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


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, 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.