The Investing Framework for Marginal Companies:

Today I will theorize a bit on the considerations that should be made when investing in marginal companies. A brief side conversation to define a marginal company because it is important to understand. A marginal company is any company that has a weak or no moat. I have a very strict criteria behind moat- it must be a clear and unassailable advantage. A good advertising campaign would be a weak moat. Apple has done a great job improving its image and increasing its sales of its products, but it is difficult to say whether this image will improve and pass on to other products, or if it will fade away. But at its current price, a continued image growth would be needed to justify its valuation. Other examples of weak moats are management(are they really better, how long will it last, can a competitor match it) and size(in most industries, owning more doesnt mean better), etc. Low cost advantages that can be toppled by capital are also weak. Management's in general will make a huge list of competitive strengths, but in the end a vast majority (95%+) of stocks will fall into the marginal category. Cars, steel, paper, finance, electronics... the list is endless.

The best way to evaluate marginal companies, and by extension most companies, is with a deep Ben Graham approach. An interesting Economist article i recently read discussed Hanson, a famous corporate buyout firm. "The firms they bought had to meet just two criteria: they had to be able to generate enough cash to pay the interest on the debt needed to buy them; and they had to cost less than the total value of their assets. Closures of head offices and mass sackings often followed."

Underlying this simple philosophy are the ideas of economics and Ben Graham. Buying below replacement cost means there is a disincentive for competitors to come into the market because the returns will be weak. Also, it would be cheaper to buy a competitor then to do a direct investment in the industry. In most cases, economics will eventually rationalize the industry and lead to a situation where competition has the incentive to come back in the industry. But at that point, returns have increased and you are making a sizeable return on your original investment cost. You are buying something for less than it is potentially worth under normalized industry conditions or better operation/management.

SFK's management has shown their understanding of this philosophy. They purchased their two RBK mills for a total of about 150 million, when each mill had a replacement cost of 250 million. That is a 70% discount to the cost for a competitor to enter the market. You can, and should, take the analysis much farther than just looking at the cost of assets, and this blog will go much deeper into the additional considerations that should be made. Currently, the Forest industry has many companies that are trading below replacement costs, but I would pass on a vast majority of them. Expect a write-up about a combined Abitibi-Bowater shortly. But for now, hopefully this article will spur you to take a second look at your investment portfolio. With the market average approaching almost 4x book value, chances are that you have not paid a market price below replacement cost for your investments. So you have to truly ask yourself, "How strong are the competitive advantages of your companies, really?"

Updates Around the Table:

Delta Financial
Highlights for 1st Quarter
-Delta reported first quarter profit of 4.9 million compared to 6.6 million last year.
-Originated 1.2 billion of mortgage loans, 11% increase over 4th quarter 06.
-Sold 177 million in loans for a 3.4% premium.

These results are spectacular when you compare them to the rest of the the industry. For example:
Novastar financial, NFI, had to cut production by 21% YoY.
-NFI is selling whole-loan for less than face value.
-NFI had a comparable cost to orignate of 3.85% compared to Delta's 2.58%.
-Accredited Homelenders, LEND, had to sell 2.7 Billion in loans for a loss of 180, and entered into a forward sales contract for 400 million loans for only 100.625%.
-I believe every other subprime lender, as well as most Alt-A lenders, have reported losses for their 1st Quarter.

Notes from Conference Call
-31% YoY increase in mortgage origination increased quarterly expenses- the income from origination is retained over the life of the loan, expenses are up front. The more loans originated, the more upfront costs.
-11% sequential increase in volume, even though 4Q to 1Q is usually slower. Ability to capitalize on market opportunities, in particular in the wholesale market.
-Still recieving some of the highest pricing in the market with 3.4%, while other lenders are struggling to receive par. Miniscule repurchase risk. $235,000 and 8 loans had to be repurchased in the quarter. 1.7% total cost to originate.
-Cost of funds on securitization was 30 basis points higher, but rates were increased to compensate for that. Mortgage rates up over 40 basis points over last few months.
-8.3 billion portfolio by year end, with expected net interest margin of 1.7%
Q: Are there new entrants coming?
A: at this point market is still not on solid ground, a lot of originators considering to fail and exit market. Wholesale market offers opportunity because of so much capacity coming off. Retail not as focused on competiton, but wholesale is very competitive. With fewer lenders competing, much easier to get their loan standards.

Q: comments on growth and loan quality?
A: increased salespeople, and account executives went from 126 to 155 and loan offices grew from 464 to 500. Average FICO 4Q was 615, 1Q 621 LTV was at 79% for 1Q.

-30+ day delinquencies at 10.8%, up from 10.5% in 4Q. 5.1% 90+ day delinquencies.

Q. O/C was 3% in 2006, what are likely O/C’s going forward?
A. 918 proceeds on 950 securitization for recent securitization, 3.5% O/C. Proceeds from NIM notes was just over 30 million. Increased interest rate to offset this in future. NIMs are about a 1 year note, usually relatively easy to sell. Note peak losses for their loans are usually between 24-48 months, so these notes are relatively safe.

SFK:
Pope and Talbot, with 800,000 yearly NBSK pulp production, seems to be heading for bankruptcy and issued a going concern warning.

Brick Group:
-Same store sales up 6% over a strong quarter.
-EBITDA up 10%.
Overall, Solid quarter, more of the same.

Fairfax:
-Fairfax is getting cheap again. Mentioned on board that if you subtract ORH and NB stakes from todays price and then add net debt, you are paying 1.3 times Crum book value. That leads runoff, Fairfax Asia, rest of business for free.
-An interesting discovery: Fairfax contributed $10 million in 2000 for its 26% stake in ICICI Lombard. Today it is the largest private insurer in India, with $700 million in premiums and growing rapidly.

Other:
I've finally found the economic report I've been looking for: "Credit Expansion, 1920 to 1929". It has been difficult to find good information about the economy for this decade before the Great Depression. The report concludes that loans from the period 1922 to 1929 increased at a 25% annual rate, and it shows the dramatic distortion credit installment had on consumer sales. When you compare this with the estimate by the Economist that global money supply has increased 21% over the last 5 years for many of the same reasons, it is not encouraging.
Fairfax is positioned very well for this type of event. Brick might be adversely impacted by a decline in easy credit.
Credit Expansion, 1920 to 1929

The Chinese market is at 43 times trailing earnings, and up 45% over last 3 months.

“What happens if we get a recession and housing is still bad?” Mr Toll asked this week. The results, he thought, could be “cataclysmic”.

Nick - Still 30% Cash and Long term bonds.