leases, the margin of safety is zero since steady state earnings are impossible to extrapolate into the future. It's a tough business when you're a travel center that derives 80% of sales from fuel. TravelCenters of America (TA) may make changes and focus on its higher margin products and services, or fully integrate its recent acquisition, but until then, the margin of safety appears to be illusory.

Though the above example seems obvious. One must be cautious when estimating a margin of safety so that you're right more often than wrong. The trick is an understandable business model, conservatism in estimating, and transparency in the firm's financial disclosure.

Disclosure: None; Citation(s): Ben Graham, The Intelligent Investor;
Image: http://www.selectrucks.com/images/models-landing/heavy-duty-trucks.jpg

Chairman's Letter

2008-03-01T17:54:00.000-08:00

Writing Puts

Though the press spun the release of Berkshire's 2007 chairman's letter one way, generally a focus on the company's 18% drop in accounting income (a practically meaningless figure), hats off to. FT.com for its article "Buffett defends sovereign wealth funds".

The chairman's letter contains the usual Buffettisms: the aggressive expected-return assumptions used by corporate America in accounting for pension expenses; expensing of stock options; the slide of the dollar; unbelievable candor; the overview of what makes a great business.

Then there was the new stuff: the defence of sovereign wealth funds; his near-term profit outlook for insurance companies; and, what piqued my interest, his expansion into put writing on indices.

Buffett is no stranger to investments outside the realm of boring but good businesses. Those familiar with Berkshire's history know that. But put writing is a first, at least at this scale and with this much disclosure. I cite a paragraph from page 16.

"The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period."

$4.5 billion in option premiums is great "float" to have over the next 15-20 years. These are European options--only exercisable at maturity--and have a strike price at current index levels! This makes me wonder, who is the counterparty? These are fantastic terms for Berkshire as markets will almost certainly be higher 15-20 years from now.

The Oracle's decades of experience and connections are proving again to be a boon for shareholders. The option writing alone is worthy of a headline in the financial press; for now, it seems to appear only in the minds of astute readers and in the blogosphere.

Disclosure: none

Thou Shalt Not Steal

2008-02-23T13:29:00.000-08:00

LoJack Corp. (LOJN)

People will always be inclined to steal, fornicate and envy. A business model that thrives on the violation of one of the Ten Commandments is intriguing. And when you combine that with a leading market position, strong returns on capital, international growth, and a reasonable valuation of 9x free cash flow, this presents a lollapalooza-like effect: factors (social, psychological, and economic in this case) that "are all operating in the same direction."(1)

I quote from the business overview of the MD&A section of the company's 2006 10k: “We are a leading global provider of technology products and services for the tracking and recovery of valuable mobile assets. Our proprietary technology, wireless network and unique integration with law enforcement agencies provide an effective means for tracking and recovery of stolen vehicles and construction equipment." Brevity is good.

LOJN earns 83% of revenues directly through networks of new and used dealers. The systems have a 90% recovery rate in the US and are integrated directly with law enforcement to track and recover equipment, vehicles, motorcycles (and now cargo and laptops). Insurance premium discounts are also mandated or offered in some foreign markets and some states within the US. Growth is a tale of domestic vs. international: while Q4 international revenue is up 59% abroad, it's down 8% domestically on a 13% decline in unit volume--largely attributable to the state of the current domestic consumer and decline in car and light truck sales.

While the current domestic environment is challenging, LOJN has a super-clean balance sheet, strong growth, spins off excess cash, a valuable brand and sound economics. The 1.19M cars stolen in '06 in the US speak volumes of how people routinely break the Ten Commandments. LoJack has a nice business built around that.

Quick Snapshot:
Pricing power: yes
Oligopoly: yes
Recurring revenue: yes
Brand strength: strong
ROIC > Cost of capital: yes
Balance Sheet: A+

Disclosure:

none as of time of post

(1) Charlie Munger

Demographic Investing

2008-02-16T16:53:00.000-08:00

I wish I could boil it down to a nifty list of "The Top 10 Demographic Trends to Supercharge Your Portfolio". Alas, such attempts made by populist business publications do one thing: they use sound ideas, only smattered with gimmickry, to sell magazines. Real 'trends' are often over-priced, as the saying goes, if it's in the news, it's already priced in. So do yourself a favor, ignore the next cover of Fortune and BusinessWeek.

This is not to say long term demographic trends don't matter. The key is what to avoid. As Keynes poignantly stated: “The difficulty lies not so much in developing new ideas as in escaping from old ones.” Avoid the trendy demographic stocks trading at 40x earnings. However, Warren Buffett has used reasonably priced, out-of-favor companies with idiosyncratic risk, to make deft long-term demographic bets (think of human thirst and the psychological power of Coke; men's shaving habits and Gillette; aging and his recent purchase of stock in GlaxoSmithKline).

On to an interesting trend. The increase in Hispanic/Latinos is a demographic worth mentioning which includes the following characteristics: high birth rate; relatively young; increasing economic clout; less likely to use formal banking; and, while not working extremely hard, enjoys lots of Spanish television. If you want lists, Texas has been less impacted by housing. Here are Texas banks with strong Hispanic/Latino population exposure: SBIB, PRSP, CFR. Check 'em out. Another compelling company to research is Televisa (TV). TV trades at 8x Ebitda, has a reasonably clean balance sheet and generates a lovely 28% return on equity. The women on the telenovelas aren't too bad either.

Imperial Sugar Co: more than a thousand words

2008-02-09T21:31:00.001-08:00

Thoughts and prayers go out the families involved in this horrific event after an explosion killed 5 and injured dozens at an Imperial Sugar refinery near Savannah, GA.

That said, the prudent investor asks, "and then what?" The Georgia refiner is one of only two of IPSU's facilities and has a production level of 14.5 million hundredweight or just under 1.5 billion pounds of sugar. This amounts to 57% of the firm's refining capacity and $482M of the company's $851M of '07 refined sugar sales. The question stands. For an interruption in refining that will likely come due to this tragedy, is a market value drop of $20.3M, or 2.4% of sales, commensurate with the underlying risks of production disruption and possible litigation?

The company faces further battles as Mexican sugar is now duty free as of 1/1/08; also, the Farm Bill (subsidies) expires on "September 30, 2008 and is currently under review by the U.S. Congress. The current version of the Farm Bill passed by the U.S. House of Representatives has several key factors which may negatively affect the Company's ability to purchase its raw sugar requirements (fiscal year 10k, page 10)."

All that goes into the sugar you enjoy with your morning coffee.

Emile: or, On Investing

2008-02-03T14:28:00.000-08:00

In his classic treatise on education, Emile: or, On Education, Rousseau extols the virtues of a responsible, natural, and deliberate education with a particular emphasis on maintaining one's natural qualities in a corrupt society. Surprising to some, this work, which Rousseau believed to be the "best and most important of all my writings" has parallels to financial markets. This is fitting. Many investors are obsessed with multi-disciplinary training, and often rightly so. Investing could be seen as the ultimate intellectual exercise which incorporates, among other fields: math, psychology, philosophy, and history. Below are points to consider.

On developing an investment thesis:

“The spirit of my education consists not in teaching the child many things, but in never letting anything but accurate and clear ideas enter his brain.”

On financial analysis:

“It is a question not of knowing what is but only of knowing what is useful”

On circle of competence:

"Thus we are reduced to a very small circle relative to the existence of things”

On contrarian investing:

"Take the opposite of the practiced path, and you will almost always do well."

This Week's Market Moving Earnings Calls

2008-01-27T18:52:00.000-08:00

It's a difficult task to narrow down this week's list of earnings calls/reports from 280 to a manageble 5; however, each day of the upcoming week has reports critical to short to near-term markets. The picks below are concentrated in financials, consumer goods, residential construction, and energy due to their impact on the consumer (consumer spending equals 70% of GDP)--notice the aversion to tech, though AMZN's numbers should be important. The five companies have an equally-weighted return of -33.4% for the period 1/1/07 to 1/25/08. vs. -6.1% for the S&P 500.

Monday - American Express	AXP
Tuesday - Countrywide Financial	CFC
Wednesday - Kraft	KFT
Thursday - Pulte Homes	PHM
Friday - Exxon Mobil	XOM

Merger Arb Plays

2008-01-23T22:30:00.000-08:00

BofA put it's $4B+ offer on the table for beleagured mortgage lender Countrywide Financial.

Terms:
-.1822 shares of BofA (40.57) = 7.39 per share for CFC holders
-2Q2008 closing target according to BofA CEO
-Spread: 23.4% for a 3-5 month closing.

Bottom line:
-Faro outlook is positive for small portion of current cash position

FCC and shareholders approved the Bain/Thomas H. Lee buyout for Clear Channel Communications; pending DoJ's nod.

Terms:
-$39.20 cash per share
-Feb 2008 closing target
-Termination fee of $500m or 12% of equity commitment
-Spread: 21.7% for 1 month closing

Bottom line:
-Faro outlook is positive for small portion of current cash position

Reading Expectations through Stock Prices: Discover Financial Services

2008-01-20T14:35:00.000-08:00

DFS is a company that generates ~$1B per year in free cash flow and currently trades at book value. Of the underlying drivers of firm value (i.e., top-line growth, ROIC, and cost of capital) the most concerning to me is ROIC. This begs the question: at today's price, what is the market's assumption for free cash flow growth over the next four years? If we assume a near worst-case scenario (widespread fraud and bankrupcty would be the worst--though my opinion does not support this) of 4 consecutive years of only $500m in free cash flow--a fifty percent reduction driven mainly by a huge increase in the current charge off ratio of 5%, followed by a return to $1B of cash flow generation followed by a valuation of 10x cash flow in year 10, the value of the company would be ~$10B vs today's current value of $6B. Clearly, the market is seeing a longer period of uncertainty since the implied cash flows out 4 years are being valued at zero! Or, DFS is being overly discounted during the current economic crisis. My guess it that the charge off ratio will grow as high as 10% but in the end most folks will pay their bills.

Quick Snapshot
Pricing Power: yes
Oligopoly: yes
Recurring Revenue: yes
Brand Strength: so-so
ROIC > Cost of Capital: yes
Balance Sheet Strengh: A

Faro Portfolio Performance

2008-01-06T20:33:00.000-08:00

Faro: (9.8%)
S&P: (8.6%)

Highlights: positions have been reduced and shift to cash has slowly occurred throughout Nov. and Dec. 2008 economic stance is flat to slightly down.

inception date: 10/15/2007

2008 Predictions

2007-12-30T20:32:00.000-08:00

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

2007-12-09T17:57:00.001-08:00

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

2007-12-01T21:53:00.001-08:00

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

2007-11-25T15:50:00.000-08:00

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

2007-11-20T19:02:00.000-08:00

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

2007-11-17T18:51:00.000-08:00

"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

2007-11-10T18:05:00.000-08:00

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

2007-11-03T18:42:00.000-07:00

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)

2007-10-27T12:39:00.001-07:00

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

2007-10-26T05:57:00.000-07:00

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

2007-10-25T01:54:00.000-07:00

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

2007-10-24T01:38:00.000-07:00

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

2007-10-23T01:12:00.000-07:00

AMEX sets aside 44% more for loan losses

Ahead of the tape

Daily Journal

2007-10-22T09:25:00.000-07:00

Credit Markets

Why firms are returning to their roots

Abreast of the market

Sulzberger and the NYT

Daily Journal

2007-10-19T06:32:00.000-07:00

'7' and premium denim

Ahead of the tape

Daily Journal

2007-10-18T09:20:00.000-07:00

The moral hazard

Morgan Stanley drops 7% stake in NYT

Ahead of the tape

Daily Journal

2007-10-17T04:25:00.000-07:00

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

2007-10-16T01:13:00.000-07:00

Mattel sees 1% drop in 3Q profit

Icahn at work: BEA Systems gets offer from Oracle

The $100B rescue

Daily Journal

2007-10-15T01:24:00.000-07:00

Plan to 'rescue' banks from mortgages losses

Funeral homes profit squeeze

Boss Talk: Avon

Ahead of the tape

20 years ago

Daily Journal

2007-10-12T01:58:00.000-07:00

The era of dogdy asset pricing is here

Retail sales report

Ahead of the tape

Countrywide lending plunges

Daily Journal

2007-10-11T00:29:00.000-07:00

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

2007-10-10T01:16:00.000-07:00

Miller and Molson Coors to merge US operations

The value and experience of older directors

Ahead of the tape

Sony Financial IPO

Daily Journal

2007-10-09T01:59:00.000-07:00

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

2007-10-08T07:26:00.000-07:00

New Fox Biz channel

Heard on the street

Ahead of the tape

Jobs data and rate cuts

New IPO offerings

Daily Journal

2007-10-05T01:16:00.000-07:00

$100B deal for ABN Amro

Bill Gates on Health Care

VC goes big

Ahead of the Tape

Small Stocks

Daily Journal

2007-10-04T09:05:00.000-07:00

Merrill cleans house

Big Bath?

Daily Journal

2007-10-03T04:56:00.000-07:00

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

2007-10-02T01:01:00.000-07:00

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

2007-10-01T01:52:00.000-07:00

Dollar lifts exports

Interview with CEO of Molson, Coors

Ebay and Amazon

Ahead of the Tape

IPO market

Daily Journal 9/28/07

2007-09-28T01:18:00.000-07:00

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

2007-09-27T01:45:00.000-07:00

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

2007-09-25T01:47:00.000-07:00

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

2007-09-25T01:37:00.000-07:00

Facebook

More on the housing slump

Treasury 'fails'

Daily Journal 9/24/07

2007-09-24T01:23:00.000-07:00

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

2007-09-21T01:00:00.000-07:00

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

2007-09-20T01:29:00.000-07:00

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

2007-09-19T00:00:00.000-07:00

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

2007-09-18T01:08:00.000-07:00

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

2007-09-17T01:00:00.000-07:00

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

2007-09-14T01:58:00.000-07:00

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

2007-09-13T01:30:00.000-07:00

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

2007-09-12T01:02:00.000-07:00

Are homes getting smaller?

When activist investing pays

Small banks and credit ills

High gas prices and customers

Daily Journal 9/7/07

2007-09-06T11:00:00.000-07:00

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

2007-09-06T00:00:00.000-07:00

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

2007-09-05T03:55:00.000-07:00

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

2007-09-04T00:00:00.000-07:00

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.