Posts By: Geoff Gannon

On Inflexible Enterprises

Yesterday’s Wall Street Journal had an interview with Anne Mulcahy, CEO of Xerox (XRX). I’m not mentioning the article because of Xerox itself. I don’t see any margin of safety in the stock.

Xerox isn’t particularly cheap on an enterprise value-to-EBIT basis. The company did earn good returns on equity in the late 90s; but, those returns were largely the result of leverage. So, investors who buy Xerox are betting on a turnaround with limited upside.

Considering the situation at Xerox and the current market valuation, it’s hard to say whether the stock is overvalued, undervalued, or fairly valued. Regardless, it doesn’t look like an especially attractive opportunity – it seems to be trading within that rather broad gray range that forces me to withhold judgment.

However, the article was worth reading, because it reminded me of a particular problem I had not yet discussed here.

Over time, a business puts down roots. It engages in activities that require it to take on economic and moral obligations. Often, investors find extricating the business from these obligations proves far more difficult than they ever imagined.

One answer in the interview contained an important lesson for investors. Said Mulcahy:

This is the pain of technology transitions. You can either sit and wait like Kodak or Fuji…and fall off a cliff when it happens. Or you can migrate…It’s always more attractive to stay in the old technology from a profit standpoint. Always. But you’ll be going out of business.

This problem isn’t limited to technology. Whenever a large investment has been made in a particular area, whenever there is a lot of capital, people, and ego tied up with some operation, the transition away from that operation is apt to be far slower than what an objective observer would have expected.

As an investor, it’s easy to look at a corporation from afar and see the business the way a rational capital allocator would see it. But, very few people within the organization are able to take such a farsighted view. They are not able to asses the matter dispassionately. There are jobs at stake. There is the admission of defeat. And there is the question of identity. Just as importantly, these problems hang over the managers every day. Staying too long in a dying business is rarely the result of one major misstep – rather, it is the result of a series of seemingly innocent steps that merely serve to delay the inevitable.

Recognizing the terrible importance of the inflexibility of an enterprise that is tied to a particular line of business, mode of production, or labor force is a difficult task. Many value investors have been caught in this trap. Some business appears to offer excellent value today; but, if it should cling too long to its old ways, that value will be destroyed. It’s tempting to think that managers will see the obvious danger, act to remedy the problem, and forever change the organization, before…

On Special Situations

I don’t discuss special situations investing on this blog both because it is not my forte and because I don’t think special situations investing is something most readers are interested in.

However, investing in special situations can be very profitable. In fact, if not for its demands on time and temperament, special situations investing might be the best way for individual investors to put their money to work.

Unfortunately, the demands on time and temperament are real, and they do preclude most investors from successfully pursuing this strategy. Simply put, you have to be willing to put some extra time and effort into such investments.

There is an almost constant flow of possible opportunities. Like any kind of investing, you are going to have to say no a lot more often than you say yes. That isn’t a lot of fun for most people. In fact, many investors will not succeed in this area, simply because they will be too eager to do too much too quickly.

But, if you’re still interested in special situations investing, I’d recommend you do two things:

1. Read “You Can Be a Stock Market Genius” by Joel Greenblatt

2. Visit Fat Pitch Financials

Greenblatt’s book is a good introduction to special situations investing, because it discusses the topic in a way that will make sense to investors who have never considered this area before. There are some other books that treat select subjects in greater detail, but they aren’t the best place to start – this book is.

George of Fat Pitch Financials discusses some excellent special situations on his blog. There’s a membership access area that discusses current situations. But, if you just want to learn more about special situations investing, the free content at Fat Pitch Financials is more than sufficient. To give you some idea of what I’m talking about, here’s an excerpt from George’s most recent post:

As you might recall, I purchased AutoNation on March 31, 2006 for the Special Situations Real Money Portfolio. This was my first odd-lot tender offer opportunity that I’ve taken advantage of.

Odd-lot tender offers provide small individual investors a unique opportunity that the big boys don’t have. By owning less than 99 shares of the stock that is being tendered, my shares received preference in this tender offer since there was an odd-lot provision to the tender. The AutoNation Inc tender was very oversubscribed and most shareholders that tendered their AutoNation shares only had 26 percent of their shares cashed out. However, since I had an odd lot, my tender was not subject to being prorated. This presented a very nice opportunity.

Let me show how nice. I purchased 95 shares on March 31, 2006 for a total cost of $2,056.10. This morning I received $23 per share for a total of $2,160.00. My broker charged me a $25 dollar fee in addition since this tender was a voluntary action. My total profit was $103.90 or a 5.1 percent

Suggested Link: Price and Value

Bill of Absolutely No DooDahs has written an excellent discussion of price and value:

“Value is subjective. The price at which goods are exchanged is at the nexus of a disagreement over value, and while prices provide an objective history, prices provide little true information about value.”

This disagreement over value has interesting implications in the stock market, where we often consider only the small number of shares that trade on any given day. We talk about why these shares traded at a different price than they had the day before, and yet we ignore the fact that a great many owners chose to turn down Mr. Market’s latest offer.

With a few rare exceptions, buyers and sellers of stock do not just disagree over value; they have wildly different views of the stock’s value. Of course, they may also have different reasons for buying or selling, especially where the money they are directing is not their own.

Anyway, it’s a good post. I encourage you to read it.

Visit Absolutely No DooDahs…

News Item: Berkshire Hathaway Buys Russell Corporation

Warren Buffett’s Berkshire Hathaway (BRK.B) will acquire publicly held Russell Corporation (RML) for $18 a share. Berkshire will also assume about $400 million in debt.

The deal values Russell at roughly $1 billion ($600 million cash + $400 million debt). In 2005, Russell’s EBIT was $84.37 million. Earnings before interest and taxes had been higher in five of the last ten years.

Russell has signed a definitive merger agreement. The deal is expected to close by October 1st. RML opened above $18 today.

For more information see Value Discipline’s most recent post: “Berkshire Buys Russell – The Advantage of Long Term Horizon”…

On The New York Times

The New York Times Company (NYT) isn’t just reporting the news – it’s making the news. At yesterday’s annual meeting, shareholders withheld 28% of their votes for the four directors elected by holders of the company’s common stock. Nine other directors are elected by holders of the Class B shares, effectively granting control of the company to a group holding less than a 1% economic interest in the business.

Most of the large newspaper companies have not done a great job of earning the best returns for their shareholders. Some of these companies overdid acquisitions. The New York Times Company illustrates the danger of adding to the empire – you dilute the crown jewel.

In 1993, the company bought The Boston Globe. Unfortunately, this is exactly the kind of paper that will be hurt by online news sources. Second-tier major city dailies are not in a strong position, because they try to be all things to all people.

A newspaper can thrive by dominating a specific niche. That niche can be geographical or topical. Community newspapers can thrive, because they still have no real competition. The news they report is unique. It is very important to a very small group of people.

A company that owns clusters of these papers in wealthy suburbs will do fine. By reporting on local schools, sports, and events these publications set themselves apart from all other news sources. They have a mini-monopoly both on the news they provide and on the ads they run.

There are places in states like New York, New Jersey, Connecticut, and Pennsylvannia where advertisers benefit from targeting specific communities, because the demographics of the next town over are not nearly as attractive. A lot of this has to do with public schools. I don’t see that system changing anytime soon. So, I imagine these properties will fare much better than big city newspapers.

The New York Times Company has one great asset – its brand. The New York Times and The Wall Street Journal each have a very valuable national brand. People all over the country have been exposed to them through other media outlets. The value isn’t really in the size of the circulation. If you think of the entire country as their potential market, their circulations are tiny (the news business is very fragmented).

A few years ago, it would have been crazy to think of the entire country as a potential market for these publications. But, I don’t think that’s the case today. These papers could earn a lot of money online. Of course, they have to figure out how to earn money online.

Long-term, I don’t like the idea of expensive online subscriptions. It looks like a great idea now, but it could limit future ad revenue. Becoming a dominant online news destination would prove extraordinarily profitable. Unfortunately, no one is going to capture more than a tiny sliver of the online news market by charging a lot of money for their …

On Confidence

I get a fair amount of emails both from readers of the blog and listeners to the podcast. Most of the emails come from people who listen to the podcast. The two most common varieties are: 1) “Before I listened to your podcast, I thought investing was impossibly complicated; now, I think it may be simple enough for someone like me.” 2) “Before I listened to your podcast, I though investing was simple; now, I think it may be too complicated for someone like me.”

Part of the reason for these two very different reactions is the nature of the podcast. I talk for almost half an hour about things that aren’t regularly discussed at length by the financial media. So, it’s natural for listeners to feel I’m discussing something familiar in an unfamiliar way.

That can cause listeners to question some of their beliefs, especially if those beliefs weren’t all that firmly held to begin with. Most people’s beliefs about investing are very tenuous. There are, of course, people who are very passionate about investing. They don’t view investing as some esoteric subject, but rather as a field intimately connected to the human behavior they observe in their everyday lives.

For everyone else, however, beliefs about investing come in the form of passive knowledge. The tendency is simply to accumulate an inventory of conventional dictums. Investing beliefs are formed much the way a student prepares for a test. If the subject of investing were as simple as a third grade spelling bee, this wouldn’t be a problem.

But, investing is a far more complex subject. That isn’t to say it is necessarily a difficult subject. For some, it is relatively easy. But, it is never simple. An investor can not analyze relationships with the certitude and precision a physicist can. The investor is concerned with human phenomena, which are necessarily complex phenomena.

The complexity of the subject is what makes it appear so difficult. While you can develop a set of guiding principles, it is impossible to devise rules that will lead you to the best course of action in each and every case.

If you try to build an intellectual edifice based on principles such as high returns on equity, strong consumer franchises, low price-to-earnings ratios, low enterprise value-to-EBIT ratios, high free cash flow margins, and rock solid balance sheets – you will fail.

The entire structure will collapse, leaving the architect disillusioned. Why? Because the items listed above are desirable attributes – nothing more and nothing less. They are not true principles. Even as rules of thumb, they are badly flawed. Ultimately, investment decisions are not made about general classes; they are made about special cases.

Every investment decision requires good judgment and sound reasoning. You need to start with the correct principles. But, principles alone are not enough. You aren’t being asked what the law is, you’re being told to apply the law to the …

Newsletter Problems

You may be wondering why I haven’t posted for over a week. The time I normally use to write blog entries has been spent on the newsletter instead. It’s been a terrible experience. I was very disappointed with the printer I had selected for the job. I’ve switched print shops, but production has already been delayed.

Everyone who ordered the April issue will still receive their printed copy via mail. I have also decided to send each subscriber a PDF file with the contents of the newsletter. There are a couple graphical problems with the PDF; but, they are limited to pages 11, 12, & 13 which contain statistical summaries rather than text.

I’ve sent an email with the attached PDF to each subscriber. Unfortunately, I had to use the emails from the payment receipts. If you’re anything like me, you get too much email at your main address, so you have a second email address to use for online payments, subscriptions, etc. If that’s the case, please let me know where you’d like the PDF sent.

I know a PDF is not the same thing as a printed, bound copy. However, it is the best I can do today. Subscribers who would like to see the contents of the newsletter without having to wait for the printed copy should check their email right now. There should be a PDF waiting for you. The newsletter runs 48 pages; 46 excluding the front and back covers.

Subscribers should feel free to email me about the newsletter, the PDF, etc. I will be happy to discuss any questions or concerns you have about all this.

I know some of you have probably emailed me about the newsletter within the past week. This printing problem has consumed all my time. I apologize for not responding sooner. I’ll spend tonight working my way through the backlog of emails (from least recent to most recent). Anyone who emailed me this week should hear back from me tonight.

Thank you for your patience.…

Wall Street 2.0: Marketocracy Contest

Wall Street 2.0 is an investment blog network. Marketocracy is a website that lets you create simulated mutual funds and track their performance. I recommend checking out both sites even if you don’t join this contest:

With many of our readers being Marketocracy users, the Wall Street 2.0 Network has decided to start a Marketocracy Club. Registration is already underway, and trading will begin on Monday, April 10th. The only rule is that your fund be compliant (if you are not yet a Marketocracy member, you will learn about their compliance rules after joining).

Did we mention the prize? The member with the highest returns after 3 months, will receive $200 cash, courtesy of the Wall Street 2.0 Network.

To join the club, head over to the Wall Street 2.0 Message Boards and register. Then check out the Wall Street 2.0 Marketocracy Club sub-forum for details on joining the club.

I already have several funds over at Marketocracy to test how difficult it is to successfully invest with various restrictions in place. These restrictions are meant to force a certain degree of concentration or diversification. For instance, the most diversified fund tries to keep 1% of assets in each of 100 different stocks. That’s pretty diversified.

On the other side of the spectrum, one of my Marketocracy funds only invests in companies headquartered in New Jersey. That narrows the investment universe considerably.

This is the sort of fun stuff you can do at Marketocracy.

I posted a check-up on these funds back on March 15th.

Visit Wall Street 2.0

Visit Marketocracy…

On Buffett’s Big Bet

Over the past few days, there have been several stories written about Warren Buffett’s $14 billion bet on global stock markets. I believe these stories are all in reference to this disclosure in Berkshire Hathaway’s annual report:

“Berkshire is also subject to equity price risk with respect to certain long duration equity index put contracts. Berkshire’s maximum exposure with respect to such contracts is approximately $14 billion at December 31, 2005. These contracts generally expire 15 to 20 years from inception. Outstanding contracts at December 31, 2005, have been written on four major equity indexes including three foreign. Berkshire’s potential exposure with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration. Thus, if the overall value at December 31, 2005 of the underlying indices decline 30%, Berkshire would incur a pre-tax loss of approximately $900 million.”

It’s impossible to evaluate exactly what this means for Berkshire (or what it tells us about Buffett’s thinking) without knowing more details. But, there are a few things I’d suggest you consider when reading the news reports.

First, the $14 billion headline number makes this bet look larger than it really is. According to the above disclosure, a 30% decline in the underlying indices would only create a $900 million pre-tax loss. One article stated that a decline in the indexes to zero was highly unlikely given historical trends. It’s a lot more than highly unlikely. But, since we don’t know the details of Berkshire’s exposure, we can’t evaluate the real risk of a very large loss.

A lot of these news stories have called Berkshire’s “long duration equity index put contracts” a bet on global stock markets. A few individuals have been quoted as saying Buffett has become bullish long-term. Buffett’s always been optimistic about the very long-term insofar as he recognizes how better things are today than they have been at any other time in history, and how that is likely to remain true for some time. Despite Buffett’s concerns about nuclear war, he doesn’t see a return to the Dark Ages and those kinds of anemic returns on capital.

That’s important to keep in mind, because I’m not sure this bet is much more than that. If you assume returns on equity will be similar to those achieved in the years since industrialization began, and you assume central governments will continue to cause inflation, a long duration equity index put contract isn’t much of a stretch.

Equity will earn returns, much of those returns will be retained by the businesses, and inflation will increase (nominal) stock prices regardless of whether the underlying businesses’ assets are increasing or remaining stable.

I’m not sure this is a bullish sign. In fact, it may be a bearish sign, because it suggests Buffett can’t find individual equities to buy, three of the four indexes are foreign, and someone wants to be protected against very large losses in a …

On Asymmetric Opportunities

Most difficult investing decisions are not caused by fine distinctions. Two apparently similar stocks are usually just that. There is little difficulty in evaluating such situations. More importantly, the magnitude of whatever miscalculations are made is likely to be small. The true difficulties arise when the investor is presented with two or more asymmetric opportunities.

The intrinsic value of a business isn’t printed anywhere. To the extent that a business’ intrinsic value is similar to its earnings power, the evaluation process is simplified. In fact, this so greatly simplifies the process that many investors are tempted to calculate earnings power alone and simply assume the intrinsic value reflects the earnings power.

This is a mistake. While you will rarely lose a lot of money by focusing on earnings, you will miss some great opportunities if you rely solely on earnings.

The intrinsic value of a business is the discounted value of the cash that can be withdrawn from the business. It is not merely the discounted value of the future cash flows generated from operating activities. This may sound like I’m splitting hairs. But, it’s an important concept to understand.

Obviously, a cash flow neutral business with several hundred million dollars in cash (in excess of total liabilities) is worth more than the intrinsic value of zero that would be calculated based on the free cash flow generated from its operating activities. You could account for this by treating the excess cash as a reduction to the purchase price. That is essentially what you’re doing when you use a company’s enterprise value instead of its market cap.

Actually, you’re doing more than that, because you are adding debt in excess of cash to the purchase price. Should you do that? It’s hard to say. For some businesses, this is an unnecessarily harsh adjustment, because the debt needn’t be repaid anytime soon. The advantages of the free cash flow generated will be amplified by the debt, which needn’t be repaid until long after the cash flows are received.

But, by the same logic, one could argue that whatever excess cash a business holds needn’t be returned to shareholders via a dividend, stock buyback, etc. within the next few years. If that cash isn’t utilized relatively quickly, its intrinsic value will be diminished.

In my experience, you will seldom go wrong by valuing a company’s cash too highly. Judging by the spreads in EV/EBIT ratios among various stocks, the market doesn’t seem to overvalue cash too often.

So, my advice is to count the cash as if it were being paid out to you at the time you purchase the shares. Since the cash has already been taxed, whatever advantages you would have in generating returns on the cash greater than those the retained cash generates will be mitigated.

Counting excess cash as a reduction in the price per share isn’t a perfect solution, but it is a simple, workable solution. As I mentioned in a previous …