Third Avenue Funds 3rd Quarter Shareholders Letter Out

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Technology Quarterly Summary

Every quarter, The Economist comes out with a special report on new and interesting technological innovations. I find it to be an important read for investors, in order to learn about what is going on in the world and also to know of trends that could affect investment decisions. But, it is also a very long read. Below is a summary of some of the noteworthy ideas mentioned.

1. The idea of transferring information through light (optical wireless) is being researched, promising better security and faster speeds than traditional radio-based communications. Advocates also like it for its convenience, and the cost to install is very low; the main drawback is that atmosphere conditions can affect the signal.

2. Researchers have developed an environmentally friendly light bulb that is cheap, uses very little energy and should last for decades. The traditional light bulb emits 5% of energy as light, fluorescent about 15%, and the new Ceravision lamp has efficiency greater than 50%. With lighting accounting for 20% of electricity use worldwide, this more efficient system could reduce energy demand as well as emissions. (Plus, reducing light bulb demand)

3. Using photosynthesis to capture exhaust gases from power plants could reduce the emissions produced by coal-fired stations, and could be re-used in the power plant as energy or converted to biodiesel. It is not yet commercialized, but a preliminary test suggested it can remove 75% of carbon dioxide from a power station’s exhaust. There stands the possibility that rather than paying for carbon emissions, power companies may soon be able to profit from them.

4. Offshore oil technology is becoming more efficient by outsourcing tasks off of rigs and by developing multiple fields from one platform, allowing for reduced levels of workers needed on rigs and resulting in lower production costs.

5. Germany is working on solving a 600 million piece puzzle from the shreds and torn papers of the documents of Stasi, the former secret police which tried to destroy the documents to keep from getting into public hands. This of course, due to the help of computer technology.

6. German engineers have created the “SeaFalcon”, a ship that flies about two metres above water, allowing it to travel far faster than a ship (80-100 knots) and for cheaper than a plane of equivalent size.

7. A new 3-seater car named “The Aquada” has the ability to fold up its wheels and convert into a boat of sorts. It will go into production in 2008 and cost $85,000.

WaMu Chief Sees Perfect Storm

Washington Mutual today, after setting aside 500 million more for loan losses, said that they are amid what he called "a near perfect storm" in US housing. I wonder if he got the term from Prem Watsa, who has used the term often and is predicting a 1 in 50 or 1 in 100 year catastrophic event. Either way, it is good to know that the Fairfax team does hold CDS against Washington Mutual, among the many other mortgage names.

To see the list of other holdings in the Fairfax CDS portfolio, see this.

It's Time for Quality

In a 1970's speech following Benjamin Graham, Robert G. Kirby made the following argument:

Economic analysis can be used to make investment decisions. In doing so, I would be inclined to concentrate my attention on two areas. The first would be in the determination of future, long-term interest rates. We have moved into an era where there are no longer two watertight compartments of "stock money " and "bond money." Equities and fixed income securities now compete for the same investment dollar. A critical factor in making good investment decisions is what the basic wage of capital is going to be in the future.

Second, I would try to determine whether we are in or entering a secular period of consumer spending or consumer saving. Because of the liquidity buildup during World War II and the post-war boom in the birth rate and in household formations, (I ought to reverse those) most of the decade of the 1950's and the decade of the 1960's was a period of consumer spending. Saving and capital formation took a back seat as a result. In recent years, we have seen evidence that we are at or near the production limits of our industrial capacity. If we are to have further real growth from this point on, we must enter a period of lower consumption and increased savings that will provide the needed capital to build new capacity.

However, these two factors — (1) future costs of long-term capital, and (2) whether we are going to be a spending society or a saving society – only influence security markets on a longer term basis. Therefore, knowledge of them is valuable only in an investment decision – not a trading decision.

Today, there is a knowledgeable camp of people (Hoisington, Zell, Watsa) who believe that long term treasury rates will continue downwards. In such an environment, it is the high quality company, one with strong competitive advantages, that will prosper as an investment. This is because in the long run, the market value of companies will track their growth in earnings. In an environment where long term treasuries yield 3%, it is the marginal company that will feel the most pressure on its Return on Investment (ROI), and hence earnings. Meanwhile, the high quality company will be better able to maintain its ROI due to the moat surrounding its business. So, finding a company that can maintain 10% long run earnings growth becomes much more valuable in a 3% discount rate environment than in a 7% setting. Such companies are difficult to find at a meaningful discount, but you can bet I'll be watching closely for anything if further market turmoil continues.

It is also interesting to note the second economic factor Kirby mentioned to watch out for: whether the future will be one of saving or spending. With the consumer "tapped" out and heavily indebted, it would seem that our future is one of savings. Such a shift could have a major impact on earnings; but again, it is the high quality company that will least likely feel these effects.

Domtar reports ABCP exposure

Something to watch out for- many companies might have unexpected exposure to financial market turmoil through their pensions. Domtar Corporation announced:

"In light of the current disruption of credit markets, particularly for third party asset-backed commercial paper ("ABCP"), Domtar Corporation is providing the following update.

The Company and its subsidiaries, including Domtar Inc., have no holdings of ABCP.

Domtar Corporation's Canadian pension funds have approximately CDN $420 million (of which approximately $308 million is held by Domtar Inc.'s Canadian pension funds) invested in multiple ABCP conduits...

Losses in the pension fund investments, if any, would result in future increased contributions by the Company or its Canadian subsidiaries. Additional contributions to theses pension funds would be required to be paid over a 5-year period. Losses, if any, would also impact operating earnings over a longer period of time and immediately increase liabilities and reduce equity."

Hayek, Friedrich. The Use Of Knowledge in Society

Added to Online Library.

"What is the problem we wish to solve when we try to construct a rational economic order? On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic. That is, the answer to the question of what is the best use of the available means is implicit in our assumptions."

...
"This, however, is emphatically not the economic problem which society faces. And the economic calculus which we have developed to solve this logical problem, though an important step toward the solution of the economic problem of society, does not yet provide an answer to it. The reason for this is that the "data" from which the economic calculus starts are never for the whole society "given" to a single mind which could work out the implications and can never be so given."

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New Info on the Mortgage Lender Bear Case

About a week ago, I posted my reasoning for avoiding most mortgage lenders, basically stating that they were adding very little value in the business- mainly, saving a person the trip to their local bank.

Well today on Calculated Risk, Tanta posted a new UberNerd on Mortgage Origination Channels, which I recommend you read from beginning to end. But the relevant part is the following:

In the old days, the depository lenders had “loan officers.” They were actually officers, and they actually decided whether to lend people money or not. In and around the 1980s, an idea arose that “loan officers” should primarily be “salespeople,” not credit underwriters, because they could reel in more borrowers that way. We took them off salary, put them on commission, and sent them to sales seminars in which everything they ever knew about evaluating credit risk was rinsed out of their brains in a deluge of sales tactics and lead generation and unspeakable “motivational” rhetoric. This resulted in a horrifying pile of terrible loans.

So we took the “officer” part out in reality, if not in name. “Loan officers” became pure salespeople, who turned over their applications to underwriters, who were salaried and paid a lot less, in most cases, than the loan officers. These underwriters were stuffed into cubicles in “back rooms” where they were expected to uphold the institution’s credit standards in the face of an aggressive sales force who didn’t get paid unless the underwriter caved in. Since loan officers were paid on volume, not profitability or loan quality, the LO just wanted to get to the closing table as often as possible. The underwriters got paid whether the loan closed or not, but they quite often didn’t get paid enough to want to be beaten to a bloody pulp by salespeople and branch managers and production vice presidents. Generally the underwriters reported up to the chief credit officer, who reported to the CEO. The loan officers reported up to the senior production manager who reported to the CEO. The CEO settled arguments based on either the good of the company or the bonus pool.

Having turned LOs into salespeople, it wasn’t much of a stretch to wonder why you needed to employ them at all. The RE market was already chock-full of real estate brokers and commercial loan brokers; why not mortgage brokers? Now, it seemed to some of us that the broker model made sense in the primary RE market, and in commercial lending, both of which are complex markets in which a buyer or borrower might need some real expert help finding a seller or lender, or vice versa. The earliest mortgage brokers were, exactly, in subprime or “hard money” lending, because those were also “illiquid” markets. Once you brought brokers into the very liquid, ubiquitous-bank-branch-on-every-corner residential mortgage market, you were, really, doing something weird.

So, he seems to be echoing what I was saying. Add into that another good point he brings up:

It is perfectly possible and even frequently the case that you have a loan that was brokered to Pissant Mortgage Company, who sold it on a correspondent flow basis to Medium Dog Bank, who sold it on a bulk servicing retained basis to Big Dog Bank, who sold it to Lehman, who securitized it. Everybody counted a loan in their own “originations” or production.

As an investor in one of these final securitizations, you must wonder how all these intermediaries are racking up fees while still selling you "a great investment opportunity." That's a great question that is unfortunately only being asked now.

Mortgage Banker's Survey

According to the group's quarterly delinquency survey, a seasonally adjusted 0.65% of loans on one- to four-unit residential properties entered the foreclosure process during the period, the highest level in the survey's 55-year history. In the first quarter, when the previous record was set, 0.58% of loans entered the process; a year ago, 0.43% entered the process.

According to the survey, 1.40% of all outstanding loans were somewhere in the foreclosure process during the second quarter, up from 1.28% in the first quarter and 0.99% a year ago.

The delinquency rate for mortgages on one- to four-unit proprieties was 5.12% in the second quarter, up from 4.84% in the first quarter and 4.39% a year ago.

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Imperialism

While reading Imperialism, A Study by John Hobson, I stumbled across the following interesting passage. Although this was written over 100 years ago to describe the British Imperialism of the era, I had the distinct impression that the message has some value in our present-day. I'll let the reader decide.

Seeing that the Imperialism of the last three decades is clearly condemned as a business policy, in that at enormous expense it has procured a small, bad, unsafe increase of markets, and has jeopardised the entire wealth of the nation in rousing the strong resentment of other nations, we may ask, "How is the British nation induced to embark upon such unsound business?" The only possible answer is that the business interests of the nation as a whole are subordinated to those of certain sectional interests that usurp control of the national resources and use them for their private gain. This is no strange or monstrous charge to bring; it is the commonest disease of all forms of government. The famous words of Sir Thomas More are as true now as when he wrote them: "Everywhere do I perceive a certain conspiracy of rich men seeking their own advantage under the name and pretext of the commonwealth."
Although the new Imperialism has been bad business for the nation, it has been good business for certain classes and certain trades within the nation. The vast expenditure on armaments, the costly wars, the grave risks and embarrassments of foreign policy, the stoppage of political and social reforms within Great Britain, though fraught with great injury to the nation, have served well the present business interests of certain industries and professions.
It is idle to meddle with politics unless we clearly recognise this central fact and understand what these sectional interests are which are the enemies of national safety and the commonwealth. We must put aside the merely sentimental diagnosis which explains wars or other national blunders by outbursts of patriotic animosity or errors of statecraft. Doubtless at every outbreak of war not only the man in the street but the man at the helm is often duped by the cunning with which aggressive motives and greedy purposes dress themselves in defensive clothing. There is, it may be safely asserted, no war within memory, however nakedly aggressive it may seem to the dispassionate historian, which has not been presented to the people who were called upon to fight as a necessary defensive policy, in which the honour, perhaps the very existence, of the State was involved.
The disastrous folly of these wars, the material and moral damage inflicted even on the victor, appear so plain to the disinterested spectator that he is apt to despair of any State attaining years of discretion, and inclines to regard these natural cataclysms as implying some ultimate irrationalism in politics. But careful analysis of the existing relations between business and politics shows that the aggressive Imperialism which we seek to understand is not in the main the product of blind passions of races or of the mixed folly and ambition of politicians. It is far more rational than at first sight appears. Irrational from the standpoint of the whole nation, it is rational enough from the standpoint of certain classes in the nation. A completely socialist State which kept good books and presented regular balance-sheets of expenditure and assets would soon discard Imperialism; an intelligent laissez-faire democracy which gave duly proportionate weight in its policy to all economic interests alike would do the same. But a State in which certain well-organised business interests are able to outweigh the weak, diffused interest of the community is bound to pursue a policy which accords with the pressure of the former interests.

2007 Wesco Annual Meeting Notes

These notes are supposed to only be for people who have signed up for the upcoming Value Investors Congress, but since Vinvesting has published it on their site, I'll gladly relay the link below.

2007 Wesco Meeting Notes

Fairfax Mentioned in Value Investor Insight

Fairfax Financial has a write-up in the August issue of VII by Whitney Tilson, with a price target of $365 (albeit, using some faulty numbers). Anyways, their thesis repeats what I've been saying here: Large CDS gain potential, and a hidden value in ICICI, combined with an overall very undervalued market price. I'd also add bond gains. Sorry, no direct link, as its subscription only.

Sequoia Funds 2007 Investor Day Transcript

A good read.

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Countrywide's Confidence turned to Crisis

"Countrywide also concedes that its vaunted proprietary system for estimating loss probabilities and delinquency rates was bamboozled by real-world conditions in 2006 and 2007"

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Critique on TFS Financial Corp. Write-Up

Hawkeye901 on Value Investors Club did an investment write-up on TFS Finacial (TFSL) stating that an 'MHC conversion' opportunity existed and the company, "at its current price of $11 per share, the company is trading at approximately 60% of its economic book value of $18 per share."

What is an MHC conversion opportunity? Well, MHC stands for mutual holding company, and it is a business structure available to banks in which the company's owners are its depositors. Some companies in the Northeast have chosen this structure, but these days you will rarely find new companies choosing this route. When MHC's want to go public and raise equity, things start to get very confusing. The company must hold more than 50% of its own shares, but the cash raised from the other shares sold goes straight to the company. Depositors, who were the original owners, get first rights to participate in the MHC's IPO. Now, the problem is how to treat the shares held by the company itself, because if and when these are eventually sold, the money for these will also go straight to the company. This means that looking at conventional shares outstanding and Price to Book or Earnings multiples would provide a very distorted figure, allowing for an opportunity for investors to profit from any misunderstanding.

This MHC opportunity has been well-covered, by me especially, and the opportunities have pretty much vanished as people caught on to the situation. This is why I was so surprised when I saw a VIC write-up with a 6.2 rating on such an opportunity, which claimed post-conversion it was trading at 60% book value. On further investigation, it appears that some optimistic assumptions were made to arrive at that figure.

I was first exposed to the MHC idea by a different VIC write-up done by jim77 on Service Bancorp, SERC. To copy a relevant paragraph from his write-up:

First a few comments on the 'mutual holding company'(MHC) structure. GAAP 'understates' both the P/E and P/B ratios because they fully count the shares the MHC holds...but the shares have never been sold publicly. Others posters on VIC have commented that all the economic value of the enterprise should accrue to the public minority shares only...but I'm afraid that 'overstates' the true
economic reality in most cases. (There is a very large exception where this does hold true, however...and, is in fact, one of the reasons why I recently bought SERC). It's not difficult 'adjusting' P/B and P/E for a publicly traded sub of an MHC at the IPO...but it is a little trickier after it's been trading for a few years. The easiest way is to assume a second-stage conversion at a reasonable
P/B (second-stage conversions are primarily priced according to book). The Mass median P/B is 117% and the national average is 108%. Most recent second-stages have conservatively been priced to go off at a minimum of 75% P/B. Assuming SERC is priced at 75% in any second-stage, the current price is an adjusted 59% P/B (this asumes all the underwriting expenses and a realistic 8% ESOP and 4% MRP expense). SERC will not stay long at that 59% P/B mark with the average Mass thrift trading at twice those levels. But is there anything indicating that the bank would want to convert?

Now, to give some comparisons, when SERC IPO'd, it had 1.65 million shares outstanding, of which it sold 736,000 to the public at $10 a share. Post-IPO, it had 18.4 million in equity, meaning a book value per share of $11.15(counting all shares outstanding). Meanwhile, the share price was at $9.75 when he recommended it, and the benefit from any MHC conversion still hadn't taken place.

In comparison, TFSL currently has 332 million public shares, of which 105 million were sold to the public. Post-IPO, it has 1.9 billion in equity, and a book value per share of $5.72. Yet somehow, they claim that both trade at an adjusted price/book value of 60%, despite SERC's far superior valuations.

The difference is, jim77 is assuming the secondary sale of sells goes off at 75% Price to book value, assuming book value is calculated using all shares outstanding. Hawkeye is assuming 120% price to book value, and hes only using the public share count, meaning 105 million shares outstanding instead of 332 million that would be used in jim's analysis. In truth, jim was probably being too conservative with 75%, especially when he says the average second-step is done at 108%. But hawkeye is using 120%, and a seriously inflated book value number to come at his numbers. Hence my surprise that it received a 6.2 rating... but maybe I'm just behind on a new era in valuations.

The Compleat UberNerd

For anyone looking to get a very detailed understanding of the mortgage industry, I recommend checking out this section on the Calculated Risk blog entitled "The Compleat UberNerd". It offers a very comprehensive (and lengthy) write-up on several areas of the industry that many people misunderstand or just don't know much about. This probably isn't for everyone; in fact, they even go ahead and say:

an “UberNerd” is someone who is compelled to understand how things work in grim detail, even if the things in question are tedious in the extreme, like mortgage insurance policies. Not everyone who visits the blog is an UberNerd, or aspires to UberNerdity, but on the other hand those who display UberNerditude in the comment threads are treated with a respect bordering on lunacy.


I guess I would qualify, because I find all of these posts very interesting.

Special Report: Heading For the Rocks

The Economist has a free special report on the turmoil in the financial markets. It can be viewed here.

My Case Against Mortgage Lending

With the price of many mortgage lenders hitting record lows, many people are wondering if now is the time to get into this sector. I am going to spell out my reasoning against investing in this area. To clarify, I am talking about the mortgage lenders which skipped traditional banking and instead focused on originating and selling large volumes of loans.

The basis of my argument revolves around the idea that the "value-added" from this industry is minimal at best. I summarize the mortgage lending business model as this: borrow at market rates from banks, hire a staff dedicated to finding and originating loans, and then sell them to other investors for a profit, and repeat. The whole process uses heavy leverage to make the returns worthwhile. Basically, they're aim is to add value in the originating process by making more profitable loans, whether through higher interest and/or more security (For sub-prime and Alt-A, it was higher rates while hopefully maintaining security) The mortgage lenders could have gone three routes:

A) originate loans to good borrowers that banks would also lend to.
B) Loan to good borrowers that banks would not lend to.
C) originate loans to bad borrowers.

In C there is no viable long-term business model. In Situation A, the "value-added" is minimal- you save the borrower the time from visiting their local bank, and in return add another layer of frictional costs. On average, the mortgage lenders total cost to originate are about 2% of loan value, so you can make a rough estimate of $4,000 per loan in additional costs.

Only in B does there exist a niche market which appears worthwhile. But the market will always occupy only a small niche outside bank lending criteria. If the non-conforming business grew large and the loans being made were truly good loans, then banks could simply loosen their criteria and add new competition, forcing it back to a situation A.

So when the market for Sub-prime and Alt-A grew to 40% of loans originated in 2006, either things got out of hand, or banks fell behind a new shift in acceptable lending. I choose to believe in the former.

Chou Funds Semi-Annual Report

Francis Chou's 2007 Semi-Annual Report is out along with some interesting commentary. He also made some purchases during the semester, which as far as I could tell were mostly:
(Numbers based on $ cost)

NEW* Alpha Natural Resources 6.3 mil
NEW* Sprint-Nextel 9.4 mil
NEW* Media General 4.3 mil
Sun-Times Media Group Increased from 4.2 mil to 13.9 mil
Watson Pharmaceuticals Increased from 1.4 mil to 11.9 mil
NEW* IDT Corp. 1 mil
NEW* Primus Telecom Debt 25 mil

For reference, Chou manages a total portfolio of 420 million. Overstock continues to be one of his significant holdings, with 36 million invested into it. The new position in Primus debt is also a very large position by Chou's standards.

Delving into Investing Theory

As I was thinking about the recent credit problems, I couldn't help but think there was a lesson to be learned for investing as a whole. Looking from today, we can say that some lending got completely out of hand. Since lending really is a form of investment, we can look at their rationale for making these loans to find the fault. Loan underwriting relaxed to a point where banks became less concerned with borrower's ability to pay, and instead focused on the asset price securing the loan. This can be seen in the rise in lending debt-income ratios, the percentage of income of the borrower going to pay off debts. Banks conventionally have a limit at 36%. Subprime lender Delta Financial, considered one of the better underwriters, went up to 55%; Other subprime lenders rarely disclosed their maximum limit. These lenders tried to make up for this by having lower Loan-to-Value ratios(LTV), which is the loan amount compared to the value of the house. This added more principal security.

The problem as I see it is one of financial misunderstanding. To me, an investment has an asset value and an asset cost. The asset value is simply the net present value of future cash flow, while the asset cost was what was paid to acquire the assets. So, a loan's "asset value" is really the discounted sum of the borrower's interest and principal payments, along with the cash-out value if or when the borower defaults. The asset cost though is simply the amount of money that was loaned. From this perspective, we can see that the problem was that lenders lost track of asset value when they became less concerned with the borrower's income and relied more on the underlying home price. If the homes could be sold for their full value this wouldn't be a problem, but there are very significant costs associated with foreclosures. So many mortgage companies made loans that were carried at face value when their real value was considerably less, given the likelihood of default.

Similarly, this same behavior can be seen during stock market bubbles. A stock is also worth the net present value of its future cashflow. This means the sum of the cash flow from the operating business as well as a final gain (or loss) if the company needs to be liquidated. In stock market bubbles, investors become less focused on the present value of the investments they purchase; instead, they are buying an asset at a certain cost and hoping it will appreciate when they sell it to someone else. The business' ability to justify the price through its cashflow becomes an afterthought. So for a long time, equity investments can be carried on the books at a price that is much higher than logic would justify.

Your goal in investing is to be buying when asset cost is significantly below asset value.
The beauty of Ben Graham's philosophy was its simplicity. His strategy was to invest in companies at two-thirds of their Net Current Asset Value (NCAV), or their current assets minus total liabilities. Current assets are expected to be converted into cash within 18 months, and they can usually be taken at near face value. Such an investment situation means that if the company stopped operations immediately, it would have enough cash to pay all of its obligations and then give what is left over to shareholder's for a decent return in a relatively short period of time- hence, you were buying a company for less than its NPV under a scenario where the fixed assets and the company were treated as worthless. So, there was a high level of cash security for this type of investment, yet the upside was also pretty limited. But Ben Graham knew that fixed asset values can be much different than their costs, and wanted to make a strategy that any Average Joe could use.

The days of finding pure NCAV ideas are getting slim these days as information has become much more available. Today, a investor must become much more accurate and comfortable in make income projections for a business. This means analyzing competitive advantages will play a much more important part in security analysis, and there will be the possibility for larger gains- and mistakes- for investors.

Flight to Safety

Dazel from the Berkshire Hathaway Shareholders board pointed out something that hasn't recieved much press- the recent dramatic fall in treasury yields, especially short-term. See this link.

Meanwhile in the world of computer-model trading,

"Wednesday is the type of day people will remember in quant-land for a very long time," said Mr. Rothman, a University of Chicago Ph.D. who ran a quantitative fund before joining Lehman Brothers. "Events that models only predicted would happen once in 10,000 years happened every day for three days."

More "black swans"!

Pope and Talbot Announces Wood Pulp Increase

"Pope & Talbot, Inc. (NYSE:POP - News) today announces a $20 price increase to its customers in North American and a $30 price increase to its customers in Europe until further notice.

The new prices will be $850 in the North American market and $830 in Europe for its northern bleached softwood (NBSK) grades."

Link

This is continued good news for SFK and the pulp industry. Meanwhile, I count three NBSK pulp producers still in troubled waters, which i define as negative EBITDA's and high leverage. These are Pope and Talbot(825,000 tonnes/year), Tembec(800,000 tonnes), and Catalyst Paper(525,000 tonnes).

Update: Also today, Catalyst announced the shutdown of 320,000 tonnes of yearly pulp production due to the B.C. union strike, which is causing a limitation of fiber in Western Canada.

Economic Recap

Back in March, I said the following:

"One can't underestimate the effects this could have. If many of these subprime loans prove unsustainable without the hope of refinancing, this could increase defaults, which could decrease home prices, which could spread the default risk up the credit quality ladder. Meanwhile, mortgage insurers will be affected, along with banks, which pretty much spreads out to everywhere. Consumer demand, which has been so reliant on asset monetization, can drop. That branches out to affect the whole economy."

Well, so far we are beginning to see the beginning of the effects on banks and mortgage insurers. (I should of included hedge funds). But it's important to remember that subprime is just one example of the overall credit bubble. If I had to make a case for overvaluation in the markets, I would focus on three things:

1. Historical P/E's

2. Historical Return on Equity
Average earnings for the the Dow Jones Industrial Average are 11% of the company's book value in any 20-year period between 1920 and 1986 (1920-39, 1921-40, 1922-41, etc.). "Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external factor." Warren Buffett said something similar, although I think he said 12%. Over the last decade, the DJIA Return on Equity has averaged 18%, with it currently running at 23%.

3. Leverage in the Economy

When things turn the other way, debt can get very messy. As the new Economist says, "because this crisis taps so deeply into the newly devised structures of finance, anyone who says the worst is definitely over is either a fool or someone with a position to protect. As risk has become bewilderingly dispersed, so too has information. ...Nobody knows how messy the inevitable bankruptcies will turn out to be. What markets need now is time to piece that information back together. Time before the next wave strikes." Similarly, many people have been claiming that high quality names have gone on sale during this recent market drop. I think it is way too early to tell.


"I place economy among the first and most important of republican virtues, and debt as the greatest of the dangers to be feared." -Thomas Jefferson, 1816


*Updated:

ICICI Lombard

ICICI Lombard recently came out with its annual report for the 06-07 year. The numbers show a company that continues to be a great growth story- here are some of the numbers:

Financial Year	2006-07	2005-06
Figures in nos.
No. of policies sold	3,136,393	1,461,039
No. of claims handled	642,777	243,951
No. of employees	4,770	2,283
No. of offices	220	154

Financial Year	2004-05	2003-04	2002-03	2001-02
Figures in nos.
No. of policies sold	607,926	249,531	98,293	9,148
No. of claims handled	84,970	23,487	8,022	420
No. of employees	1,249	561	284	116
No. of offices	96	63	35	11

Fairfax currently has a 24% stake in the company and has it recorded on the balance sheet at a conservative valuation. I see the largest private insurer in a fast growing industry, and the chance to take a lot of business from inefficient government competition. This could be a much more significant part of Fairfax in the future.

The Brick 2nd Quarter Results

EBITDA down 3.5% for the quarter, up 1.8% YTD.
4.8% Same-store sales growth
Total sales up 7.3%
3 more franchises opened during the quarter, bringing the total to 29.
“With seasonally higher sales in the second half of the year and continued focus on cost management, we believe that we are very well positioned to drive increased profits for the Brick Group.”

Link

A Closer Look at Exchange Bank

I wanted to show you what really caught my eye with Exchange Bank of Santa Rosa. And, I also wanted to practice using Excel. Below is the resulting chart I made:



Note first that some fields are obviously missing because I was unable to ge that data. Also, the Net loan losses for 2Q07 is an annualized number. Delinquent refers to 30+ days late loans, while non-performing is 90+ days late loans plus non accrual. Also note my excellent Excel skills. A few things stand out about these numbers.

One, their overall loan underwriting is superb. As a comparison, a look at Countrywide's servicing portfolio in the 2nd quarter showed 5.02% delinquencies, and 1.74% non-performing, and their portfolio is heavily adjustable. Second, they are also simultaneously very conservatively reserved. Most other banks I have looked up have a ratio of allowance to non-performing of 100 to 150 percent. Exchange Bank hasn't been under 300% for ages. (Countrywide is under 50%)

So despite my belief in a credit bubble, I am willing to invest in this bank because of their allowance cushion and their strict underwriting. This goes along with the other many qualitative aspects: Their number 1 county market share, low cost deposits, and a Return on Assets averaging 1.5% in an industry where 1% is considered good. (Countrywide is at 1.06%, and theyre also origination 460 billion in loans each year on only 14 billion in equity. I didn't intend to pick on Countrywide, but its just too easy. Fairfax does also own CDS's against their debt.) And to top it off, it is at 10x earnings. Now, due to the company's structure it can not get bought out, and there is a chance it might ride the financial momentum downward in price, but it would be an opportunity to add to a longer term holding.

SFK Pulp 2nd Quarter Conference Call and Recap

A lot of people are dissapointed with SFK's 2nd quarter report, so I thought I'd share my thoughts.
The two main things I think need to be addressed are the drop in sales volume, and the strengthening Canadian dollar and its effects.

Sales Volume
SFK's NBSK pulp sales volume was a very low 75,514 tonnes this quarter. In the conference call, the company addressed this due to a major customer cutting back purchases for the quarter. Someone on the call asked whether the drop was due to them being unable to shift the business fast enough, and management said it was partly that and partly a decision to wait until the customer came back, because the customer was close by and the transportation savings accrete to SFK. Regardless, I wouldn't be concerned because in the end pulp is still a commodity product, and one that is currently at low industrywide inventories. In the end, sales volume will be close to production, and in the call management said sales volume and inventories have already returned to normal. The NBSK Mill has a yearly production of 375,000 tonnes, so "normal" is about 93,750 tonnes per quarter. Note also that 2nd quarter and 4th quarter take maintenance downtime, so these quarters have lower production, offset by higher 1st and 3rd quarter production.

For those that want to know the effect, here's some basic math:
NBSK business cost of sales as total sales was 78.8% (47,628/ 60,414)
18,236 more tonnes x $800 CAN price per tonne = $14,589,000
21.2% x 14,589,000 = $3,093,000 extra free cashflow

Note also that this doesn't take into account the fact that labor and maintenance would not take additional expenses for the added sales volume, meaning our gross margin used is likely understating the extra free cash flow. But at the risk of becoming short-term Wall Street analyst-like, im going to not bother doing that calculation.

Strengthening of the Loony
This is where things that getting (more) complicated. The Canadian dollar strengthened from an average of .8535 to .9107 US/CAN. This has a few effects. First, since pulp prices are derived in US dollars, a stronger Canadian dollar means lower realized prices for SFK in its own currency, while its costs remain the same. But also, the company had an additional 3.8 million impairment of cash and accounts recievable that are denominated in U.S. dollars.

Also, and this seems to have been missed by many, is the effect of this on the RBK business. The RBK business is cost, revenues, and profit are all in US dollars, but since SFK reports in Canadian dollars, the income from this segment drops when the loony rises (in canadian dollar terms). But, to hedge this currency risk, SFK took the debt for this acquisition out in US dollars, so its debt obligations also fall as the Canadian dollar rises. However, due to accounting treatment, the company does not report this change on the income statement until the RBK business pays its first dividend to the parent company. So instead, SFK recorded a 5,451 million currency translation adjustment on its balance sheet to take into account the lower debt outstanding in Canadian dollar terms, but this never made it to the income statement (Unlike the 3.8 million impairment mentioned above)

Where Now?
The Canadian dollar has continued to increase since last quarter. Assuming the rate averages out to a new .95, we get the following "run rate" quarterly calculations:
1. Exchange rate at .95 US/CAN

2.$786 CAN NBSK revenue per tonne
2nd Quarter sales price was $800/tonne CAN. If you take into account an $18US rise in prices and the new exchange rate, the sales price for 3Q will be about $786.

3.$618 CAN NBSK cost per tonne
Cost of sales in 3Q is usually lower due to a lack of maintenance expense- it was $571 CAN 3Q06. But since this is run rate calculations, I will start from the 2006 cost of sales of $603 CAN. Costs are up 1.8% this year so far, but I added some leeway, giving a cost of sales of $618.

4. 93,750 tonnes sold per quarter
Again, due to the sales slowdown in 2Q, sales volume will likely be much higher than average next quarter, but since this is run rate im using the average number.

Run Rate
NBSK EBITDA 15,624,000
RBK EBITDA.. 3,500,000
SG&A Expense -1,350,000
Interest Expe. -4,000,000
Capital Expen. -4,000,000

Yields Free Cash Flow of $9,764,000. For those that were concerned, yes this run rate would mean a distribution cut seems likely. Oh, and also, the stronger Canadian dollar would also reduce debt obligation by 4,850,000 in the 3rd quarter, meaning when that currency adjustment is realized, that will be upward of 10 million now on the income statement, though that should also be ignored as far as income goes.

Those are the numbers. Now here's why I'm holding, and you can choose to agree or disagree from here. The company is still cheap, at about 10x cashflow under current conditions. But on a broader worldwide scale, the Eastern Canadian production is ripe for change. Canadian pulp does not need to be automatically considered at a disadvantage to worldwide production. Labor makes up a small percentage of costs, and in fact operational costs at most eastern Canadian mills are actually lower than other places due to very low energy cost. The main burden is fiber. Fiber makes up about $300 of the cost per tonne of pulp in Eastern Canada, about $125 in Western Canada, and significantly lower in Latin America. Canadian fiber doesnt need to be so expensive- rather, it is a problem of too much fiber demand in one region, escalating prices. The industry figures are below:
49 million tonnes worldwide hardwood pulp demand per year
11 million tonnes of pulp(all grades) production in Canada
12 million tonnes of pulp production in Europe including Nordic countries and Russia
9 million tonnes of pulp production in South America

13 million tonnes worldwide NBSK pulp demand per year
7 million tonnes NBSK pulp production in Canada

NBSK pulp is a particular grade that requires stronger fibers found in only some places (mostly, Canada). NBSK also accounts for 28.8% of pulp demand. As a grade, it will likely survive, and give Canadian producers a competitive advantage. But on a broader scale, the fiber disadvantage of Eastern Canada is taking its toll, and this is the first place that excess capacity is coming off. Looking at it today, both Tembec and Pope and Talbot seem discounted already for bankruptcy in the markets. Tembec has 825,000 NBSK production, 1,035,000 hardwood production; Pope & Talbot has 820,000 NBSK production. Also, the merger of Abitibi and Bowater combine two powerhouses in Eastern Canada, possibly spurring much needed rationalization. As a very low cost producer, obviously any fall in fiber prices will greatly benefit SFK. This may sound like wishful thinking to some, and you are slightly right- more research is needed to make a compelling case one way or the next, and hopefully a few calls can help answer some of my new questions. Yet, this year western Canadian fiber is up 57%, compared to only 3% in eastern Canada. A cheap valuation with a possible catalyst, good management, and secured by higher replacement value keeps me invested and feeling relatively safe.

Just Some Economic Charts

A Peak Inside Fairfax's CDS Portfolio

Given the enormous volatility going on in Fairfax's CDS portfolio, I thought i might try to shed some light on the matter. Below are some of the major holdings for a subsidiary, Odyssey Re America, at end of December 2006. Prem has stated that some of these are looking for capital appreciation, while others are to hedge their reinsurance recoverables and business. The ones in bold are the ones I assume were for investment rather than hedging purposes.

Company / notional amount in millions
Ace Holdings - 110
Allianz France - 130
Societe Generale- 175
Aegon - 105
Swiss Re- 75
Ambac - 110
AIG (?) - 330
Countrywide- 130
Freddie Mac- 235
Hanover - 155
JP Morgan - 75
MBIA - 65
MGIC - 205
PMI Group - 230
Radian - 260
Washington Mutual - 210
XL Capital - 200

Most of the counterparties for these deals are Citibank, Duetsche Bank, and Barclays. I'm particularly glad to see Countrywide, MGIC, PMI, and Radian among the bigger holdings on that list, especially since I'm not too optimistic on their futures and because their debt protection costs have been soaring the past few days. I'll be watching these names closely for updates.

2nd Quarter Earnings Update

Earnings season has come and mostly gone for the companies in my portfolio. Here's a brief overview.

The Bad
Bancinsurance
The company reported 1 million in net earnings, or $.20 diluted EPS.
Shareholder's equity increased to 37.41 million, or $7.406 per share.
The big negative for this quarter was the .5 million increase in reserves for the discontinued bond program, as well as the addition of this statement:

"Highlands has provided claim information to the Company with respect to alleged losses during 2001 and 2002 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 certain of these additional losses or allocate such losses among the 2001 and 2002 years in which the Company participated and the 2000 year in which the Company did not participate. As of June 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."

Also, commission expense continues to go up as business shifts to other products.
The one positive is that the company started providing more information about their premiums, including how much is ceded to the reinsurance companies. For the six months ended june 30, written premiums ceded were 14.29 million, compared to 4.16 million last year.

SFK Pulp Fund
SFK earned distributable cash of only 7.6 million for the quarter, although several factors were affecting the figure.

On the NBSK side- besides it being a maintenance shutdown quarter, the company also lost some business from some customers and was unable to replace it in time. Sales volume in the quarter was only 75,514 tonnes, while production per quarter for the mill averages approximately 93,000. Since NBSK pulp is a commodity product currently at record low inventory levels (24 days according to Canfor), I am not worried about the quarterly drop in volume.

The other main factor was the continued strengthening of the Canadian dollar. Quarter over Quarter prices actually fell from $821 CAN to $800CAN, even though prices have been rising in US terms. Also, the company took an additional 3.8 million charge from writing down U.S. accounts recievables.

The main thesis behind SFK still remains intact. Although the Canadian dollar has continued to increase since the 2nd quarter, this affects all other Canadian pulp mill operators equally, and Econ 101 tells us producers will continue to curtail production. (The most recent announcement being from Pope and Talbot for 68,000 tonnes NBSK pulp) Also, we are seeing the fiber price imbalance between Western and Eastern Canada also starting to reverse, which will put additional upward pressure on pulp prices. There will be a profitable spot for a low cost producer like SFK in such an environment when all is said and done.

The Good
Fairfax Financial
FFH has come along way and things are really starting to shine.
Underwriting income for the quarter increased to 87.2 million, net earnings per share of $8.92.
Book value increased to $165.50 per share, debt continues to be paid off or extended.
I've long stated my agreement with Prem's prediction of a one in fifty year event coming along in the markets. The positioning of his portfolio looks brilliant right now.
-Majority in cash and long term US government bonds, and no exposure to mortgage securities.
-Equity portfolio is 80% hedged with shorts against the market or specific stocks.
-a large CDS portfolio against financial services companies. At the end of the quarter this had a market value of 198 million. By the end of July, given recent market events, the market value of this has increased to 537 million, and so far since August the move has been significant as well.
Also, so far the hurricane season has been benign, and if things continue this way we can look for a positive reserve adjustment by year end.

Exchange Bank of Santa Rosa
YTD net income of $6.59 per share, Book value of $78.16 per share.
Continued excellent loan performance and conservative accounting:
-Nonperforming loans as % of total loans at .41%
-Total Delinquent loans as % of total loans at .66%
-Allowance for loan losses of 1.81%

As I am writing this, I'm realizing that I have never done a complete and thorough write-up on Exchange Bank. Many of you are probably wondering why I would invest in a bank given my negative thoughts on the financial industry, so look forward for some clarification soon.

"Black Swan" Event for AHM

Earlier this month, I shared my thoughs about the underwriting at American Home Mortgage (copied below for your convenience):

And finally, some food for thought: American Home Mortgage, an Alt-A loan originator, recently withdrew its guidance for the year and said it expects a loss because of a large influx of warranty penalties. To clarify, when most loan originators sell a loan to an investor, they usually include a warranty that the loan will not go delinquent within the first three months, or otherwise the company will buy back the loan. Those following the subprime fiasco know that this was the cause of the downfall of New Century and several other lenders. (Delta Financial, on the other hand, has so far avoided this) The question is, if loan underwriting has gotten so bad that many loans are going bad in three months, how much better could the loans be that they wrote 6 months, a year, two years ago? The question is important considering subprime and Alt-A combined made up 40% of 2006 loan originations, and many loans written in the last few years are set to reset in the 07-09 period.

Well, late Friday afternoon American Home decided to delay dividend payments on their common and preferred shares in order to preserve liquidity. "The disruption in the credit markets in the past few weeks has been unprecedented in the company's experience and has caused major write-downs of its loan and security portfolios and consequently has caused significant margin calls with respect to its credit facilities."(my italics) So in other words, they were hit by one of Nassim Taleb's black swans: a rare, large-impact event that is beyond normal expectations. It's not that this credit tightening was unpredictable- anyone following the matter could have seen how poor loan standards had become and the future instability to come. But because the good times have been rolling for so long for the financial industry, many choose to ignore the possibility of a credit crunch. Now, those same firms are getting hit hard. I'm starting a new label entitled "Black Swan" that will keep track of the firms that will claim to have been struck by unprecendent, black swan type events. My guess is the list will soon be pretty long.

Wall Street: The World's Biggest Casino

As I was reading a Businessweek article entitled "Profiting from Mortality", I couldnt help but think that this is more of the same: gambling. Let me try to explain why these death bonds are just that, and how they differ from true investing. The new asset is life settlements, arrangements that offer people the chance to cash-out their life insurance policy early to investors, who keep paying the premiums until the sellers die and then collect the payout. Basically, the earlier the people in the pool die, the greater the profit. "Now, Wall Street sees huge profits in buying policies, throwing them into a pool, dividing the pool into bonds, and selling the bonds to pension funds, college endowments, and other professional investors... There's big potential." The truth is, this is just another Wall Street concoction to dope investors.

There are several reasons why these death bonds make terrible investments. The first reason is the all-important competition. The process of making a death bond has many self-interested parties along the way. First, there is the life insurance holder. He or she is looking for the best possible cash-out value for his policy, driving up the initial cost of the investment. Also note the inherent dilemma: A policy holder looking to cash out is more likely feeling healthier than average, meaning lower returns for the investor. But the process doesnt end here, because the settlement on a death bond isnt just between the policyholder and the investor- there are the middlemen. In this case, there is 1) the life settlement providers, who call and arrange the settlement for the policyholder, and 2) the investment banks, which package these settlements together into a securitization pool. Both of these industries are looking to take their share of fees in the process before finally selling the death bond, taking away much of the potential gains from the investor.

Why do investors bite for these esoteric products? Gullibility. Investors are going to be told the sales-pitch that these death bonds should return 8% a year and be uncorrelated to other markets. Most people just accept that right there, without digging further. Why 8% a year? What are those assumptions based on? What do the underlying life arrangements in the securitizations look like? These are questions rarely asked. Because the investor doesn't realize that he got the bad-end of the deal until much later, Wall Street can continue this scheme for some time. For a recent example, just look at the sub-prime market. Years of poorly underwritten loans made into securitizations are now being uncovered for what they really are, and many investors who 6 months ago felt like they were in on a great investment have all of a sudden been wiped out completely. But not before Wall Street and loan originators took their fair share of fees.

A real investment, on the other hand, is backed by solid logic and conservative assumptions. You need to dig to the core of the matter, research into what really matters, and uncover the underlying prospects. Even better is when you can find an investment whos intrinsic value will grow over time, such as stocks. Ben Graham's words ring true: "An investment operation is one, which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

As I've been thinking about this, I couldn't help but also think of two things: First was Sam Zell's Christmas Card, seen here. The other is John Bogle's recent speech entitled "A Tale of Two Markets" (Added to the new "Favorite Readings" tab on the right):

As professional institutional investors moved their focus from the wisdom of long-term investment to the folly of short-term speculation, “the capital development of the country [became] a by-product of the activities of a casino.” Just as he warned, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism is likely to be ill-done.”

Psychology of Intelligence Analysis

I highly recommend everyone to read all the chapters of this publication, entitled The Psychology of Intelligence Analysis, posted for free on the CIA website. As I have been reading through this, I have learned a lot more about the way the mind works and the limitations it can put on ourselves. There are a lot of parallels between the recommendations this book makes and the characteristics needed for successful value investing.

Be Careful

Anyone picking up a newspaper recently has read about the quick turn of events unfolding in the sub-prime market. Two leveraged Bear Stern funds have wiped out all their investors capital, while the ABX index tracking sub-prime loans has fallen sharply and keeps hitting record lows. With every new low the market keeps trying to shrug it off as the new "bottom", yet I believe this is just the beginning of things to come. Here are two things that haven't been mentioned frequently that you should know about.

1. Accounting Tricks
There was a recent change in accounting rules that allows companies to mask investment losses and keep them out of their earnings statements, even though the balance sheet and equity will still be negatively impacted. Well, we are beginning to see the first signs of companies using this policy. In my opinion, investors should look unfavorably on any company that tries to hide their true results using an accounting rule which makes no sense. But this isn't the first accounting rule that has seemed illogical.. remember the time when options didn't need to be treated as an expense?

2. Inverted Yield Curves
We've all heard about the recent inverted yield curve in the United States and its usual indication of recession. Well, what you might not have known is that it is a common phenomenon worldwide. A look at the Economist's interest rate statistics shows that 13 other countries (of the ones listed) currently have inverted yield curves, also.

So, in short, be careful.

Updated Write-up on Bancinsurance

I wanted to do an updated write-up on Bancinsurance now that I have a greater understanding of the company and hence the investing situation. You can find a link to the original write-up at the bottom.

The Company
Bancinsurance is a small insurance company(market cap of 30 million) that focuses mostly on two small niche lines of business. 53% of their premiums are from Ultimate Loss Insurance(ULI). ULI covers physical damage to collateral in cases where it has been repossessed and is not insured, up to the lesser of fair market value or the remaining loan balance. The 2nd biggest line is GAP insurance, which makes up 23% of premiums. When a car is damaged beyond repair or stolen, GAP insurance pays the difference between the amount left owed on the lease and the insurance on the car. (Generally, the fair market value falls much faster than the amortization of the loan or lease.)

The Situation
In 2001, Bancinsurance expanded into a new line of insurance in a bid to grow their business. This ended up being a huge disaster- In 2004, huge losses came up, the auditors left, an investigation began, and the company took the company who managed the new line of business to court for missrepresentation.

Bancinsurance Today
The investigation concluded with no wrongdoing, the company hired a new auditor and became up to date with their filings, and most the claims have been handled and the rest have been reserved for on a practically worst-case basis. The last court arbitration should finish by this year and with it, take away a huge legal expense which cost Bancinsurance approximately 4 million in '06.

Valuation - Safety
Bancinsurance's losses in their lines of business are fairly predictable and stable. GAP relies on a car being either stolen or damaged beyond repair, while ULI covers physical damage on car's that are being repossessed. A recession would lead to more repossessions, but the combination of recession and physical damage is needed for bancinsurance to pay anything. Hence, I think book value is the safety net, especially considering that the company is still making healthy profits. The book value as of last quarter was $7.54, compared to a current price of $6.05. (24.6% return)

Upside Potential
Bancinsurance is in small niche lines of insurance and has been able to earn nice returns on capital throughout its history. And although growth has stagnated recently, over a longer time horizon they have done an excellent job running the business.
The following numbers are the results from 2006 to 2000. (numbers in millions)

Premiums: 49.1, 51.7, 50, 50, 42.6, 33, 25
Net Inc: 5.5, 6.3, -8.5, 3.9, .9, 3 , 3.9
One time
expenses: -1.8, -.4, -20.2, 0, -1.5, 0 , 0
(included in
net inc)
From 2004 to 2006, these one-time expenses consisted of reserves for the discontinued bond program, while in 2002 it was from the affect of an accounting change. Also, keep in mind that expenses were inflated in 2005 and 2006 due to approximately 4 million in yearly legal expenses. Put it all together and there is considerable upside potential for the company.

Moat
The company operates in niche lines of insurance, keeping many competitors away due to the small size. Also, the company sells its products mostly to lending institutions and car dealers, and there is some efficiency gained by having Bancinsurance operate a centralized claims management.

Risks
The main risks revolve around the discontinued bond program and the SEC investigation, but I believe these are accounted for because they are reserved for it and the SEC investigation has been open for a long time without any prosecution. (Usually, it takes a long time for the SEC to formally close an investigation, but if nothing happens within the first two years it diminishes the risk of the situation greatly) There is also a risk that premiums and business will continue to decline.
Given the price, I believe these risks are more than accounted for.

Original Write-Up on Bancinsurance on 9/19/06

Disclosure: I own shares in BCIS. This is neither a recommendation to buy or sell any of these securities. All information provided believed to be reliable and presented for information purposes only.

Too Much Information

"AT 13.16 British Summer Time on July 11th, traders watching the “All News” page on their Reuters screen would have seen 21 headlines flash up. That would have given them less than three seconds to absorb each item—always assuming, of course, that they had finished reading the 16 stories that appeared at 13.15.

So when one starts to wonder why investors were so slow to wake up to the problems of the subprime mortgage market, information overload has to be a factor. An economist, Fischer Black, described this information as “noise”; investors trade on the back of it even though it has no value. The trouble is that it is very hard to distinguish noise from useful pieces of data.

...

All this confirms what most investors who lived through the dotcom bubble must feel: investors are not always rational and markets are not always efficient. But, judging by the subprime saga, spotting those irrational moments is no easier than it ever was."

Direct Link

The Black Swan

One of the greatest books I have come across is The Black Swan by Nassim Taleb, which discusses our attempt to generalize and oversimplify a world that is really chaotic in nature. (The book was originally recommended by Charlie Munger at the Berkshire annual meeting) We can see this everyday in the stock market- as Chris Anderson put it:

Four hundred years ago, Francis Bacon warned that our minds are wired to deceive us. "Beware the fallacies into which undisciplined thinkers most easily fall--they are the real distorting prisms of human nature." Chief among them: "Assuming more order than exists in chaotic nature." Now consider the typical stock market report: "Today investors bid shares down out of concern over Iranian oil production." Sigh. We're still doing it.

Our brains are wired for narrative, not statistical uncertainty. And so we tell ourselves simple stories to explain complex thing we don't--and, most importantly, can't--know. The truth is that we have no idea why stock markets go up or down on any given day, and whatever reason we give is sure to be grossly simplified, if not flat out wrong.

Even more importantly though, is that none of us want to consider the possibility of a truly shaking event, such as a market crash. As the Economist put it:

Betting on a black swan does not offer attractive odds. If a catastrophe only happens 1% of the time, then 99 times out of 100, betting on such an event will lose money. The investor will underperform the benchmark and lose clients.

Staying fully invested, and waiting to get sandbagged by events, makes more business sense. After all, if a catastrophe does happen, the investor has the perfect excuse: nobody saw it coming. The chances are that everybody's portfolios will suffer in tandem.

Needless to say, Warren Buffett would disagree with this type of thinking. In his 2006 Letter to shareholders, Buffett discussed his criteria for a new Chief Investment Officer. He commented:

"But there is far more to successful long term investing than brains and performance that has recently been good. Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions."

How does someone avoid getting blindsighted? Keep your mind open, keep asking questions, and avoid over-generalization.

Heads Up versus Chou

In 2006, Francis Chou gave a presentation in which he outlined his investment in BMTC Group, a large Canadian retailer of furniture, mattresses, and appliances. He discusses his rationale for betting big on the company in 2002. The company was generating extraordinary returns on capital, and it was trading at a very cheap valuation: 8.9 times earnings, and 5.5 times EV/EBITDA. Since that time, the company has appreciated from $9 to $23 per share, allowing us to now say that it was clearly an excellent investment.

I'm mentioning this because one of my company's, The Brick Group, is in direct competition with BMTC in the Canadian retail space. Both companies earn high returns on capital and distribute a bulk of their earnings back to shareholders. But my purchase was made at 8.1x EV/EBITDA compared to the 5.5x purchase made by Chou. Some of this difference is justified- since Brick is an income trust, it does not have to pay taxes for 4 more years, allowing it to keep more of its EBITDA. But, earnings in 2002 were a lot more stable than today. The massive liquidity of the last five years has inflated corporate earnings and made it difficult to figure out what true earnings power is for most companies. So, kudos to Francis Chou for taking advantage of the great opportunity presented to him at the time.

Key terms:
Ebitda- Earnings before interest, taxes, depreciation and amortization
EV- Enterprise value, which is market capitalization plus net debt.

A Closer Look at Prem Watsa's Portfolio

Prem Watsa, CEO and Chairman of Fairfax Financial, is a person I would term "a superinvestor". Over the last 15 years, he has returned 17.2% in common stocks, compared to 10.6% for the S&P500. Through news releases, it is known he owns large stakes in both SFK Pulp and Torstar. By digging through some insurance filings, I was able to find some of the other stocks in his portfolio, which include:
*As of 12/31/06
Pfizer
Dell
Marsh and Mclennan
Takefuji Co
International Coal Group
Eastman Chemical
Citizens Communications

This is as good a place as any to start researching from.

Francis Chou

I have great respect for the deep-value investing style of fund manager Francis Chou. In addition, he has been publishing great annual letters for several years that I think everyone should read from front to end. Here are some notable statements that stood out for me as I was reading through them. (Note: Words in bold are my own)

“Those whom the gods wish to destroy, they first blind them with greed.”

As for what’s new, we are finding pockets of bargains in commodities, commodities-related industries, and companies that have business interests in Eastern Europe and Asia. A proviso, however: because the economics of these types of businesses are not as clear cut, they have to be compellingly cheap before we buy them. We have invested in such companies in the past and have done well with them. -April 15, 1999
This was amazing call given what has happened in the 8 years since this statement. Note his warning about the economics of these businesses.

The Fund is not invested in technology stocks. Their current inflated prices make them unattractive and unsuitable to the investment philosophy of the Fund, which is: 1) To buy above-average to excellent companies run by skilful managers, at a price far lower than what a knowledgeable and rational acquirer would pay for cash; and 2) To buy at deep discount to liquid book value for companies with average prospects.
See my posts on Marginal Company Investing and the self-test on my own portfolio.

Over time I have sifted through thousands of bargains which have come in different shapes and flavours
such as discount to net-net working capital, discount to book value and low P/E ratio. When all is said and
done, those which continue to give me the greatest satisfaction are the ones which display the following
1) Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.
2) Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.
3) Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.
4) A stock price which is far lower than what a knowledgeable and rational buyer would pay.

If there is a secret to the Buffett/Munger success story, it is their willingness to be brutally honest and realistic in their analyses and assessments. They are highly introspective, always checking and rechecking their assumptions and premises against reality. Executives who sugarcoat business realities and embellish results, downplay issues and disguise potential problems to investors may well fool even themselves. They start believing in their own world of make-believe. Buffett/Munger’s formidable powers of analysis would be worth nothing if they looked at problems with rose colored glasses.
Take this to heart.

Seven questions to be answered for any investment operation:
1) How favorable are the economics of the business and where does the company rank in terms of market share?
2) How sustainable are its earnings stream?
3) How skilful have management been in deploying capital?
4) What is the appropriate discount rate to take?
5) Is the capital structure too leveraged?
6) What would an acquirer pay for in cash?
7) And most important of all, what is the appropriate price to pay for such a company that would give an investor more than adequate margin of safety? Margin of safety is simply paying far less for a company than what it is worth, measured by sustainable earning power and/or hard assets that are not depreciating in value. This concept, while unappreciated and ignored by many at the moment, is what distinguishes investment from speculation.

Recent Events

It's been a relatively slow week with not much to post about. Here are a few updates to keep in mind. First, I've been invited as a guest contributor to Reflections on Value Investing, a daily blog dedicated to collecting and posting great reading material relevant to value investing. So rather than post every good article I come across here, I encourage you to make a daily stop at Reflections and read the posts from me and the other great contributors on the site.

Second, back in January I mentioned that the Value Investors Club report on Interoil was a great example of investment analysis. It spelled out various reasons why the company was worth considerably less than its stock price of $23. Well, since that time, the stock has appreciated to a high of $44, before dropping precipitously in three days to $19. Today, the stock is up 26% on news realeased by the company that the price drop is "an overreaction". As Buffett has said, shorting is never really a fun sport. It is difficult to get shares (i was never able to sell it short through my broker), the interest can be high, and the stock can stay irrational longer than you can stay solvent. And to top it off, you are going against insiders that are doing what they can to inflate their stock price. So if you are going to be short a company, be prepared for an emotional roller coaster.

And finally, some food for thought: American Home Mortgage, an Alt-A loan originator, recently withdrew its guidance for the year and said it expects a loss because of a large influx of warranty penalties. To clarify, when most loan originators sell a loan to an investor, they usually include a warranty that the loan will not go delinquent within the first three months, or otherwise the company will buy back the loan. Those following the subprime fiasco know that this was the cause of the downfall of New Century and several other lenders. (Delta Financial, on the other hand, has so far avoided this) The question is, if loan underwriting has gotten so bad that many loans are going bad in three months, how much better could the loans be that they wrote 6 months, a year, two years ago? The question is important considering subprime and Alt-A combined made up 40% of 2006 loan originations, and many loans written in the last few years are set to reset in the 07-09 period.

I am adding to an old position, and there will be a more detailed write-up on the company soon.