Sunday, December 30, 2007

A Look at Abatix Corp.

Abatix Corp. "markets and distributes personal protection and safety equipment and durable and nondurable supplies predominantly to the environmental industry, the industrial safety industry and, combined with tools and tool supplies, to the construction industry." (hat tip to Chris) It is a fairly simple distribution business, and it is a micro-cap stock with a market capitalization of 11.97 million. The company is heavily owned by management (49.2%) and recently de-listed to save the costs of Sarbanes-Oxley regulation, but still reports quarterly financial results for its shareholders. On first glance, there are two things that make an investment in Abatix seem attractive.

First, the company's stock offers a very nice earnings yield. In 2006, the company had net income of $998,000. The company is well ahead of last year so far, with earnings of $995,000 for the first three quarters of 2007. This translates into a 10% earnings yield. There is also a bonus: the company incurred $135,000 in Sarbanes-Oxley costs in 2006 and I estimate at least $200,000 for 2007. These additional expenses will now be gone because the company has de-listed, providing a boost to future earnings.

Second, the company is trading only slightly above its Net Current Asset Value ("NCAV"). As a quick lesson, NCAV was one of Benjamin Graham's favorite measures. It is defined as current assets minus total liabilities. Because current assets are expected to be converted into cash within a year, the NCAV was essentially what the company would be worth if it was liquidated immediately. Of course some adjustments had to be made because things like inventories might not always fetch full value. But when a company could be bought for meaningfully below its NCAV, that represented a great investment. In Abatix's case, the stock is approximately equal to NCAV, meaning if the company stopped operations tomorrow, there would be a safety net for shareholders at approximately today's price. Considering that the company is meaningfully profitable at the moment, this seems like a very low-risk investment proposition.

However, I always recommend looking at a multi-year history of a company and charting some key figures. And looking at the data for Abatix going back to 1996 raises some concerns.


First is the most obvious: although sales have doubled since 1996, profitability has stagnated. The company has been unable to increase earnings or show any consistency over the long term. This isn't surprising, as Abatix is a small player with no competitive advantages, and it operates a business with very minimal expertise and start-up costs. Thus, any increase in earnings will likely be temporary as competition drives down returns.

Second, rather than generating cash flow, the company's earnings have flowed almost entirely into more inventories and accounts receivables. We can see this by taking a historic look at "NCAV - cash". In this situation, since the company has minimal long-term liabilities, NCAV is essentially the same thing as working capital. Since the company does not pay dividends, does not buy back stock, and has minimal capital expenditure expenses, we would expect to see a large cash pile being built up over the years. Instead, we've seen inventories and accounts receivables skyrocket. Thus, the business requires more and more invested capital, in the form of inventories and accounts recievables, just to generate the same earnings as before. This problem is magnified by the shaky quality of both of these assets. At the end of 2006, the company had $9.2 million in accounts receivables and $9.7 million in inventories. For accounts receivables, the company has provisioned $731,000 for bad debts, or 8% of its receivables. For inventories, over the last three years the company has provisioned $165,000, $252,000, and $151,000 for obsolescence. These are both very large numbers and they raise doubts about the safety-net that NCAV will provide in this situation.

Finally, management does not seem to be working in shareholder's interests. The top 3 executives of the company own 49.2%. This large ownership can work in two ways. They can act in shareholder's interests, realizing it is the ethically correct thing to do and that they will still receive half of the benefits because of their shares. Or they can go the second route, and abuse their power to pay themselves exorbiant wages at the expense of their shareholder's interests. A look at management's pay shows that they have chosen the latter route. Over the years, executive pay has steadily increased even as company income has essentially gone no where. Over the past 5 years, the average earnings for the company was $726,600 per year. Over the same period, the top 3 executives took an average of $665,400 in yearly pay. That is a very large chunk of shareholder's earnings going towards their compensation.

So, this began with an idea that seemed simple and looked great from traditional value metrics. But the company has no moat; earnings were coming in the form of inventories and accounts receivables, rather than cold hard cash; and management has put their self-interests ahead of their shareholders. An investment in Abatix may still very well be a low-risk proposition, but these factors are enough to dissuade me from making this purchase.

Friday, December 28, 2007

Buffett's New Bond Insurer

By now everyone has probably read about this, but I just wanted to highlight something:

Warren Buffett is finally moving to make some money from the nation's credit crisis by starting a new company that will insure debt issued by state and local governments...

Unlike Berkshire's Geico property/casualty insurer which stresses its low rates, Buffett's new venture will charge a premium for its likely triple-A credit rating, a price local governments will probably be willing to pay to avoid the now "wobbly" credit ratings of other insurers that backed mortgage-related bonds that "could lead to massive losses and significantly erode their capital."

Here is a summary version of the balance sheets of MBIA, a major bond insurer, and Berkshire Hathaway at the end of the most recent quarter(left column) and the end of 2006(right).

Even after subtracting Berkshire Hathaway's 33 billion in goodwill from equity, we have equity/liability ratios of:

.56 for Berkshire Hathaway
.17 for MBIA

Which brings up an interesting dilemma. People are already questioning the validity of the current AAA-ratings of bond insurers. But credit agencies do not want to downgrade the existing bond insurers because it will set off a chain reaction of further downgrades. And now you have Berkshire Hathaway coming in with its Fort-Knox balance sheet, and everyone is definitely going to favor doing business with them. So what rating can you give to account for Berkshire Hathaway's clearly superior financial strength?

Wednesday, December 26, 2007

RGE: Time To Downgrade the Monoliners

The forest issues is simple: a business – the monoliners’ insurance of securities and holding of risky ABS securities – that is fundamentally based on having a AAA rating is a business that does not deserve a AAA rating in the first place: it is clear to all that if a monoliner were to lose its AAA rating the essence of its business model would fail and such monoliner would have to close shop. But in any industry you have firms that can do business and thrive with an AA or A or even lower rating, even among major financial institutions. Here we have instead an industry that would go bankrupt as soon as its AAA rating is lost: by definition this is not an industry that can deserve a AAA rating. So the issue is not one of how sound these monoliners are managed or whether they have enough capital or whether they can raise new capital to maintain their AAA status. There is a fundamental and conceptual flaw in a business model that is conditional on a AAA rating and that is in a business that insures assets and firms that do not have a AAA rating. This is analogue to the voodoo finance of taking subprime and BBB mortgage backed securities and turning them into AAA by the black magic of CDO tranching.
...
Roubini brings up an interesting point.

Sunday, December 23, 2007

New Position: Finishmaster

This idea begins courtesy of Tweedy Browne:
For instance, in our Value Fund, we recently purchased shares in a small company called FinishMaster, Inc., which is the largest independent distributor of aftermarket automotive paints, coatings and related accessories to the collision repair industry with an estimated market share of 18%. The company buys automotive paint and paint-related accessories from a concentrated group of suppliers (BASF, Dupont, PPG, and 3M) and distributes the products to a highly fragmented customer base of collision repair shops, auto dealerships and organizations that maintain their own automotive fleet. Size in this industry is an important competitive advantage for FinishMaster, because it allows for price discounts and rebates only available via volume purchases from the original equipment manufacturers (“OEMs”). As the only national distributor, they have a cost advantage versus their competitors. They have an excellent long-term operating record, having compounded their intrinsic value at nearly 13% annually. Margins have been stable, and the company generates significant free cash flow, which has been used primarily to pay down debt, and secondarily, to make modest tuck-in acquisitions.

At the time of our initial purchase, the company was trading at 6.8 times trailing twelve-month earnings before interest, tax, and amortization (“EBITA”), and approximately 11 to 12 times earnings per share. At this valuation, FinishMaster provides us—as investor/owners—with an
underlying pre-tax yield on our investment of 14.7% and an after-tax earnings yield of 8.3% to 9.1%. It also appeared to be trading at roughly a 40% to 50% discount from valuations paid in observable acquisitions (buyouts) of comparable companies. This company may sound somewhat boring, but it is cheap, growing, and has what appears to be a sustainable competitive advantage. We’d love to own 100 bargains like this. One caveat is in order. This company is small, and was de-listed in 2003, so it currently trades in the Pink Sheets, and has a publicly available float of only $50 million, so the Value Fund has a very modest position.
For Fiscal 2006, Finishmaster had income from operations of $35,015,000. Assuming a 35% tax rate, that leaves $22,760,000 in after-tax income. But there is also a bonus: Finishmaster's net income understates their true free cash flow.

Depreciation and Amortization over the last 3 years has been:
9,038,000 .... 7,777,000 .... 6,114,000

And Capital Expenditures has been:
2,072,000 .... 3,753,000 .... 3,205,000

So if you assume a run-rate capital expenditure of 3 million, thats an additional 6 million in income, bringing free cash flow up to about $28,760,000 for 2006.

As for the valuation of the company, the most recent quarter had 7,834,000 diluted shares outstanding. Adding the recent special dividend to the stock price brings it up to $32.50. And adding debt brings Enterprise Value to $302,259,000. That means 2006 cash flow yield is at 9.5%. For the three quarters up to this year, net income is down 2.3 million, yet Depreciation and Amortization is also up 2.76 million and the run-rate capital expenditure rate hasn't changed. So free cash flow is about even so far this year, but growth has stalled.

Which brings us to the second factor: Moats. It was already mentioned by Tweedy Browne that they are the largest distributors in their field and have an advantage in terms of volume discounts. But there is also some other things we can perceive from a look at the historical data on Finishmaster:


The chart is not complete, but we see:
1) The company has shown phenomenal and consistent growth over the last 12 years. Part of that has been organic, and part has been because of tuck-in acquisitions.
2) Because their industry has had stable revenues over the years, their growth has been largely due to expanding market share.
3) Inventory Turnover in 1995 was 3.37. In 2005 it was 6.75.
4) The company has been able to reduce operating costs as a percent of sales and gain efficiencies as they've expanded their business. As a result, they have a competitive advantage against smaller competitors and they have been able to reduce gross margins and increase sales, while still expanding their net margins.

Overall, Finishmaster is a pretty simple business, and it provides a necessary service that doesn't appear to be going anywhere. It has possibilities for continued growth by stealing more market share and by using its distribution for expanding into similar products. It has a low cost/market-share advantage over competitors. And as a distribution business, it requires very little in capital expenditures, so the free cash flow is really free. Management appears to be focused on the right things, and is incentivized appropriately with about 73% of the outstanding shares. They have chosen the shareholder-friendly rather than abusive route and their wages are very reasonable. And finally, you can buy a piece of this business at a current yield of 10%.

Wednesday, December 19, 2007

@Google

I happened to stumble across @Google today. It appears that Google regularly hosts famous authors at their headquarters to give talks about their books or whatever is on their mind. And even better, they videotape these discussions and post them on YouTube for everyone to view. You can search through the list here, and there are a lot of notable authors and academics, i.e.

George Soros
Michael Lewis
Paul Krugman
Joseph Stiglitz
Michael Bloomberg
Phillip Zimbardo

There is also Candidates@Google, with discussions from many of the presidential candidates, such as Obama, Ron Paul, McCain, Edwards, and more. This, along with TED.com, has given me a large backlog of informative and interesting videos to watch.

I watched the Authors@Google on Paul Krugman, a respected economist, and took notes on what he had to say. This is my shortened summary of a slightly over one hour discussion.

How we got to our current credit crisis? We had this amazing bubble in housing, which had its origins from the technology bubble before it. Back then the Fed cut rates to 1%, and at the same time money was pouring into the US from outside. Long term rates went down and house prices started to pick up. Afterwards, it was just classic bubble experience, as the price rises attracted more and more speculators. The price-to-rent ratio went up about 50% above historic averages. The housing bubble led to more construction jobs and higher consumer spending.

But, you have to remember Stein's law: if something cannot go on forever, it will stop. The national averages underscored the true regional imbalances in places like California and Florida. There is now huge havoc in the system, yet interestingly financing from abroad still hasn't stopped.

What really happened was lenders were giving loans to people with little or no cushion in the collateral. The Fed has found the rate of change of home prices is the best determinant of foreclosures. If house prices fall 20%, we will have 13 million houses with negative equity. If a 30% fall occurs, 20 million houses with negative equity. That's 40% of U.S. households.

Financial institutions are taking these losses and we don't know where it is. Fed tried to step in August like it was business as usual, similar to previous crisises. This time, it didn't work. We are facing today a solvency problem, not a liquidity problem. The Fed's policies are meant to step in and provide short term lending to prevent an unnecessary loss of confidence and a run on a bank. But this time we have a lot of loans not worth their full value. The question is if this will lead to a recession, and I don't know.

Assume we don't have a complete financial meltdown. It is hard to see what policy or financial engineering we could do. I think it is plausible that financial markets will remain crippled until house prices fall enough, enough loans and bad institutions get cleansed, and then we can continue.

What strikes me is during the tech bubble, we had a new technology with lots of possibilities and no one really knew how to correctly value this potential. But this time, it is just houses...

Sunday, December 16, 2007

TED: Ideas Worth Spreading

TED (Technology, Entertainment, Design) is a semi-annual conference which brings together some of the worlds best and brightest to make a compelling presentation. (hat tip to Erinne) Speakers have approximately 18 minutes to make their case on a variety of topics. Fortunately for us, TED also posts over 150 of the best talks on their site here and they update it frequently. If you are looking for something fascinating and informative to watch, it would be here.

One particularly relevant one is Amory Lovins: We Must Win the Oil Game. Although we hear a lot today about peak oil, we forget that we can also reduce demand. Lovin outlines a few steps which the United States could take to drastically reduce its energy demand for a very low cost per barrel. This has implications for my investment in Harvest Natural as well as any other energy company.

Tuesday, December 11, 2007

Warren Buffett and Hillary Clinton at San Francisco

I heard Warren Buffett and Hillary Clinton speak today as part of a fundraiser in San Francisco. Overall, it went exactly as I expected- Warren showed an uncanny ability to explain things intelligently and simply. Below are some notes I took from the event.


Q: "Buffett, why are you a Democrat?"

A: I have what I call the minus 24 hour genie test. Imagine a genie poofed up 24 hours before you were born and asked you what kind of world you would want to live in. And you being the smart minus 24 hour baby would ask, "what's the catch?" And the genie would respond that you would have to participate in the "ovarian lottery" and draw one of 6 billion tickets. Things such as born United States or Bangladesh; white, brown, or black; male or female; smart or dumb; these would all be completely up to chance. Well then, what kind of world would you create? And my [Buffett's] world would be a society with equality that treated everyone fairly. And the Democrats seem to be better at doing that.


Q: Your views on the US Dollar?

A: The most important question to ask in economics is "X happens, and then what?". We are living prosperously but every day we are sending 2 Billion dollars overseas because we consume more than we purchase. It is similar to if we owned say a large farm in Texas. We are extremely wealthy, but every year we mortgage a little bit of that farm in order to enjoy more of the present. And it is gradual, but then at some point you have to spend an hour or maybe 2 hours a week of your work to go towards servicing this debt. The problem is at some point either foreign investors will stop financing our consumption, or our future generation will be burdened with a debt and have to work some X hours towards servicing the debt of the earlier generation. But the present over-consumption is unsustainable.


Q: Your views on new products such as derivatives, SIVs, etc. ?

A: There's utility in securitizations. But the problem is these have become complex and the originators and investors have been stretched so far in part in the whole process.
"If you can't make money off the things you do understand, how do you expect to make money off the things you don't?"

Q: On Taxes.

A: In the U.S., 2 Trillion out of 2.5 Trillion in taxes come from income and payroll taxes. Of those, 60% is income taxes, and 40% is payroll taxes. I [Buffett] did a survey at Berkshire HQ and the average worker paid 33.2%. I paid 17.7%.

The worth of the Forbes 400 was 220 Billion in 1987, and for 2007 it is 1.5 trillion. A seven-fold increase. During the same period, wages went up only 80%.


Q: What is the best way to get kids off to the right start?

A: The most important job is parenting, and there is no rewind. Imagine if you could get one car of your choice, and get it for nothing. But the catch is you only get one. Well you will do everything and take the best care of it, reading the car manual, garaging it, etc. You should have the same mentality with your kids.

Clinton added: The Federal Reserve of Minnesota did a survey into the best investment that can be made for the country as a whole. Their answer was early education. We have to get government into a quality mentality and improve early education.


Q: Sense for the future of our country Warren?

A: In the 20th century, real standard of living increased seven-fold. That was unprecedented, and included the Great Depression and other scares. The American system has unleashed the greatest potential of its citizens. Back in 1790, China had 290 million people, and America had 4 million. But today look where we are at. We will be better off in the future, the real question is how it will be shared.

Monday, December 10, 2007

An Investing Principles Checklist from Poor Charlie

This is a list by Charlie Munger from his book Poor Charlie's Almanac, and it describes principles which apply to value investors and ordinary people alike. Very quick read and well worth it. (Hat Tip to Lincoln Minor for bringing this to my attention)

“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”

Sunday, December 09, 2007

1933 Inaugural Address of Franklin D. Roosevelt

This was the famous speech in which FDR made the memorable remark:

So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself--nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.
There are some other comments I felt worth mentioning...
Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply. Primarily this is because the rulers of the exchange of mankind's goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.

And also...
Finally, in our progress toward a resumption of work we require two safeguards against a return of the evils of the old order; there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people's money, and there must be provision for an adequate but sound currency.
These 3(?) safeguards seem to have been forgotten.

Saturday, December 08, 2007

Warren Buffett's Coming to San Francisco

A Lunch and Conversation with Warren Buffett and Hillary Clinton at the San Francisco Hilton on December 11th. More information about the event can be found here. If you do buy tickets, please select Michael Billings as your host. I will be attending and I'll take notes of anything interesting brought up.

Roubini: Uncertainty and Risk

This was posted a few months ago, but it is a great read discussing risk and uncertainty in today's financial markets. Direct Link
In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”.
...

Indeed, for many reasons the current market panic has to do with unpriceable uncertainty rather than measurable risk.
...
This increased financial uncertainty is in part due to the increased opacity and lack of transparency in financial markets.

As pointed out by Gillian Tett in a January FT article the opacity of financial markets vastly increased in the last few years thanks to the rise in credit derivatives...

But it is not just credit derivatives that create market opacity. This increased lack of transparency in financial markets is much broader: thousands of hedge funds that not only are unregulated but whose activities are opaque and not measured by any supervisor; shift of the corporate system from a public to a private one via LBOs and private equity transactions; increased size of unregulated over-the-counter trading in derivative instruments rather than on regulated exchanges; development of complex financial instruments whose correct pricing and rating is increasingly difficult; mis-rating of these new instruments by credit rating agencies saddled with severe conflict of interest as a large part of their revenues come from rating these new structured finance instruments; a laissez faire attitude among US supervisors and regulators that allowed reckless lending to foster.

So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing. The last two asset and credit bubbles in the US – the S&L real estate bubble and bust of the late 1980s and the tech stock bubble of the late 1990s – ended up in painful recessions. The latest credit and asset bubble was much bigger: housing, mortgages, credit, private equity and LBOs, credit derivatives, corporate re-leveraging. So, the current bust and de-leveraging of the financial system is likely to lead to another painful economic hard landing.
It has been my own observation that this is true. Many financial companies can just not be valued and have to be thrown into the "too hard" pile. It is not that there is just uncertainty- it is that there is very highly leveraged uncertainty that could very easily wipe out many of these companies. The risk to investors can not be measured, and there is no comfortable margin of safety.

Some financial companies were better and more transparent than others (Wells Fargo, Bank of America come to mind), but they're stock prices have also been only very minimally affected. It has mostly been the most opaque and complex institutions where prices have fallen the most.
Credit derivatives, level three assets, low loss reserves, unmentioned counter-party risks... investors can not value these themselves with the information given in financial statements. An investor would be forced to trust in management's estimates, but these are the same management's that were doing some really silly things a few months ago.

Friday, December 07, 2007

The Economist: Food Prices, Cheap No More

In our series on Tectonic Shift, we have been discussing how globalization and technology are leading to a balancing of wages as:

1. competitive pressures push developed world wages down, and
2. people in the developing world are being employed more productively.

The thesis is that this should lead to an increase in demand for basic necessities which are highly valued, such as food and energy. Meanwhile, more conspicuous types of consumption might start coming under pressure.


Well this week, The Economist had a special report about Food Prices, Cheap No More : (subscription might be required?)

The Economist's food-price index is now at its highest since it began in 1845, having risen by one-third in the past year.
...
Yet what is most remarkable about the present bout of “agflation” is that record prices are being achieved at a time not of scarcity but of abundance. According to the International Grains Council, a trade body based in London, this year's total cereals crop will be 1.66 billion tonnes, the largest on record and 89m tonnes more than last year's harvest, another bumper crop. That the biggest grain harvest the world has ever seen is not enough to forestall scarcity prices tells you that something fundamental is affecting the world's demand for cereals.
...
Higher incomes in India and China have made hundreds of millions of people rich enough to afford meat and other foods. In 1985 the average Chinese consumer ate 20kg (44lb) of meat a year; now he eats more than 50kg.

So we are starting to see increased demand for food leading to "agflation". But it is also important to note that farming is a very basic and low barrier business, and it is cheap and relatively easy to add more production. So we might see prices stabilizing fairly soon.

That is not the situation with oil and paper. Oil has some scarcity and it is becoming more difficult to add production. Paper is a money-losing venture and requires a costly investment. I believe the value of these products to society and the difficulty in adding supply will eventually translate to higher profits for two of my investments, Harvest Natural Resources and SFK Pulp Fund.

Tuesday, December 04, 2007

The Futility of Market Timing

From John Bogle's Of Black Monday and Black Swans:

For example, the Standard & Poor’s 500 Stock Index has risen from a level of 17 in 1950 to 1,540 at present. But deduct the returns achieved on the 40 days in which it had its highest percentage gains—only 40 out of 14,528 days!—and it would drop by some 70 percent, to 276. Or eliminate the 40 worst days; then, the S&P would be sitting at 11,235, more than seven times today’s level. A good lesson, then, about “staying the course” rather than jumping in and jumping out.

The same concept applies to individual stock investments as well. (hat tip to Arpit Ranka)
Empirical research has shown that 80%–90% of investment returns have occurred in spurts that amount to 2%–7% of the total length of time of the holding period. The rest of the time, stocks’ returns have been small. With stocks, you have to be in to win. We believe that value-oriented stocks with extreme investment characteristics are likely to beat the returns from cash over the long run. Index funds stay fully invested with no cash. The long-run odds of having your portfolio generate returns in excess of returns from fully-invested index funds
are enhanced by keeping cash to a minimum and staying as fully invested as possible. (Note: It is a little painful for us to write this section because, in our past, we often sat on our thumbs with too much cash in clients’ portfolios before empirical research and our own analysis convinced us of the error of our ways. We were not knowingly market timing, but were overdiversifying: Instead of investing 3% of portfolios in a perfectly good bargain stock, we invested 1% because we wanted to buy more at even lower prices. Cash, and lower investment returns, were the residual of this process.) - Tweedy Browne Partners. (Link)
If you can buy something for a meaningful discount to its value, then buy and stay the course. If you try to time your purchase too precisely, chances are it will suddenly run up with out you.

Economist: Mean Score on PISA Science Scale

Monday, December 03, 2007

Bill Ackman: How To Save The Bond Insurers

Last month, I took A Practical Look at the Bond Insurers and concluded that bond insurance was a terrible business. They face competitive forces with Mr. Market, with each other, and with their clients. Meanwhile, their accounting profits were largely fictional and reserves could quickly prove inadequate if the credit cycle turned negative.

So it was to my surprise tonight when I saw that Bill Ackman made the same exact point in his Value Investor Congress Slides last weekend in the section he entitles, "Does the Bond Insurance/ Financial Guarantee Business Make Sense?" To show a slide which summarizes the argument:


Overall, it is an interesting read, although it gets a bit technical.

Selling The Brick

The Brick has always been a relatively small holding in my portfolio because I could not get over two main concerns. One was my inability to find any real competitive advantages. Brick had several competitors which were also publicly traded companies. All of them were earning extraordinary returns on investment, yet this was the retail business and I could not see anything to stop them from eventually cannibalizing each other's business.

My second concern was that a credit crisis would have a very large impact on its business. A very large proportion of Brick's sales are made on credit with relatively easy terms. If credit were to tighten, sales would probably be hit hard. This would really hurt the business because of their warranty business. Essentially, Brick's warranty business generates large amounts of cash flow for the company because premiums are paid upfront but claims aren't made until much later. That is great; but the company has chosen to treat this as basically free cash flow and they have paid this money out in their dividends. This process is fine as long as warranty sales are stable or growing, but if they were to decline the process would reverse and the company's free cash flow would be less than its earnings. And if overall sales decline, it is very likely that warranty sales will as well.

Today, the possibility of a credit crisis appears to be much more certain. And I have still to discover any competitive advantages. As such, it appears logical to exit this position now.

The results of the Brick investment depend on your perspective. Over the 8 month holding period and counting dividends, it made 3% in Canadian dollar terms. In US dollar terms however, it made 19.7% (conservatively using a .86 exchange rate for all the dividends). As a US investor, I would prefer to look at the latter, but I think it is only fair to include both. Either way, at only 4% of my portfolio, the position was destined to be fairly inconsequential. It served as a placeholder instead of cash in my portfolio, and in that respect it was successful.

Thursday, November 29, 2007

A Tribute to Minsky, Part I

Hyman Minsky is someone who I have mentioned a few times on this blog, yet I've noticed that I have not ever shared my own interpretations on his work. So in Part 1 of my tribute to Hyman Minsky, I will be going over "The Financial Instability Hypothesis", and what I have built on his idea.

The first thing to understand is the idea of debt-income relationships. This term refers to the idea that a borrower's debt relies on the borrower's income to get paid back. But I think underlying this is an even more general and important relationship: price-value. Below is a chart I came up with.


For now, we will focus just on debt and investment ( I threw the idea of consumption in there just because I know it too plays a part and to remind myself about this later) Debt is a relationship whose value is derived from the borrower's income, and an investment is similarly has its value derived from the underlying cash flow. Now there are some differences between these two. For example, with debt the upside is capped. The borrower's income can triple, but he will most certainly not start paying any increased amount to his bank. But in an investment, any increase in cash flow accrues to the owner. So, we see that:

With Debt, the maximum upside is known and quantifiable. All that exists is downside.
With Investment, the range of values is infinite, meaning there is no limit to your potential gain.

Nassim Talib described this phenomenon as negative and positive black swans. (debt and investment, respectively. See Post) Otherwise, I think you can see that the relationships are fairly similar.

Now the essence of Minsky's work revolved around the idea that debt-income could be characterized into 3 broad categories- hedge, speculative, and ponzi. In hedge financing, the borrower's income can cover both his interest payments and his eventual principal payments. In speculative financing, the borrower's income can cover his interest, but he must either refinance or sell assets to pay the principal. Finally, in Ponzi financing the borrower's income can not cover either the principal or the interest payments. Some people might already be thinking something along the lines of:

"Hey, not even able to afford their interest payments? Isn't that what is causing this mortgage crisis right now, with loans being made to people who could not afford it?"

With the answer being yes. But what is interesting for value investors is that these three classifications apply to the broader price-value spectrum as well. Let's take common stocks for example. We have a purchase price, which is the market capitalization we are paying, and we have the value, which is the company's cash flow. If the company's cash flow can cover both our interest (cost of capital) and the principal (purchase price), then we have a hedge financing relationship. Worded differently, if we can discount the cash flow(cost of capital) and get a value more than the principal (purchase price), then we are hedge financing. Sound familiar? It should, because this is the dictum that value investors live by: A common stock is worth the discounted value of its future cash flow. Our goal is to buy something for less than that.

So let's move down the chain a bit. A speculative arrangement in stocks would mean that the cash flow can cover the cost of capital, but it can not cover the purchase price. And with Ponzi, the cash flow can not even cover the cost of capital. Now in the world of stocks, this environment has usually been referred to as a bubble. Think of the tech bubble as an example. Many companies were trading at earnings yields of 2% or less, while treasury rates were north of 6%. So, an investor in common stocks at that time could not cover his cost of capital out of cash flow.

This analogy has helped me describe the current mess we're in as a true Credit Bubble, or as Minsky would say a Ponzi. Loans were made on a large scale to people who could never afford to make the true cost of interest out of their incomes, yet adjustable rate mortgages helped mask this for some time.

Now some people have tried to claim that the problem will not be so bad because these loans are secured by homes, which have real value. But again, we can apply the all too familiar concept from value investing to show this is not the case. An asset is worth the discounted sum of its future cash flows. We've seen how this is the case for common stocks. A home is the same thing, although with the value being derived from the property's rent. And using current rents, homes as an asset are also in a Ponzi relationship, not being able to cover the cost of capital.

Now it is important to also realize that just because current cash flow does not cover interest doesn't mean it is necessarily a bad deal. I'll use another stock example to make the point. It is perfectly reasonable for me as an investor to invest in Coke at lets say a 4% earnings yield when the cost of capital is 6%, and for it to still be a value. This is because I expect Coke's cash flow to continue to grow into the future. So although currently my cash flow can not cover interest, in the near future it will. If I am correct and Coke's Net Present Value is greater than the price I am paying for it, then it is in actuality still a hedge financing arrangement.

So is there a similar hope for mortgage debt and housing? Well, mortgage debt is based off borrower's income. And housing is derived from rent, but rent is also a function of income. So for these loans to work out, we would need to see incomes rise in the future. And the recent trend is not encouraging. Below is a graph of REAL household income from 1967 to 2005. Nominal would be more appropriate, but I could not find a chart for it, and real incomes is suitable. Since 2000, household incomes have actually declined. An important factor in this has likely been globalization, which I have discussed in the "Tectonic Shift" series. With the competition of the entire world's labor market, it is difficult to assume incomes will be able to rise considerably in the near future.




So for now, that is the dilemma we face. In part two, I will try to expand on this concept and describe some of the possible effects.

Wednesday, November 28, 2007

Hoisington Third Quarter Review and Outlook

Hoisington Investment Management has released their Third Quarter 2007 Report. I am a big fan of their work and I share very similar opinions as they do. I think those who read this to the very end will find this very informative. Some notable remarks:

More amazing, perhaps, is the fact that over the past 5 1/2 years, $1.1 trillion in equity has been extracted from homes. This represents 46% of the increase in total consumer spending over the same period (Table 2). The tightening of credit standards and declining home prices will virtually guarantee that $1.1 trillion will not be extracted in the next few years. Consequently, slower consumer outlay growth can be expected for an extended period.
...
The Fed’s reduction of short-term rates serves to lessen slightly the finance charges of these massive debt burdens, but it does not reduce the magnitude of those obligations relative to income. Moreover, the reduction in short-term interest rates will not serve, at least for the next year or two, to make the household debt more manageable in relation to home prices to which those debts are also directly tied. Thus, credit losses stemming from the debt binge of this decade are far from being realized, and the recent tremors of the credit markets may be a sign that all is not well.

Four considerations suggest that the current housing depression will continue for at least the next two years. First, home prices remain near record highs in spite of the largest yearly decline on record...

Second, housing starts and building permits are still well above prior cyclical lows, despite the 42% decline in both...

Third, there is a record inventory of unsold homes relative to sales--nearly ten months for existing homes and 8.2 months for new homes...

Fourth, nearly $800 billion of adjustable rate mortgages will reset between October 2007 and December 2008, with the peak in the first and second quarters of 2008....

While a decline in wealth would be spread out over time, the housing sector would impair consumer spending in other ways. Falling home prices will result in additional losses for the financial sector, which, in turn, will tighten lending standards and reduce credit availability for consumer spending. Also, job losses in housing and related sectors will limit the growth in household income, putting consumer spending under downward pressure. Accordingly, domestic demand growth should continue to weaken, serving to transmit the U.S. growth recession to the rest of the world.

A continuing contraction in both the growth of total reserves and the transactions-based monetary aggregates, as well a downturn in the velocity of money, suggest that monetary conditions remain restrictive. These monetary considerations, combined with greater slack in the labor markets, will serve to put additional downward pressure on the inflation rate. Even though a weak dollar and increases in commodity prices suggest that inflation will rise, this is not likely to be the case. Demand will be too weak to allow cost increases to be passed along to consumers. Thus, weakness in domestic demand suggests that profit margins will be compressed in this environment.

Yellow BRK'er Party Information

I am not planning on attending the Berkshire annual meeting this year, but those of you who are should consider this:

Yellow BRK'er Party Information Details (Friday, May 2, 2008)

Yellow BRK'er Party Information:

2008 Meet & Greet Happy Hour

Date: Friday, May 2, 2008
Time: 4:00 pm - 7:00 pm
Place: DoubleTree Hotel, Omaha

Berkshire Hathaway shareholders from all online communities are welcome.

If you feel most comfortable wearing a suit, go for it. With that said, it's Omaha; please feel under no such obligation. This is a casual atmosphere, with light snacks available. It's a "happy hour" type of gathering - not a formal dinner or anything of that sort.

The DoubleTree is located on 16th and Dodge. There may be some street parking, otherwise, one can use the parking garage with an entrance from the South at 16th & Dodge street, just east of the First National Bank.

To RSVP:
http://www.yellowbrkers.com/

---

Directions to venue:
http://tinyurl.com/ystqqb

About Yellow BRK'ers:
http://tinyurl.com/2fqajh

---

2008 Official Berkshire Hathaway Annual Meeting Press Release:
http://www.berkshirehathaway.com/meet01/2008meetpre.pdf

Sunday, November 25, 2007

Remember the Frog

CR: What is Subprime?

The main impact of subprime lending on the overall mortgage business was the take-out function. As subprime lending grew, you saw better “performance” of prime or near-prime mortgage portfolios. This was not because subprime lending did away with the traditional default drivers of job loss, illness, divorce, or disorderly conduct; it was because loans in that kind of trouble had a place to go besides foreclosure. Prime lenders could and did congratulate themselves on their low foreclosure rates as if it were a matter of their superior underwriting skills, but that involves a high degree of naiveté. It’s really important to understand this issue, because it gets to the heart of the “contagion” thing. It is not that subprime delinquencies are “spreading” to prime loans as if some infectious agent were in play. It’s that the drain got backed up: when subprime lenders go out of business, or investors won’t buy subprime loans, there is no place for the inevitable prime delinquencies to go except foreclosure. Prime delinquencies become “visible” because they don’t move out of the prime portfolio via refinance into the subprime portfolio, where we “expect” to see them.

Friday, November 23, 2007

Prem Watsa: He Has Never Been More Bearish

In a rare interview, the chairman of Fairfax Financial Holdings Ltd. said he thinks it's possible the United States is on the cusp of a prolonged market slide, similar to the one endured by Japan between 1990 and 2003, when the Nikkei index plunged 80 per cent.

...
Mr. Watsa suggested the decision to put 75 to 80 per cent of Fairfax's portfolio .into government debt - "for the first time, I think, ever" - reflects his view that credit markets will take a long time to digest the problems in the U.S. real estate and mortgage business.

"We don't know how bad the recession's going to be, so credit is going to be tough," he said. "You're going to have these big losses, the banks are going to have big losses. So we are worried."

Mr. Watsa took particular aim - not for the first time - at the structured-products industry on Wall Street and Bay Street. Many of those securities got high ratings from the credit agencies, but have cracked under the strain of rising U.S. mortgage defaults.

The Fairfax chairman said the products were always flawed because they shifted the risk away from the person making the lending decision - which encouraged auto finance or mortgage companies to give loans to almost anyone, since they would not have to bear the losses on defaults.

Positive Black Swans

As I received my copy of The Black Swan back last night, I began flipping through some of the pages just as a refresher. I luckily came across one of my favorite paragraphs, and a concept which I had almost forgotten:
Learn to distinguish between those human undertakings in which the lack of predictability can be (or has been) extremely beneficial and those where the failure to understand the future caused harm. There are both positive and negative Black Swans. William Goldman was involved in the movies, a positive-Black Swan business. Uncertainty occasionally pay off there.
A negative-Black Swan business is one where the unexpected can hit hard and hurt severely. If you are in the military, in catastrophe insurance, or in homeland security, you face only downside. Likewise, if you are in banking and lending, surprise outcomes are likely to be negative for you. You lend, and in the best of circumstances you get your loan back- but you may lose all of your money if the borrower defaults. In the event that the borrower enjoys great financial success, he is not likely to offer you an additional dividend.
Aside from the movies, examples of positive-Black Swan businesses are: some segments of publishing, scientific research, and venture capital. In these businesses, you lose small to make big. You have little to lose per book and, for completely unexpected reasons, any given book might take off. The downside is small and easily controlled. The problem with publishers, of course, is that they regularly pay up for books, thus making their upside rather limited and their downside monstrous. (If you pay $10 million for a book, your Black Swan is it not being a bestseller.) Likewise, while technology can carry a great payoff, paying for the hyped-up story, as people did with the dot-com bubble, can make any upside limited and any downside huge. It is the venture capitalist who invested in a speculative company and sold his stake to unimaginative investors who is the beneficiary of the Black Swan, not the "me too" investors.
I had forgotten this idea of positive Black swan type businesses, and I came up with a little exercise: Could you recognize the potential in Google, a real positive-Black Swan business, and invest in it at its IPO?

In 2002, Google had revenues of 439 million and 185 million in income before taxes.
In 2003, Google had revenues of 1,465 million and 346 million in income before taxes.
In the first half of 2004, Google had revenues of 1,351 million and 325 million in income before taxes.

If you annualized the first half of 2004 numbers, you get about 430 million in net income. Now, taking into account its growth prospects, what value would you pay for the company at that time?

Well, the market capitalization of Google at its IPO was 27 billion. So you were paying 62 times earnings, a multiple which would make many value investors cringe. And there was only 1 billion in shareholder's equity, leaving no safety in the traditional Ben Graham sense. But Google was also doubling its revenues and earnings each year, and it offered great value to both consumers and businesses. Today, the company is earning 4 billion a year, so the initial valuation seems actually very cheap.

How has Google defied logic and built a such a profitable internet company? Where is the moat? Well I guess (and I'm no expert) what makes it different from other internet companies is the fact that nearly everyone sets a search engine as their home page. And although other search engines now have similar performance, the fact that Google had the best engine first has made it "sticky"- every time a consumer opens his web browser it pops up, and they really have no reason to switch. In contrast, there is exogenous factor compelling me to go to Expedia every time I want to book air travel. I believe this is what has allowed them to keep their market share and hence make it the most valuable company to advertisers.

I looked at Google at its IPO and I knew it was a positive-Black swan type business. But I also knew that "paying for the hyped-up story, as people did with the dot-com bubble, can make any upside limited and any downside huge." So I passed because I thought it was too expensive and couldn't see the moat. But if you saw the competitive advantage, then the valuation of Google really depended on the potential for the online search and advertisement market, and that was much more obviously enormous. In the end, there are two important points to remember. One, the most important factors are the value a business provides and the moat around it. Two, keep your mind open.

Wednesday, November 21, 2007

Brick Income Fund 3rd Quarter Report

This one almost slipped by me considering there was no news report on Yahoo. Thankfully it was a pretty good report.
We are very pleased with our third quarter and year to date results. Sales remain strong, reflected in our seventh straight consecutive quarter of same store sales growth, driven by a strong promotional calendar. As we had in the first half, we continued to make good progress on managing key revenue and expense line items. In its most simple terms, our strong quarter was driven by more effectively executing against strong written sales. We have improved our supply chain, reduced inventories, improved our cash position, and narrowed our focus to driving sales and maximizing customer satisfaction. Management remains excited not so much by what we have done, but more so by what we believe the future holds.

The strong Canadian dollar has been killer for SFK. But in the case of the Brick, the benefit has been twofold. One, because the Brick does its retailing business in Canada, the value of its profits and its business increases for me, a US investor. Two, because some of their purchasing costs are in US dollars, the Canadian rise has decreased their costs and so also helped to boost their profits. I'm reminded of something Pabrai said at his annual meeting, which was approximately- "We don't try to specifically hedge for events in our portfolio, it just ends up working out that way."

Tuesday, November 20, 2007

Updated- More Pulp News

Yesterday, Pope and Talbot filed for Chapter 11:
Pope & Talbot, Inc. (PTBT.PK) announced today that, in order to address its financial challenges and to support efforts to be a more efficient organization, the company has filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code...

Persistent record low demand for lumber, high priced pulp chips and sawdust, the appreciation of the Canadian Dollar and the high cost of debt service have combined for an untenable business environment.
And today, the company announced wood pulp price increases:
Pope & Talbot, Inc. today announced a $30 price increase to its customers in North America and Europe.

Concurrently prices into Asian markets will be increased by $20 per ton. All prices are effective December 1st and valid until further notice.

This is on top of the $20 price increase in November, and will bring the new price to $900 in North America. In addition, the Canadian dollar has finally eased from its relentless climb. These are encouraging trends for SFK Pulp. By my calculations, Pope and Talbot's pulp operations would still require another $50 in price increases just to make them EBITDA neutral (Assuming 1.01 CAD/USD exchange rate). It will be interesting to see in the coming months whether they will be able to exert even more pricing power.

But in the meantime, SFK did cut its distribution down to $.01 unit, and at the current pace the 4th quarter numbers look like they will be very weak.

From Tembec's 4th quarter earnings report:
Reflecting the strength of the pulp market, inventories were at 19 days of supply at the end of September, down from 20 days at the end of the prior quarter.
And from Catalyst's Earnings Report:
Global NBSK pulp markets continued to be strong with global
pulp shipments up5.2% in Q3 year-over-year and 2.7%
year-to-date. Strong demand and low inventories prompted
NBSK price increases of US$10 per tonne to US$30 per tonne,
effective September 2007. The average Northern Europe NBSK
benchmark price in Q3, 2007 was US$810 per tonne, up US$27
per tonne, or 3.4%, from Q2, 2007. Compared to Q3, 2006,
the average benchmark price increased US$100 per tonne, or
14.1%.

Monday, November 19, 2007

Peter Eavis Is At It Again

Long term shareholders of Fairfax Financial surely remember Peter Eavis, TheStreet.com journalist who repeatedly claimed the company was under-reserved, unethical, low on cash, and heading for bankruptcy. The allegations and the bias got so bad that Sanjeev Parsad from the Berkshire Board wrote a response letter to TheStreet.com explaining the problems with many of his claims. But this didn't stop Eavis' reports from causing panic and hurting Fairfax's share price in the short-term.

That was back in 2004. Flash forward to today and we see the same thing, but with a different company. Almost a week ago Eavis published an article criticizing Fannie Mae's credit loss ratio accounting as "fuzzy math", and claiming "Uh-oh. It's Enron all over again." It was enough to send the share price diving nearly 20% and compelled the company to hold a conference call explaining the reason for the change. After the conference call though, Eavis maintained his original position and published his second article reaffirming his original claim.

In comes Tanta from Calculated Risk to the rescue with her response- Fannie Mae's Credit Loss Ratio: Fuzzy Math or Fuzzy Reporter?.
This is going to be a long post. It is going to attempt to answer the question stated in the post title. It is also going to function as further proof of the old axiom that you can create quite a ruckus in 150 badly-chosen words, but it takes ten times that many words (at least) to return some sanity to the discussion. “Gotcha” reporters of course know this, which is why they do what they do. Most people don’t have the time or desire to wade through the high-attention span Nerd part to evaluate the reporter’s claim. That it’s a deadly serious business for anyone who owns shares in a publicly-traded company being compared to a criminal conspiracy on the basis of a misunderstanding of accounting rules doesn’t seem to bother writers who just want a “scoop.”
After exposing the flaws in Eavis' argument, she concludes with the following:
I firmly believe in beating the press up a little when they do egregiously bad reporting, but that’s largely because I care about understanding what the real story is. And I hate being distracted by red herrings in my personal quest for understanding. Yesterday I spent over two hours rooting through SEC disclosures and listening to a 57-minute conference call trying to independently verify Eavis’s point; today I’ve spent a couple of hours writing this post. I am willing to believe that very few people have the time and the expertise to do what I just did. I therefore feel compelled to share my point of view with the rest of the world, in the interest of a worthwhile public discussion of financial and economic matters, which is the purpose of this blog. So I didn’t start out with the goal of catching Eavis being a lousy reporter; I started out with the goal of reading about Fannie Mae in a CNN Money article. But I believe that I did discover hyped, misleading, and ignorant reporting, and I believe it is fair to say so in public. (my emphasis)
I think Tanta summarizes the dilemma well. The truth takes more than 150 words, but most people still want their news in such shortened form. And as long people want the truncated version of things, then they will have to live with occasionally mixing up some of the bad with the good. Since I am in the midst of reading a book on Einstein, I will end with one of his relevant quotes: "Blind respect for authority is the greatest enemy of the truth."

Friday, November 16, 2007

Tectonic Shift, Part III

The idea of the tectonic shift first came from Mohnish Pabrai's Mosaic, in which he mentions:
There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.
This is Part III in our look at this effect being caused from globalization. (Links are here for Part I, Part II) I recently finished reading Robert Reich's The Work of Nations, which takes a close and honest look at this problem. Below are some key points from the book.

The economic well-being of Americans no longer depends on the profitability of the corporations they own, or the prowess of their industries, but on the value they add to the global economy through their skills and insight. This is because today capital and goods can flow nearly uninhibited. So, corporations seek to invest where the skills they require can be attained for the lowest cost.

There are 3 broad categories for American jobs:
1. Routine production services - repetitive tasks, done over and over again, performed in the high-volume enterprise. These face competition from worldwide labor and require little skill, and so these jobs are quickly moving to areas with the cheapest labor.

2. In-person services - Like routine production services, in-person services also entail simple, repetitive tasks. Their pay is also a function of hours worked or amount of work performed, they are closely supervised, and they need not have acquired much education. The big difference is that these services must be provided person-to-person, and thus are not sold worldwide. Included in this category are retail sales workers, waiters and waitresses, hotel workers, janitors, cashiers, etc. Because of this local requirement, their wages are not deteriorating as fast as routine production services, but supply and demand still does not bode well for them. As routine production services move offshore, there is a larger supply of workers looking for these in-person service jobs.

3. Symbolic-analytic services - includes all the problem-solving, problem-identifying, and strategic-brokering activities. Examples include consultants, specialists, engineers, bankers, scientists, etc. This group is adding the most skills to the global economy and can not be easily replicated.

There is a growing inequality, as the skilled get richer and poorest get hurt by competition.
The law of supply and demand does not bode well for routine and in-person services.
Differences in education has played a very large part in wage outcome.

The important skill is learning how to conceptualize problems and solutions. There are 4 basic skills: abstraction, system thinking, experimentation, and collaboration.
1. Abstraction- making sense of all the data that surrounds us.
2. System-thinking- relating abstraction to different information; seeing the whole.
3. Experimentation- continuously trying out new things.
4. Collaboration- working with peers to share information and expand knowledge.
From then on, knowledge comes from doing.

There are two reasons America will stay ahead of the pack:
1. No nation educates its most fortunate and talented children as well as America.
2. No nation has the same agglomerations of symbolic analysts already in place, with the ability to learn continuously and informally from one another.

America has several large cities with special skills; think Hollywood for film production, Silicon Valley for technology, New York for finance and law. More talent is encouraged to these areas because there are more opportunities and there is a large network to informally learn from.

The role of the nation within the emerging global economy should be to improve its citizens' standard of living by enhancing the value of what they contribute to the global economy. The problem is some Americans are adding substantial value, while most are not. This is leading to growing inequality, and the bottom four-fifths requires the fortunate fifth to share its wealth and invest in the wealth-creating capacities of other Americans. Ironically, as the rest of the nation grows more economically dependent than ever on the fortunate fifth, the fortunate fifth (the symbolic analyst) is becoming less and less dependent on them.

Finally, just a particular quote I like from the book:
The predictable failure of all prediction notwithstanding, the public continues to pay attention to stock analysts, trend spotters, futurologists, weather forecasters, astrologers, and economists. Presumably such respect is due less to the accuracy of their prophecies than to the certainty with which they are delivered. The reader of these pages is duly warned...

Delta Financial: New Financing

A few days ago, I mentioned the following about Delta Financials 3rd Quarter Report:

But the very poor delinquency performance of their securitizations this quarter show two things. One, their equity is in danger of being wiped out, and that another cash infusion at very unfavorable terms will probably be necessary. Two, Delta's niche underwriting in the sub-prime market might not be as good as they made it out to seem.

Today, we got confirmation of 'One'.

Delta Financial Corporation (the “Company”) entered into a letter of intent, dated November 15, 2007, with an affiliate of Angelo, Gordon & Co., one of the Company’s principal stockholders...

If the proposed transaction is completed, an affiliate of Angelo, Gordon & Co., AG Special Situation Corp. (“AGSSC”) will purchase from the Company a new series of 10% Senior Secured Notes. The maturity of the notes will be three years after issuance. The initial aggregate principal amount of the notes will be equal $100.0 million, minus the principal amount outstanding under the August 2007 residual financing facility as of the issuance date of the notes. The Company currently estimates that if the transaction closes in December 2007, such principal amount will be approximately between $45 million and $49 million, such that the initial principal amount of the 10% Senior Secured Notes will be between $51 million and $55 million. Interest on the notes is expected to be payable on a payment-in-kind basis until the first anniversary of the closing date. In connection with the proposed note issuance, the Company will issue to AGSSC 40 million newly issued shares of common stock as additional consideration, which may be initially issued in the form of convertible preferred stock or convertible debt securities. The Company will also reduce the exercise price of Angelo Gordon’s warrants to purchase 10.0 million shares of common stock to $1.00 per share. The warrants remain due to expire in February 2009.

...

If the transaction closes as planned, Angelo Gordon will be the beneficial owner of approximately 61.4% of the Company’s outstanding common stock, and approximately 66.5% of the Company’s outstanding stock if it exercises all of its warrants. Upon the closing of the transaction, subject to certain limitations intended to comply with certain state lending regulations, AGSSC will obtain the right to elect a majority of the Company’s Board of Directors. AGSSC will also obtain registration rights with respect to the new shares of common stock, and preemptive rights with respect to the issuance of new shares of the Company’s capital stock.

The company had about 24 million diluted shares outstanding at the end of the 3rd Quarter. The company is giving Angelo Gordon 40 million new shares just for the ability to borrow money- $55 million at 10%.

Thursday, November 15, 2007

Wells Fargo CEO: Housing Slide Not Over

Here is a link to the article.

Wells Fargo & Co. President and Chief Executive John Stumpf said Thursday the housing market is experiencing its worst decline since the Great Depression.
...
Stumpf said the weakening market is due to a combination of factors, ranging from too much demand for homes during the first half of the decade to an increase in fraudulent loans and risky loan products.

Wells Fargo has increased loss provisions in recent quarters to cover increasing defaults on mortgages and home-equity products. Declining home prices have led to larger losses in Wells Fargo's portfolios, though so far, the increased losses are related more to severity than increased frequency of losses, Stumpf said.

The slides and audio for this conference can be accessed here. Some notable information from it:

- Unprecedented decline in national home prices
- Increase in losses in Q3’07 primarily a severity issue
- Certain markets with more housing stress – e.g. Midwest and CA Central Valley
- Correspondent channel: 7% of portfolio at 9/30/07, yet 25% of Q3’07 losses
- Disproportionate losses in correspondent channel. Contributing factors:
1. Acquired closed loans from third party originators
2. Typically purchase-money loans
3. Higher CLTVs at origination
4. Average CLTV at 9/30/07: 74% total home equity portfolio. 87% correspondent portfolio
5. Largely concentrated in 2006 and first half 2007 vintages
6. Largely sourced in MSAs that experienced steep, sudden
declines in housing values


Briefly, the retail channel refers to loans made by a company's own loan officers, while wholesale and correspondent loans are made by third-party brokers/salespeople. There is an UberNerd on Mortgage Origination Channels which explains this in detail, as well as some of the problems that it has caused, much better than I ever could.

Wednesday, November 14, 2007

Bancinsurance 3rd Quarter Earnings

This was not a typical filing. I'm going to separate this discussion into two parts, the operational side and the legal side.

Operationally, this quarter was a blast. The news reported premiums were down, but a closer look shows that they are writing more premiums than ever- they are just ceding more to their Producer-Owned Reinsurance Companies (PORC's).

Now, these ceded policies do earn a nicecommission:

During the three months ended September 30, 2007 and 2006, ceded reinsurance decreased commission expense incurred by $1,571,611 and $300,420, respectively, and $4,456,986 and $1,061,833 during the nine months ended September 30, 2007 and 2006, respectively.

Overall, earnings were boosted by a low tax rate and hurt by a realized loss on an investment, the effects of which approximately cancel each other out. But "normalized" earnings for the quarter of about $1.6 million was a big improvement. During the quarter the expense ratio dropped to 31.4% from 44.6%, which was one of the expectations in the original analysis. Meanwhile, book value per share increased to $39.4 million, and the stock is currently trading at a market capitalization of about $30 million. So on a pure-numbers we see this is definitely cheap.

Now, the legal front is where some uncertainty arises. With respect to the discontinued bond program, this statement from the last 10-Q was still present:

Highlands has provided loss information to the Company with respect to alleged losses for bail bonds issued in the State of New Jersey and for federal immigration bonds. Highlands has indicated in filings that it has additional exposure for bail bonds issued in states other than New Jersey. Highlands has not provided sufficient information for the Company to quantify these additional losses. As of September 30, 2007, the Company is reserving to its best estimate of future Highlands losses based on the most recent loss information received from Highlands with respect to immigration bonds and New Jersey bail bonds only.

Meanwhile, on a slightly more positive note:

In October 2006, the Company commenced arbitration against Ernst & Young LLP (“E&Y”), the Company’s former independent registered public accounting firm, in accordance with the terms of the engagement letter between the Company and E&Y. In the arbitration, the Company alleges that E&Y improperly withdrew the Company’s audit reports for the 2001 through 2003 fiscal years. The Company is seeking monetary damages in excess of $21 million. E&Y has counterclaimed, seeking to recover in excess of $475,000 from the Company for unpaid invoices and additional costs. An arbitration panel has been constituted and the hearing is currently scheduled for December 2007. The Company does not believe the ultimate resolution of this dispute will have a material adverse effect on our financial condition or liquidity. See Note 14 to the Condensed Consolidated Financial Statements for subsequent events related to the E&Y arbitration.


....

In connection with the Ernst & Young arbitration disclosed in Note 10, on November 12, 2007, the Company and Ernst & Young tentatively agreed to a settlement of this dispute whereby the Company would release its claims against Ernst & Young and Ernst & Young would agree to pay the Company $20,000 and forgive its counterclaim of $475,000. Upon execution of a settlement agreement, which is currently anticipated to be sometime during the fourth quarter of 2007, the Company would record a pre-tax gain of approximately $0.5 million related to the Ernst & Young settlement.

This was surely settled though just to save them both from a big legal battle. The sum being paid was very insignificant, so we can not assume any particular strength to Bancinsurance's claim. I mention this as important because the following was also new in this 10-Q:

On October 23, 2007, the Company and certain of its current officers (Chief Executive Officer, Chief Financial Officer and Vice President of Specialty Products) received a “Wells Notice” (the “Notice”) from the staff of the SEC indicating that the staff is considering recommending that the SEC bring a civil action against each of them for possible violations of the federal securities laws. The Notice provides the Company and each officer the opportunity to present their positions to the staff before the staff recommends whether any action should be taken by the SEC. The Company continues to cooperate fully with the SEC and intends to continue to do so in an effort to resolve this matter.

Pursuant to separate undertaking agreements dated November 12, 2007 between the Company and each officer who received the Notice, the Company has agreed to advance reasonable legal fees and expenses incurred by each officer in connection with the ongoing SEC investigation. The undertaking agreements require each officer to repay the amounts advanced if it is ultimately determined, in accordance with Article Five of the Company’s code of regulations, that the officer did not act in good faith or in a manner he reasonably believed to be in or not opposed to the best interests of the Company with respect to the matters covered by the SEC investigation. A copy of the form of the undertaking agreement is attached to this report as Exhibit 10.2 and the foregoing discussion is qualified in its entirety by reference to Exhibit 10.2. Under the Company’s code of regulations and Ohio law, the Company may also be required to indemnify each officer in connection with the SEC investigation.

That is something that I was hoping would not happen. You can read up more about Wells Notices (in general) here. We know from the 10-Q that this case "concerned the chronology, events and announcements relating to Ernst & Young LLP (“E&Y”), our former independent registered public accounting firm, withdrawing its audit reports for the years 2001 through 2003 for the Company." Finding out how costly this can be will be important in judging its ultimate impact. Overall, while the business showed improvement this quarter and valuations became more compelling, a new risk has also popped up with regards to this SEC matter.

The Logician

Plato, through the character of Socrates, has a specific method of presenting his position on a given topic. His method of argument being comprised of three steps:

1. Starting with certain premises
2. Through a process of reasoning, leading his opponent to
3. His conclusion

The only way to dismantle the so-called “Socratic method” of argument is also a three-step process:

1. If the truth of the first is challenged successfully
2. And if the remaining premises that are based on original premise follow logically
3. The conclusion is false

Now the first time I read this, I didn't really understand its significance. It seemed to me a pretty obvious statement. But while sitting in class a few days back I had a striking thought about this quote and about technical analysis. What are the initial premises which form the basis for technical analysis? It appears to be the idea that a stock's future price can be dictated by its past price action. But that premise can be so easily challenged, and there seems to be no way to show how or why past price action has any effect on future stock price. The only thing I was able to think of is that if you see large volume of buying, that perhaps this signifies a big buyer is trying to accumulate stock and so this should push the price upwards in the near term. But this is easily challenged, too. 1) You have no idea whether this buyer is done buying or not. 2) If you are basing your logic on the fact that you are following buyers who have come up with their own sound reasoning, then that is flawed too- everyone has opinions, most will likely be wrong. And for every buyer there is a seller, so someone else is obviously disagreeing.

Now compare that to the idea of value investing. By value investing I don't mean buying beat-up companies or companies that appear cheap. I mean buying companies for less than their expected discounted cash flow. You can challenge this by asking, "what's to say a company will eventually trade at its DCF?" There is a solid response to this though: the company can use this cash flow to pay out dividends, ensuring that an investor will recognize the value of his investment. "What if they don't pay out their cash in the form of dividends?" Then investors can get on the board and force this to happen. "What if the board and founders own a majority stake and refuse to treat shareholders properly?" Well, in that situation, you might be out of luck. Still, we see that the foundation for value investing is based on a much more solid framework.

Now despite this shakiness to the ideals of technical analysis, there is no shortage of people who have faith in this system. Just turn on CNBC one morning and you will see for yourself. And they have come up with elaborate techniques and fundamental rules, yet they don't realize that the foundation of their entire belief structure is suspect.

And unfortunately, I think this is prevalent in society. And a lot of bad habits are taken up because people will just accept a certain premise and never challenge it, and then go all their life never looking back on it. Warren Buffett has said every year you should throw away at least one of your most cherished beliefs. So, the past few days I have stopped every now and then and asked myself, "hey, why am I doing this or why do I believe that?", and it has been a very enriching exercise that I recommend to others. If you are honest, it will help you to better understand yourself and the world around you.

Friday, November 09, 2007

Delta Financial 3Q Report

The fate of Delta Financial does not look too promising based on its third quarter earnings report. Due to market disruptions, the company could not continue with its traditional approach of securitizing and retaining the excess interest. Instead, the company needed to securitize and unload everything, at a steep 10% loss to the company.

And, I would look at their balance sheet in the following light. Take their 115 million in equity and add the 75 million in allowance for loan losses, giving you 190 million in "adjusted" equity.

Now, they have 6,630 million in securitized loans plus 62 million real estate and 32 million trustee receivables, adding up to 6,724 million. The debt balance that these loans secure is 6,510 million. That leaves approximately 214 million in "at-risk" capital in their securitizations, which counts on their balance sheet towards equity. You can judge how at-risk it is based on their current delinquency numbers:

The 214 million is only about 33% of 90 day + delinquencies, meaning there is a strong likelihood that most of this capital be wiped out. The only hope would be that some of the earlier securitizations will perform better than others, leaving some capital to be returned to Delta.

Meanwhile, Delta also has 480 million in pre-securitized loans which are backed with about 475 million in warehouse facilities and other borrowings. If the conditions in the market have not improved since the end of the 3rd quarter, then Delta will probably also take a further hit in capital from the sale of these loans. We saw in that in the 3rd quarter they were taking 10% losses on these loan sales.

Delta has been increasing the interest rate on its loan, and they just cut a quarter of their staff to lower their costs and loan production. So we can hope that fairly soon the ongoing business can stabilize. But the very poor delinquency performance of their securitizations this quarter show two things. One, their equity is in danger of being wiped out, and that another cash infusion at very unfavorable terms will probably be necessary. Two, Delta's niche underwriting in the sub-prime market might not be as good as they made it out to seem.

Wednesday, November 07, 2007

A Practical Look at Bond Insurers

A bond insurer provides credit protection by giving its guarantee to pay any unpaid principal and interest payments in a default. By giving its guarantee, a debt security can then be issued with a higher rating, usually AAA, and this lowers the interest cost of the debt. Now, I'd argue that if you take a close look at the competitive forces these companies face, you'll come to the conclusion that this is a mediocre business at best.

The most obvious competition is from other bond insurers and there really is no moat within this group. The AAA credit-rating is favorable because it lowers the cost of guaranteed securities to almost government treasury rates, but there are a few insurers who have this rating. Otherwise, the business is strictly based on how much capital you have and what price you are willing to pay. MBIA mentions in their annual report that it "also competes with other forms of credit enhancement, including senior-subordinated structures, credit derivatives, over-collateralization, letters of credit and guarantees."

But an even more significant competitor is "Mr. Market" himself. An issuer of debt likes bond insurance because it diminishes the investor's risk, and so it can potentially lower the issuer's interest costs. It all depends on cost of the insurance, and the spread between what the market will charge the issuer and what the market will charge its guaranteed security. If the cost of insurance is less than the spread, then the bond insurer gets new business and the issuer lowers his borrowing cost. But if the cost of insurance is more than the spread, then there is no transaction- the issuer would be better off selling the debt directly to the market. Thus, we see that credit insurers are competing against the market's perception of risk. Effectively, the bond insurer is saying that they have expertise and can profit by being better judges of a security's risk than the overall market.

Now that is plausible. But for one, these insurers are doing this with a large amount of money, making it more difficult to earn out-sized returns. And two, before the recent turmoil in the credit markets, spreads on risky securities were at unprecedentedly low levels.


So taking into account the competition, the large capital base, and the credit spread tightening, you would think that these companies would have been marginally profitable recently. But instead, these companies have been recording record profits with very healthy margins.

MBIA, 2002- 2006 ratios

Loss and LAE ratio

9.7 % 10.0 % 10.0 % 10.0 % 10.5 %

Underwriting expense ratio

26.6 24.7 21.5 22.2 22.9

Combined ratio

36.3 34.7 31.5 32.2 33.4


So that begs the question of how a credit insurer was able to underwrite so profitably(loss reserves at 10% of premiums) in an environment where "Mr. Market" was so willing to buy risky debt. And I guess you can say part of the answer lies in the fact that a bond insurer's loss reserves are very much up to judgment. In traditional property and casualty insurance, you typically have a very good sense of what your total losses will be by the second year. But in bond insurance, the time horizon is much longer. For example, we know that the average of MBIA's insured debt outstanding is over 10 years. That means that at anytime within those 10 years, a credit contraction could reveal that their reserves are drastically inadequate. This makes investing in a bond insurer sort of like a black-box, because you never really know what you are getting without knowing their loss assumptions.

Many bond insurers have lost 50 to 75 percent of their stock value in the last 6 months. (See MBI, ABK, AGO) Perhaps at these prices they are actual values, and maybe I am missing some factor that allows them to underwrite so effectively. All I know is based on these competing forces and the leeway available in their accounting, that it is very likely they have been under-provisioning for future losses, and that I can not tell you by how much. As I was writing this though I did come across this post on Calculated Risk- Egan Jones: Expect "Massive" Losses for Bond Insurers.