On the Northern Pipeline Contest

When Standard Oil was broken up, eight of the resulting companies were small pipeline operators. Wall Street didn’t pay much attention to them. Little was known about their finances – and they liked it that way. Their “income accounts” literally consisted of a single line. They didn’t provide detailed balance sheets.

Ben Graham spent a lot of time looking through information provided by the Interstate Commerce Commission (ICC), a regulatory body that oversaw the railroads (among other businesses). One day, as Graham was looking through an ICC report, he found some statistics clearly furnished by the pipeline companies. The statistics were accompanied by a note that read “taken from their annual report to the Commission“.

Graham realized that the pipelines were filing reports with the ICC that contained information not known on Wall Street. So, he requested a blank copy of the report from the ICC. The blank form included “a table which required the companies to set forth a list of their investments at cost and market value.”

Ben left for Washington the next day. He reviewed the reports for all eight pipeline companies. What he found amazed him:

“I discovered all of the companies owned huge amounts of the finest railroad bonds; in some cases the value of the bonds alone exceeded the entire price at which the pipeline shares were selling in the market! I found, besides, that the pipeline companies were doing a comparatively small gross business, with a large profit margin, that they carried no inventory and therefore had no need whatever for these bond investments. Here was Northern Pipeline, selling at only $65 a share, paying a $6 dividend – while holding some $95 in cash assets for each share, nearly all of which it could distribute to its stockholders without the slightest inconvenience to its operations. Talk about a bargain security!”

Northern Pipeline had the greatest amount of securities per share relative to its market price; so, Graham focused on buying shares of that company. He bought slowly but surely. Eventually, he was able to acquire a 5% stake in Northern Pipeline. Not surprisingly, the Rockefeller Foundation was still the largest shareholder. The foundation held 23% of the shares outstanding.

Graham didn’t count on a contest. There were no such things as “activist investors” in those days. Besides, Graham didn’t see any need for activism. The correct course of action was clear. He would simply explain the situation to management and they would distribute the excess cash.

Graham met with the company’s President and General Counsel (they were brothers). He explained the situation and what needed to be done.

The Bushnell brothers explained they couldn’t distribute the cash, because the par value of the stock was too high. Graham explained how they could reduce the par value and treat the distribution as a return of capital. The brothers explained they needed the capital. Graham asked for what. The brothers said the investments were a depreciation reserve. Graham said fine …

On Disney, Pixar, and Ratatouille

One of the Eight Best Investing Blogs, Cheap Stocks, has posted the second part of its look at Disney (DIS).

Another one of the eight best investing blogs, 24/7 Wall St., has a new post entitled “Disney’s Pixar Purchase: Never Give a Sucker an Even Break“. The post mentions that this weekend’s estimated $47.2 million opening for Disney/Pixar’s “Ratatouille” was the worst Pixar opening in nine years.

Regardless, Ratatouille was number one at the box office despite tough competition from films such as Live Free or Die Hard and Evan Almighty – well, not exactly tough competition in the latter case as Evan Almighty has been a big financial disappointment.

You could see it coming. If you look at any list of top grossing movies (adjusted for inflation) comedies don’t do particularly well, especially considering how many get produced. The recipe for a huge money maker is simple – and goes back to long before the beginning of movies – make it epic, make it exciting, make it fantastical or historical (just don’t make it commonplace), and make it for all ages. Most comedies don’t score well on those counts. I suppose Evan Almighty does better than most comedies in aping the epic dramas that work. In fact, it matched them a bit too well with a price tag around $175 million.

Why have I spent a full paragraph on Evan Almighty when I’m supposed to be writing about Disney, Pixar, and Ratatouille? Because price matters. Here’s some of what 24/7 Wall St. had to say about Disney’s acquisition of Pixar:

It would appear that Jobs sold at the top. It would also appear that Disney got a lousy deal. It’s their own fault. Jobs was able to get more for the company than it was worth. The markets have learned not to underestimate him…But, Disney got burned.

I’m sticking with that I wrote about a year and a half ago:

Is Pixar worth $7 billion (or whatever the offer ends up being)? That’s a complicated question. First of all, you have to ask if $7 billion of Disney’s stock at today’s market price is actually worth more or less than $7 billion. What’s the chance that Disney’s stock is currently undervalued and Pixar’s is currently overvalued? It’s a real possibility.

On the plus side, this could mean Disney CEO Robert Iger wants to take Disney in a different direction from what we’ve seen lately. I’ve always thought the real value at Disney would come from providing content not distributing it. If the company really wants to be some sort of “diversified entertainment company” wouldn’t a company built around kids make more sense?

A company focused on animation, theme parks, the Disney Channel, etc. would make more sense to me. In fact, a few years ago, I would have been very happy if Disney announced an acquisition of a toy maker, video game publisher, or licensing company that had something to

On the Dangers of Homogeneity

One of the Eight Best Investing Blogs, Value Discipline, has an excellent new post entitled “The Dangers of Homogeneous Thinking.” Diversity of thought and interpretation is an important concept.

A lack of variation within any population is a dangerous thing. An evolutionary system in which an overall sense of conservatism (carrying what has worked in the past into the future) combined with a lot of variation at the margins (sometimes in extreme and eccentric ways) has often succeeded in consistently creating truly remarkable and effective outcomes that could never have been devised by a single omniscient actor.

This is something I spend a lot of time thinking about. Unfortunately, there is a tendency for success to sow the seeds of future failure, because the greatest enemy of great new ideas is acceptable old ideas.

Major League Baseball is an extreme example of a system in which variation is surprisingly stifled. I’ll use it, because although large corporate bureaucracies display some of the same attributes (and thus outcomes), any discussion of specific corporations would be both less concrete and somewhat more controversial – because it’s closer to the topic I normally write about here.

Pitching techniques are surprisingly uniform in Major League Baseball. There’s basically no evidence to suggest that any physical constraints should cause such bizarre uniformity. Historical evidence shows that other techniques are pretty effective. Furthermore, employing an unusual technique should be especially effective during a period in which a batter is highly accustomed to pitches thrown at different angles and speeds from a different release point following from a different motion. In other words, there’s a lot of evidence to suggest that pitching counter to a batter’s overall experience and his expectations of a certain situation should (all other things being equal) work better than pitching like everyone else does and like the batter expects (both generally and in a specific situation).

Anyway, pitching techniques don’t vary a lot in the major leagues today. Try to pick a range of speeds and a range of release points that will encompass a large percentage of all the pitches thrown in the major leagues. It’s not very hard to do. The range won’t be that wide. Why is this?

I’ve come to only one good conclusion. I’m not sure if it’s the right conclusion; but, it’s the best I can come up with for this very important question – and the question really is important, because a system like professional baseball should display a lot of variation in this regard if it works the way most such systems do.

My best guess is that it doesn’t. I think the relationship between the major leagues and the minor leagues is the answer. Not all professional baseball players are doing everything they can to win. Some are doing everything they can to advance.

There’s a huge difference between those two motivations. If winning is the key to success at all levels, then techniques (however …

Berkshire Owns More Than 10% of Burlington Northern

Warren Buffett’s Berkshire Hathaway (BRK.B) has disclosed a greater than 10% stake in Burlington Northern Santa Fe (BNI). Through three insurance subsidiaries (Columbia, National Indemnity, and National Fire & Marine) Berkshire beneficially owns 39,027,430 shares of Burlington Northern common stock according to an SEC filing made on Friday, April 6, 2007.

Berkshire’s most recent reported purchase was made on Thursday, April 5th, and consisted of 1,219,000 shares purchased at $81.18 each.

Upon presenting the familiar table of Berkshire’s major investments in his most recent letter to shareholders, Buffett wrote:

“We show below our common stock investments. With two exceptions, those that had a market value of more than $700 million at the end of 2006 are itemized. We don’t itemize the securities referred to, which have a market value of $1.9 billion, because we continue to buy them. I could, of course, tell you their names. But then I would have to kill you.”

It appears that Burlington Northern was one of the two large positions Berkshire was accumulating. Clearly, Berkshire has been a big buyer of Burlington Northern shares since Buffett wrote his letter to shareholders, because Berkshire’s position now has a market value of approximately $3.2 billion.

The size of the Burlington Northern investment will make it one of about a half dozen very large positions held by Berkshire. This investment dwarfs each of Berkshire’s investments made during the past few years – it is already considerably larger than any other single investment recently disclosed by Berkshire including the investment in Posco (PKX), US Bancorp (USB), ConocoPhillips (COP), Anheuser Busch (BUD), Johnson & Johnson (JNJ), USG (USG), Wal-Mart (WMT), and Tesco (TSCDY).

This is the biggest single common stock investment made by Berkshire in a long time.

It’s big news – and it seems to have caught most Buffett watchers off guard. GuruFocus, a site that tracks Buffett’s moves religiously, announced that its contest to name the two mystery investments alluded to in Buffett’s annual letter had failed to turn up any guesses that Burlington Northern would be among the pair.

Burlington Northern Santa Fe operates one of the largest rail systems in North America. The system includes 32,000 route miles of track of which 23,000 are owned route miles.

In recent years, Burlington Northern Santa Fe has been buying back stock. The company expects share repurchases will remain the primary use of its free cash flow. In fact, Burlington Northern may allow “a moderately higher level of debt” so the company can “devote additional financial capacity to share repurchases”.

In that respect, at least, it is a typical Berkshire investment.

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On the Mueller Mispricing: “A” Shares vs. “B” Shares

Some smart investors see value in Mueller Water Products (MWA). They’re probably right; but, Mueller isn’t the kind of situation that jumps out at me as a clear bargain I can understand. However, there is something peculiar about this situation that makes it worth writing about.

A or B?

There are two shares of Mueller Water Products common stock – Series A common stock and Series B common stock. There are roughly three times as many B shares as A shares. The A shares and B shares have identical economic rights. So, ownership of all of the B shares would provide a roughly 75% economic interest while ownership of all of the A shares would provide a roughly 25% economic interest.

Here’s where things get interesting. “Shares of Series A common stock and Series B common stock generally have identical rights in all material respects except Series B shares have eight votes and each Series A share has one vote per share.”

So, what’s the premium on the B shares? There is none. The last trade on Mueller A shares (MWA) was at $13.98; the last trade on Mueller B shares (MWA.B) was at $13.64. Buyers of the A shares are currently paying $0.34 a share more to reduce their voting power by 87.5%.

You can’t convert A shares into B shares or B shares into A shares. If you could, there would be a profit in simply buying, converting, and selling. Unfortunately, you can’t do that. So, there’s no “manual” arbitrage opportunity here. Obviously, you can bet that the discount on the B shares will be eliminated – but, the market has to close the gap for you.

Regardless, there is a nonsensical discrepancy in price between the A shares and the B shares.

Anyone looking to make a new investment in Mueller should buy the B shares. There’s no reason to even think about touching the A shares until they are trading at a discount to the B shares.

Owners of Mueller A shares who currently hold those shares in a manner that would cost them less than $0.34 a share to sell should immediately begin selling their A shares and putting the proceeds into the B shares. Doing so would slightly increase their economic interest in Mueller’s business (because they would end up with more shares), greatly increase their voting power – and, over the long-term, possibly provide additional appreciation in the share price, if and when the B shares consistently trade at a premium to the A shares.

Do the B shares have to trade at a premium to the A shares? Technically – no. But, in the future, it’s possible that circumstances may make the B shares far more attractive to certain investors. The A shares are extremely unattractive to any large shareholder who isn’t committed to complete passivity as nearly 96% of the votes are tied to the B shares – the A shares are essentially non-voting shares.

Furthermore, …

On “Three Ideas and an Award”

Today, I’m going to try something a little different. Many longtime readers have told me how much they enjoy discussions of specific stocks and how rarely I discuss specific stocks these days.

Other bloggers often look back on the past performance of stocks mentioned on their blog. That’s difficult for me to do, because my conclusions regarding individual stocks tend to be pretty varied. I’ve written about many businesses I liked that weren’t selling at prices I liked. I don’t want to give up writing about interesting businesses merely because they’re overpriced today. The name of the blog, “Gannon On Investing” sums up what this site is all about – it isn’t a personal trading blog; it’s just me writing about investing.

I decided a short monthly post that focuses on a very small number of stocks and eliminates all the nuances of longer posts is the best way for me to give you some of my best ideas – at the moment – while also providing a record I can dissect at a later date. This way, I can still write about the stocks that are the most interesting stocks to write about – and yet keep them separate from the stocks that look most appealing as investments.

I’ll try to have a little fun with this monthly post. I’m calling it “Three Ideas and an Award”. I’ll always start by listing my three best ideas. Then, I’ll make up some award to present to a fourth stock that doesn’t make my top three ideas list – but is worth looking into.

The prices presented will simply be a recent price included for future reference. If a stock is one of my “three best ideas” it’s safe to say I believe there’s a wide margin of safety; so, I’m not worried about small price differences – I just want the post to be archived with relatively current prices.

Finally, unless otherwise indicated, you should assume I and people connected to me both professionally and personally own the stocks mentioned. If these are my best ideas, why wouldn’t I own them? Still, I’ll try to include a generic disclosure with each post.

I’d appreciate hearing what you think about this idea. Feel free to give your opinion about this new idea, or anything else you do or don’t like about my blog, by commenting to this post or sending me an email.…

Three Ideas and an Award – April 2007

Ideas

Bancinsurance (BCIS): $6.05

Rex Stores (RSC): $16.55

Strattec (STRT): $43.00

Note: Despite the fact that I plan to update this post at the beginning of each month – these are not short-term stock picks. In fact, this particular group of stocks is likely to do little or nothing for long periods of time. Value investing is about buying an asset for less than it’s worth; the shares of these businesses are now selling for less than the businesses are worth. That’s why they are my three best ideas for the month of April. Expected short-term price movements have nothing to do with the selection.

Regarding BCIS – it trades very infrequently. If you decide to buy it (and you manage to find some shares) you’ll do best if you forget it’s a public company, ignore the daily market quote – and judge your investment by the quarterly updates on underwriting results and per share book value. Do not buy this company if you need a quote to sleep at night – fluctuations in market price are meaningless for such a small, thinly traded security.

Award

Best DIY LBO Candidate – Timberland (TBL): $26.05

Description: The Best DIY LBO Candidate Award is presented to the company I believe is in the best position to benefit (continuing shareholders) by taking on debt and repurchasing its own shares through a large tender offer.

A good do-it-yourself leveraged buyout candidate requires both an unduly low public market value (market cap/enterprise value) and the ability to consistently cover large interest payments from free cash flow – Timberland meets both requirements.

Disclosure: I and people connected to me both professionally and personally own some or all of the stocks mentioned in this post.

I’d appreciate hearing what you think about my plan to do a “Three Ideas and an Award” post at the start of each month. Feel free to give your opinion by commenting to this post or sending me an email.…

20 Questions for Clyde Milton of Cheap Stocks

Clyde Milton became enamored with deep value, off the beaten path investment ideas through years of fundamental research, and ultimately, as a writer/editor for a now defunct personal finance magazine.

He strives to research stocks that few others will, using valuation techniques based on Ben Graham’s ideas (such as stocks trading below their net current asset value) as well as some ideas he has developed himself.

Milton freely admits that his site is written under a pseudonym; Clyde and Milton being the first names of his beloved grandfathers, to whom the site is dedicated. While Cheap Stocks was originally launched primarily to keep Milton’s research and writing skills sharp (and not as a public site) it has developed a following.

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1. Are you a value investor?

There’s no doubt about that. I am a dyed in the wool, card carrying, unapologetic value investor. That’s generally how I’m wired. I don’t understand how to value growth companies for the most part, perhaps I’m just not smart enough.

2. What is value investing?

Value investing is the ultimate pursuit, the ultimate treasure hunt, the extremely rewarding (financially and otherwise) quest to buy a buck’s worth of assets for much less than a buck – be those assets land, cash, marketable securities, pieces of other companies, water rights, or what have you. It’s the attempt to find that situation where true value is not reflected in the current price (market cap or enterprise value) of a given company. There’s a huge dependency here: that the markets ultimately discover what your analysis has revealed, and that your analysis was accurate. It doesn’t always work that way in practice, and patience is paramount.

3. What is your approach to investing?

It’s “off the beaten path” for lack of a better description. I try and turn over the rocks that few others do (maybe they are way smarter than I am, and know not to waste their time). For example, I will buy illiquid securities such as profitable companies that have “gone private”, and no longer file with the SEC, and are not required to comply with Sarbanes Oxley, but still trade on the Pink Sheets. Sometimes, liquidity is over-rated….if you can afford to be patient.

4. How do you evaluate a stock?

I start by identifying a potentially interesting situation. It may be that I discover a little-known thinly traded company that has some “hidden” or undervalued assets on its balance sheet. It might be a down and out company with a relatively large amount of cash relative to market cap, that is on the verge of profitability. It could be a situation where inventories are carried at lower of cost or market, and these inventories, in our estimation, are worth several times carrying value—this situation is rare. Could be land holdings that are undervalued. Most of these situations require some digging.

5. Why do you buy a stock?

When I’m convinced that there’s a real opportunity that the market is ignoring. …

On Buffett, Berkshire, and You

At the end of my post “On Billionaires, Their Buys, and Buffett“, I said “I will follow up with another post on this topic tomorrow. Hopefully, I can give you some idea of what you should and shouldn’t do based on news of Berkshire’s activities in specific stocks.”

This is that post. Unfortunately, before sitting down to write this post, a piece by James Altucher (author of “Trade Like Warren Buffett“) was brought to my attention. I’ll link through Value Investing News, because you should be visiting that site regularly – here’s Altucher’s article.

It’s good. However, there are still some things left for me to cover.

Altucher is right in stressing that Berkshire holds many positions that aren’t presently of interest, because the business has changed (or more usually) the stock price has changed. A rare example of the former is the Washington Post Company (WPO). If you want some idea of what the Washington Post (the stock and the business) looked like back when Buffett bought it, see Max Olson’s excellent article “Warren Buffett and the Washington Post“.

Buffett Holds

The Washington Post is a rare example of a Berkshire position that is no longer attractive because of changes in the business. In most cases, it’s a change in the stock price that disqualifies a Berkshire position from inclusion in your own portfolio. Several years ago, it was painfully obvious that Coca-Cola (KO) was one such stock.

During the Millennium Bubble, shares of Coke were priced for pluperfection. Buffett didn’t sell because he intends Coke to be a permanent holding for Berkshire. If he had been running his partnership, he would have sold. He has a different attitude at Berkshire – one he has made clear to shareholders countless times. As a result, he sometimes sacrifices better returns for Berkshire by sticking with a permanent position he knows is overpriced. Coke is probably the biggest and best known example of Buffett holding a stock he knew Berkshire would be better off selling.

But He Sells Too

However, Berkshire has many lesser known positions that it’s held for a long time. That sometimes leads people to believe that Berkshire never sells. Not true. Berkshire does sell; in fact, it has even gone as far as completely eliminating some large positions.

One recent example of such selling is H&R; Block (HRB). The company, which Berkshire once owned more than 8% of, became badly distracted with operations outside of its core tax preparation franchise. It seems clear Berkshire has eliminated its stake in H&R; Block. The company’s single minded pursuit of diversification and cross-selling is probably what turned Buffett off the stock – since Buffett bought in 2001, management has done a remarkable job of shrinking the company’s moat and scattering its eggs across many different, less secure baskets.

So, how can you avoid having a bad experience in a Berkshire stock? Don’t overpay. Even in some situations where Berkshire has …

Book Review: Supermoney

Gannon On Investing’s contributing writer, Steven Rosales, reviews Adam Smith’s Supermoney.

Read Review…