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Geoff Gannon March 30, 2011

Berkshire Hathaway’s David Sokol Resigns

Many pundits believed David Sokol was the most likely person to replace Warren Buffett as CEO of Berkshire Hathaway (BRK.B).

On Monday, David Sokol resigned.

Here is Warren Buffett’s letter explaining the resignation.

This press release will be unusual. First, I will write it almost as if it were a letter. Second, it will contain two sets of facts, both about Dave Sokol, Chairman of several Berkshire subsidiaries.

Late in the day on March 28, I received a letter of resignation from Dave, delivered by his assistant. His reasons were as follows:

“As I have mentioned to you in the past, it is my goal to utilize the time remaining in my career to invest my family’s resources in such a way as to create enduring equity value and hopefully an enterprise which will provide opportunity for my descendents and funding for my philanthropic interests. I have no more detailed plan than this because my obligations from Berkshire Hathaway have been my first and only business priority.”

I had not asked for his resignation, and it came as a surprise to me. Twice before, most recently two or so years ago, Dave had talked to me of resigning. In each case he had given me the same reasons that he laid out in his Monday letter. Both times, I and other Board members persuaded him to stay. Berkshire is far more valuable today because we were successful in those efforts.

Dave’s contributions have been extraordinary. At MidAmerican, he and Greg Abel have delivered the best performance of any managers in the public utility field. At NetJets, Dave resurrected an operation that was destined for bankruptcy, absent Berkshire’s deep pockets. He has been of enormous help in the operation of Johns Manville, where he installed new management some years ago and oversaw major change.

Finally, Dave brought the idea for purchasing Lubrizol to me on either January 14 or 15. Initially, I was unimpressed, but after his report of a January 25 talk with its CEO, James Hambrick, I quickly warmed to the idea. Though the offer to purchase was entirely my decision, supported by Berkshire’s Board on March 13, it would not have occurred without Dave’s early efforts.

That brings us to our second set of facts. In our first talk about Lubrizol, Dave mentioned that he owned stock in the company. It was a passing remark and I did not ask him about the date of his purchase or the extent of his holdings.

Shortly before I left for Asia on March 19, I learned that Dave first purchased 2,300 shares of Lubrizol on December 14, which he then sold on December 21. Subsequently, on January 5, 6 and 7, he bought 96,060 shares pursuant to a 100,000-share order he had placed with a $104 per share limit price.

Dave’s purchases were made before he had discussed Lubrizol with me and with no knowledge of how I might react to his idea. In addition, of course, he

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Geoff Gannon March 18, 2011

Blind Stock Valuation #1 – Watlington Waterworks

A couple months ago, I posted a blind stock valuation. Basically, I just gave you 7 important financial figures for each of the last 6 years and asked you to value the stock as best you could. I didn’t give you the name of the stock.

And – although I didn’t tell you this – I multiplied all figures by 10 to eliminate any bias caused by you realizing this was a very small stock.

I promised I would give a copy of Ben Graham’s The Intelligent Investor to the reader who sent in the best email telling me how much the stock was worth.

The stock was actually a foreign microcap called Watlington Waterworks. It’s a water company on the island of Bermuda.

Bermuda is a rich island nation – actually a territory of the United Kingdom – 650 miles off the coast of South Carolina. It has a population under 70,000. Bermuda’s economy is based around insurance and American tourism. Its currency is convertible into U.S. dollars at a fixed 1-to-1 ratio.

There is no fresh water on the island. Bermuda’s water comes from removing salt from seawater and collecting rainwater.

This is an analytical exercise. Not a stock tip. In all likelihood, your broker doesn’t have the ability to buy stocks for you in Bermuda.

Here is the information I provided about the company:

And here is the best email a reader sent in:

1) Growth in sales and earnings is roughly tracking inflation.  This is a mature, roughly no-growth business so I will pay no premium for growth.

2) FCF is consistently less than earnings.  So this is a business with a significant amount of long-term assets which causes CapEx to exceed accounting depreciation due to the effect of inflation.

3) FCF in this case is a more relevant determinant of value than earnings.

4) The FCF yield on equity has averaged roughly 10% over the 6-yr period presented.

5) My hurdle rate for investment is 10%, therefore I am willing to purchase the company at 1X equity.

6) So I would be willing to pay up to 181/10.5 or approximately $17.25 per share.

7) An additional consideration: The company is carrying very little debt and has stable earnings.  As a control buyer or an activist investor, I would give strong consideration to leveraging up my equity.

The stock trades on the Bermuda Stock Exchange. Shares last traded hands at $13.95 a share.

Most readers sent in valuation estimates in the $20 to $30 a share range.

Thanks to everyone who participated.

Talk to Geoff About Blind Stock Valuation

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Geoff Gannon March 16, 2011

Buy Japan

I haven’t posted to the blog in a while. But the situation in Japan – and Japanese stocks – is definitely worth coming out of hiding for.

No matter how bad the nuclear situation gets, the earthquake and the events that followed will probably be classified by history as:

  • A major human disaster
  • A moderate economic disaster
  • A minor investment disaster

Public companies in Japan have already lost more value in terms of their market caps than could ever be justified by the disaster – no matter how bad the nuclear situation gets – because there’s no way these companies’s future cash flows could be permanently impaired to the degree necessary to cause a loss in intrinsic value equal to their recent loss in market value.

And Japanese public companies were already some of the world’s cheapest businesses. So some of the world’s cheapest stocks just got cheaper.

Some folks are going to argue that the disaster in Japan – and subsequent stock sell-off – provides an opportunity to buy stocks elsewhere. Ignore them. U.S. stocks aren’t cheap. Japanese stocks are. Don’t get fooled into buying stuff on the other side of the world. Go straight for the center of the crisis. Buy there. That’s where the bargains are.

There are lots of problems in Japan.

And I’m going to be brutally honest about them here. Seeing the human tragedy in Japan is something we can mourn as fellow human beings. But it shouldn’t color our view of Japan as investors.

I don’t like most Japanese businesses. The country’s business culture is toxic. It is very shareholder unfriendly. Returns on capital are – and frankly, have always been, even in the boom years – completely unacceptable. Most Japanese companies pander to their customers and do not price their products at the best levels for their shareholders. Japan is an investment basket case. And Japanese stocks deserve to trade at lower price-to-book ratios than the rest of the world’s stocks now and forever.

Having said that, I’m going through the Tokyo Stock Exchange and finding dozens of bargains.

Examples include grocery stores, logistics companies, and gas utilities. Some of these companies – unlike the vast majority of Japanese businesses – earn unleveraged returns on invested capital equal to their counterparts in the United States and Europe. Of course, they are all irrationally underleveraged. Many Japanese companies are.

There are tons of net-nets in Japan.

Some of these companies deserve to remain net-nets forever. Such justifiably permanent net-nets are very rare in the rest of the world. In the U.S., I can name – at most – about half a dozen net-nets that are consistently profitable but have such consistently pathetic returns on capital to deserve a fate of staying a net-net forever. One American example is Duckwall-ALCO (DUCK).

Economists may argue this has to do with Japan’s economic circumstances. I’m more inclined to believe Japan’s economic circumstances have been exacerbated by its business culture.

The profit motive is very weak …

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Geoff Gannon March 16, 2011

Barnes & Noble – The Human Element

A reader sent me this email:

The way Barnes & Noble (BKS) is trading is starting to bother me.  I don’t see anything in the recent 10-Q that wasn’t already announced.  Borders CEO is saying they hope to come out of (bankruptcy) by end of summer, ok but that is not the end of B&N.  Other than that there is nothing but the market trading as if B&N is going to end in (bankruptcy) itself.  I don’t get it.

Can you offer your take?  I realize you no longer like B&N or maybe you are not interested to offer comments but this sort of movement seems irrational and I am getting uncertain.

One of the really big issues with Barnes & Noble – and probably the reason I sold out – is that the non-profit motivations of Riggio and others didn’t align with my (as an outside investor) very much for profit motives of buying the stock. My fear was that once Riggio defeated Burkle in the proxy contest, the company would be more geared to relentless pursuit of being a big, relevant force in bookselling regardless of what that meant for profits that could actually repay shareholders.

In other words, I was very scared that Nook spending wasn’t a one-time thing. That the existential threat to Barnes & Noble as a company was what management would respond to instead of minimizing direct investment in the Nook and maximizing the milking of today’s cash flows from the actual stores. Basically, I thought Burkle’s motives were safely capitalistic while Riggio’s motives were dangerously paternalistic.

I still do.

Maybe things will work out for Barnes & Noble the company, for Barnes & Noble the institution – but I didn’t think they’d work out well for shareholders. The actions they are taking are crazy from a return on capital perspective. But they obviously make sense from a long-term survival perspective. Still, they are unnecessarily dangerous from a short-term survival perspective. Barnes & Noble’s financial health would be fine without the Nook. It isn’t fine right now and that’s entirely because of the combination of cashing Riggio out of B&N College and spending on the Nook combined with maintaining the dividend through the proxy fight.

Ironically, this pursuit of long-term relevance has endangered the financial health of the company. Unless they stop spending on the Nook, they’re going to be flying a lot closer to the sun than they ought to be. A company with these cash flows shouldn’t be doing this kind of new product investment. They’d say the level of spending is temporary. I’d say you either commit to an arms race or you don’t. But once you commit, it’s out of your control how many missiles you’re going to need next year. Both sides get a say in how much you have to add to the arsenal each year. If Amazon raises the bet, you have to match them or fold. But you no longer get to choose your level …

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Geoff Gannon March 16, 2011

Investing in Japan – Questions and Answers

A reader sent me this email:

In your research have you come across any good closed end funds? So far I’ve only found JEQ and JOF.

I don’t plan to buy a closed end fund. I plan to buy stocks I select myself.

If your broker can buy in Japan, I’d suggest doing that. Last I saw, the discount/premiums on Japanese closed end funds and ETFs are tighter than normal not wider. In other words, like in Egypt, foreigners are buying into the country wide funds in the middle of the crisis. People are fleeing the specific stocks. But that doesn’t seem to be matched – and certainly not exaggerated – in the funds. Usually, slow motion market declines show the reverse trend. But people may actually be attracted by bad headlines when they happen fast in a country they normally don’t invest in.

I’m working on a list of 100+ Japanese stocks. These are individual stocks I picked myself based purely on their 10 year earnings records. I’ll probably just make my own basket out of those instead of buying into a fund.

But, depending on your broker, that could be too expensive in your case.

A reader also sent me this email:

How are you sizing your Japanese positions? Are you setting a maximum limit of how much your portfolio will be invested in Japan?

I expect to put 25% of my net worth into Japanese stocks.

If prices fell a lot from here and I found stocks I liked, I’d definitely put 50% into Japan.

I’m unlikely to put more than 50% into Japan under any circumstances. It would be possible. But the Japanese stock market would have to drop further by some crazy amount like 50% or something for me to put more than half my net worth into Japanese stocks.

I’m saying that now, but I could change my mind. If I really liked the prices, there’s ultimately no limit to what I’ll put into one country. They’ve got enough public companies in Japan that interest me. If they offer them at low enough prices, I’d be willing to go to 100%. But I already own some American stocks I like, so putting more than 50% in Japanese stocks would be hard right now.

I’m expecting my portfolio will be 25% to 50% in Japanese stocks very soon.

Beyond that – your guess is as good as mine.

But I won’t buy indiscriminately. I’m not going to buy a fund. I’m going to buy from my own list of the cheapest Japanese stocks.

A reader also sent me this email:

“How are you thinking about currency risk?”

I always think about currency risk in terms of purchasing power parity. I just assume I will exchange my foreign currency back into U.S. dollars at the lower of today’s exchange rate or purchasing power parity.

So, I punish overvalued currencies, but don’t treat undervalued currencies as being more attractive. That keeps me out …

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Geoff Gannon March 11, 2011

15 Japanese Net-Nets

Since my “Buy Japan” post I’ve been getting lots of emails asking exactly which Japanese stocks are worth buying.

The simple answer is net-nets.

Net-nets are stocks selling for less than the value of their current assets – cash, receivables, and inventory – minus all liabilities. Basically, they’re stocks selling for less than their liquidation value.

I’ve put together a list of 15 of Japan’s best net-nets. These are small, unknown, super cheap stocks.

I ranked these 15 stocks on 5 key criteria:

  1. Size
  2. Sales Growth
  3. Profit Margin Variation
  4. EV/EBIT
  5. Price/NCAV

By combining those 5 criteria, I was able to sort these 15 Japanese net-nets from most attractive to least attractive. In other words, I was able to make a list of 15 Japanese net-nets with the best ideas up top and the worst ideas at the bottom.

This report is perfect for someone looking to buy a basket of 5, 10, or even 15 Japanese net-nets.

Or for anyone who would like to start researching Japanese net-nets but has no idea where to start.

The price of the report is $100.

That’s about $7 per stock.

If you click the “Buy Now” button below you can pay using PayPal. Once you’ve paid, you’ll be taken to the page where you can download the report as a PDF.

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