Wednesday, September 27, 2006

The Newspaper Industry: Cheap or destined for failure?

The onset of the internet has revolutionalized many of our lives for the better, but newspapers are clearly one exception. The internet has reversed the core advantage that newspapers once enjoyed. Newspapers used to dominate their market and people relied on them to inform them of major and local events. Their only other news source was television, which usually was not as extensive and informative. This established a huge audience for newspapers, which was truly their prized asset. Newspapers used this audience to give advertisements and classified ads a way to reach a targeted and local market. Once a newspaper dominated a market, it was near impossible to establish a competing brand. For a long period, these companies used this competitive advantage to earn extremely high returns. Most the cash went straight to shareholder value, because newspapers had minimal capital expenditures that they needed to make.

The internet has changed that. Warren Buffett recently commented on newspaper companies at the 2006 annual shareholders meetings. (courtesy of hypergene Mediablog for the comments)

Do you think that the media business has become permanently less profitable due to new technology?

WB: People will always want to be entertained and informed. But people just have two eyeballs, and there are only 24 hours in a day. Fifty or 60 years ago, media for most people consisted of the local movie theater, radio, and the local newspaper. Now people have a variety of ways of being informed faster (if not necessarily better), and have more entertainment options, too. But no one has figured out a way to increase the time available to watch entertainment.

Whenever more competitors enter a business, the economics of that business tends to deteriorate. Newspapers are still highly profitable, but returns are falling. The size of the audience for network TV is declining. For years, cable TV was thought to operate in its own world, but that’s changing. Few businesses get better with more competitors.

The outlook for newspapers is not great. In the TV business, a license from the government was essentially the right to a royalty stream. There were basically three highways to people’s eyeballs, and companies like P&G, Ford, Gillette, and GM would pay a significant amount of money to be get on those highways and advertise their products to a mass audience. But as the ways to get in front of people’s eyeballs increases, the value of those highways goes down.

World Book used to sell 300,000 sets per year in the mid-1980s, each for $600. Then the Internet cam along; it didn’t require printing or shipping, and people became less willing to pay for World Book sets. It doesn’t mean that it’s not worth $600. But competition has eroded returns.

CM: It’s a rare business that doesn’t have a way worse future than it has a past.

WB: The thing to do was to buy the NFL when it was first organized. There are now more ways than ever to transit events; value can be extracted from them in different ways.

If you were looking at newspaper publishers as possible investments, what would you use as a margin of safety?

WB: What multiple should you for a company that earns $100 million per year whose earnings are falling by 5% per year rather than rising by 5% per year? Newspapers face the prospect of seeing their earnings erode indefinitely. It’s unlikely that at most papers, circulation or ad pages will be larger in five years than they are now. That’s even true in cities that are growing.

But most owners don’t yet see this protracted decline for what it is. The multiples on newspaper stocks are unattractively high. They are not cheap enough to compensate for the companies’ earnings power. Sometimes there’s a perception lag between the actual erosion of a business and how that erosion is seen by investors. Certain newspaper executives are going out and investing on other newspapers. I don’t see it. It’s hard to make money buying a business that’s in permanent decline. If anything, the decline is accelerating. Newspaper readers are heading into the cemetery, while newspaper non-readers are just getting out of college. The old virtuous circle, where big readership draws a lot of ads, which in turn draw more readers, has broken down.

Charlie and I think newspapers are indispensable. I read four a day. He reads five. We couldn’t live without them. But a lot of people can now. This used to be the ultimate bulletproof franchise. It’s not anymore.

CM: I used to think that GM was a bulletproof franchise. Now I’d put GM and newspapers in the “Too Hard” pile. If something is too hard to do, we look for something that isn’t too hard. What could be more obvious?

WB: It may be that no one has followed the newspaper business as closely as we have for as long as we have—50 years or more. It’s been interesting to watch newspaper owners and investors resist seeing what’s going on right in front of them. It used to be you couldn’t make a mistake managing a newspaper. It took no management skill—like TV stations. Your nephew could run one.

That pretty much sums it up. The internet added a huge new competitor by providing a cheaper and quicker way to distribute the news. This clearly has hurt their circulation numbers as more people have migrated to the use of internet. But the problem gets even worse. The internet also provided more effective ways of advertisement. Companies can use pay-per-click models to ensure that every advertising dollar corresponds with an interested user. Classifieds can target national or local markets for practically free through the use of Craigslist or other online classified sites. Newspapers don't seem to have a way to counteract either of these trends. Most companies were too slow to realize the changes happening before them with the interact and didnt prepare for these shifts.

All these problems could be overlooked if newspaper stocks were trading at the right price. But unfortunately, most of the companies are heavily leveraged and their stocks continue to trade at hefty multiples. If you use a discount rate of 10%, you would need a PE of at least 10 to justify flat earnings. But most companies still trade at multiples in the mid teens. These prices do not justify the inevitable deterioration of their core business. At a recent media conference, Warren Buffett raised his hand and asked an executive "If the internet had been invented first, do you think we'd have newspapers today?"
The executive thought for a little and finally responded with a no. "Then that's all you need to know about the future of newspapers."

Of the potential stock investments in the newspaper industry, only one company has stood out as a possible value. This company will be written up shortly. But in general, readers will be best advised to keep newspaper companies out of their investment portfolios for the time being.

Monday, September 25, 2006

The Flaws of the American Democracy

Recently, my political science class was asked to write a paper answering the question, "Is our Constitution a democratic document?" Reproduced below are three paragraphs from my essay which discuss two important trends occuring in our country that need to be addressed. These factors are hurting our government by aligning the interests against democracy in our country.

"The Constitution was skillfully crafted with the provisions necessary to ensure a lasting democracy. The Framers felt they implemented all the ideals necessary to ensure the progress of the United States. Yet, as time has passed, special interests have been able to wield increasingly disproportionate influence and have harmed the democratic process. Is this a sign that our democracy is faulty and destined for failure? Not quite. Rather, certain trends after our country’s formation have allowed money and organization to increasingly influence elections.

Money has been used throughout the history of the country to influence elections and agendas. This problem has increased as campaigns have become more complex and costly, forcing politicians raise more funds. The problem with campaign contributions is that they make elected officials feel obligated to their financial supporters, and this causes them to implement the requests of these few wealthy patrons. The second problem has to do with the rising power of organized groups. Jesse Jackson has said that “in politics, an organized minority is a political majority“. Their political power has arisen due to the increasing pervasiveness of elections today. “A century ago, officials usually were elected on the same day,” but today a citizen is called to the polls repeatedly (FPSV 12). This has deterred a majority of people from participating, leaving the door open for any organized group have significant influence. These groups seek measures that directly benefit them, but the costs are usually spread amongst the entire population. The incentive is not in place for the population to participate in an election simply to vote against a measure that will marginally cost them. As a result of these two factors, special interests can wield unequal power and damage the democratic process as it was intended.

The root of this problem does not stem from a flaw in the design of the Constitution. The massive political organization of the population and the incredible complexity of campaigns were both unforeseeable by the Framers. Simplifying the voting process and coordinating elections so that they fall on fewer days will help voter turn out and decrease the power of organization. Stricter limits on direct campaign financing will limit the conflicts of interest regarding political donations. The Framers spent too much time coming up with an effective form of democracy that protected the individual’s powers and rights. The Constitution is proof that Agnes Repplier’s remarks are false and democracy can be achieved. Many foreign entities would be better off if they set up a government with similar properties of its structure. It would be a shame to allow these minor faults lead people to miss the truly intellectual beauty behind our democratic Constitution."

The Three Rules to Intelligent Investing

In order to practice sound investing, you need to religiously follow these rules. (Courtesy of Ben Graham) Once you truly accept these, your on the path to learning and growing true investment acumen.

1. that you should look at stocks as part Ownership of a business,

2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,

3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.

Saturday, September 23, 2006

Learning from Past Mistakes

I have a mistake that I hope none of us repeat. I invested in W Holding(WHI), a puerto rican bank, a little over a year ago on the belief it was chief. My reasoning was this. The company had a long history of making good returns on equity. It continued to gain market share in its home market, and it was even planning on starting expansion into the US. It had a CEO with a stake in the company and it had a history of never being unprofitable. Plus, it was trading under 10 times earnings.( An analysts estimate of earnings)

So What went wrong? Well, alot of things. For one, i ignored a lot of important factors that must be analyzed for a bank. These factors led to a steep drop off in the earnings/earnings potential of the company. I now understand some of these, though I havent invested in a bank since this incidence. One, WHI was able to grow their market share so fast because they were being very agressive in acquiring funds. A majority of their deposits were high-yielding, something I failed to consider. Whereas some banking institutions, such as Wells Fargo, have a huge supply of virtually costless deposits in the form of checking accounts, WHI was only able to attract all the money it got through its costly savings accounts and preferred shares. The second factor I didnt take into account was the difference between interest and non-interest income. This factor, when combined with the first, can lead to a deadly combination. A bank can only control so much when it comes to their interest spread and profitability. But non-interest income is usally recurring, safer, and far more desirable. Certain banks, again such as Wells Fargo, have a very high percentage of non interest revenue (approx 40%). WHI had under 10%. The result of all this is recent history. As the yield curve flattened, WHIs cost of funds increased while the yields on its loans decreased. It also began to take increased charges for loan due to an increase in bankruptcy filings in puerto rico. (This was another mistake.. the market and economy of the bank's constituency is also very important).

Two dreadful earnings reports and a 20% loss later, I cut my losses and realized there was a lot about the banking industry that was at the time outside my comprehension. The above factors are VERY important to consider when buying a finanial institution, and they probably illustrate two reasons why Buffett continues to add to his Wells Fargo investment.

For a read through several other mistakes, visit the link below.

Thursday, September 21, 2006

Aegis Communications (AGIS): Profitable arbitrage opportunity

Aegis Communications is currently trading at .044 . Its majority shareholder, World Focus, has offered to take the company private at .05 a share, offering a 8.8% after-tax return and naturally sparking my interest. So, as in all arbitrage opportunities, we turn to analyzing the risks and the rewards.

How likely is it that the deal will go through? There are currently 3 main risks inherit in this deal. First, shareholders have the right to protest and demand a fairer value for their share. Second, there is the possibility that World Focus will cancel the deal. Third, and final(and probably the greatest risk), There is approximately 30,000 preferred shares that need to consent approval of the merger, but the company cannot track down the holders and instead is seeking to bypass this step through Delaware courts.

The first risk is unlikely to lead to any problems. World Focus offered a 66% premium to the prior price and they used very generous multiples when coming up with the final price. Also, the only way this risk can bear fruit is if someone protests to the Delaware court of Chancellery. There is no common shareholder vote approval needed.

It is also very unlikely that World Focus will cancel the deal. World Focus currently owns 94.7% of Aegis' stock. To complete the transaction, they have to only use another 3.7 million. Given that World Focus is a subsidiary of the Essar Group, a 15 billion market cap indian company, it is unlikely that the price of the deal will have any funding problems. By taking the company private, they will also be able to eliminate $500,000 in audit and Sarbanes Oxley fees, and the managers can remain focused on the business. Thus, the means and incentive seem to be in place for World Focus to want to complete this deal.

The third risk is the one that could bring about the most problems. The company requires approval from the Series B shareholders in order to complete the deal. As World Focus was unable to locate these shareholders, they decided at the time of filing to go ahead and seek approval through the Delaware Court of Chancellery unless they could be located beforehand. There are several reasons the Series B shareholders will seek out the company though and approve the deal. Prior to this announcement, the Series B preferredholders were recieving no dividends on their shares as a result of one of Aegis's recent debt agreements. World Focus is offering to buy them out at face value plus accrued and unpaid dividends. This allows the holders to cash out with a nice profit on an otherwise risky and unprofitable investment.

BUT, even if the holders cant be located, World Focus has said they have bypassed approval before through the courts and they expect this to be closed by October 30.

*The author has a position in Aegis Communications. All information provided is believed to be reliable and presented for information purposes only.

That is one month and 9 days from now. Assuming it takes longer to complete and also to recieve the payment from your broker, we will assume a scenario of 2 months. That provides a 52% annualized gain, and there is no limit on the amount of shares you can own - unless you buy up all the 3 million in float. For smaller investors, and myself included, this offers a compelling return opportunity and the incentives are in place for the deal to go through.

Tuesday, September 19, 2006

Bancinsurance Corp (BCIS): undervalued and off the radar

Bancinsurance is a microcap insurance company whose main business involves providing insurance against collateral for lending institutions. Basically, if someone defaults on a loan, bancinsurance makes sure that the collateral is still worth as much as it was originally. Bancinsurance provides its services to approximately 400 lending institutions, and it operates in a small and highly profitable niche. So why the great opportunity?

5 years ago, Bancinsurance entered into a new line on reinsurance covering for immigration and bail bonds. The results were disastrous; the company was forced to take a big hit to reserves, their auditors left, and they were delisted from the Nasdaq. Bancinsurances responsed quickly, hiring a new auditor, discontinuing the business, and hiring a legal firm to dispute the charges.

This was 2 years ago. Bancinsurance has now returned to filing, its legal disputes are coming to a close, and its core business is still highly profitable. Adverse loss reserves from the discontinud bond program are pretty much not a problem as the company has already assumed close to worst case scenarios for its legal disputes and the policies were also short-tail. We are left with a company that is severely cheap and with a catalyst to improving earnings.

How Cheap?

BCIS currently has a market cap of 30 million, and total debt of 15 million, minus 4.2 million recieved from the sale of its publishing division, giving an Enterprise value of 40 million. It has a 95 million investment portfolio; assuming a 4% yield, this gives you approximately 4 million in earnings. If discounted at 10%, this gives you 40 million. With simply the investment portfolio, the current price is already justified.


05 04 03 02 01 00 99 98 97 96
Loss Ratio 45.8 95.1 66.1 69.3 56.6 60.7 57.8 63.9 54.4 53.3
Expense Ratio 47.8 34.6 26.0 21.0 35.4 27.4 26.6 16.5 22.1 30.5
Combined Ratio 93.6 129.7 92.1 90.3 92.0 88.1 84.4 80.4 76.5 83.8

BCIS currently writes over 50 million in premiums annually. Historically, the company has averaged combined ratios in the mid 80's. What has changed recently? A comparision of the loss and expense ratios makes this clear. BCIS's expense ratio has increased significantly in the past few years as a result of increased legal and audit fees. The company has been able to increase pricing to compensate for this, resulting in the lowest loss ratio in the company's history. This shows to me the pricing power the company possesses in this niche. Regardless, management has stated by the end of the year they should be mostly finished with their legal fees and the expense ratio should fall to a more normal level.

Assuming the 93% CR the company achieved in 2005, this would be an additional 3.5 million in pre-tax income, or 2.25 million after tax. If the company improves the expense ratio to 37%, that changes it to 5.5 million after tax. If it improves the expense ratio back to the historic average of 25%, it will earn 9.25 million after tax. Combine any of these figures with the 4 million earned from the investment portfolio and you get a net income range of 6.25 million to 13.25 million.

As for manamgent, the Sokol family owns 62% of the stock, does not take excessive pay, and has done a good job steering the company.
At an EV of 40 million, BCIS has a significant margin of safety and a huge potential for upside.

Disclosure: I own shares in BCIS.

Saturday, September 16, 2006

Hi Everyone. I created this blog in order to share my thoughts on a variety of subjects, but I will mostly focus on Investing, Economics, and Politics. I stick to facts and make my decisions based on what I view to be rational. My investment philosophy is based on finding severely undervalued companies that are usually misunderstood or unheard on Wall street, and generally requires a longer term time frame. Occasionally I will post about short term arbitrage ideas that generate attractive annualized returns. With regards to Economics and Politics, I believe in open trade and a free market society, and that government should only interfere to bring about a collective good that individually can not be accomplished. My knowledge and perspective has been influenced by the thoughts and teachings of several "value" investors, most importantly Warren Buffett, Ben Graham, and Martin Whitman. I also gain insight from chronic reading of The Economist. I hope that by sharing my thoughts I will be able to stimulate discussions and criticisms that will challenge me to more deeply analyze and understand my ideas.