Value Investing Congress Blog

Boykin Curry from Eagle Capital Management starts off the second day of the Value Investing Congress. His presentation is on value investing and time arbitrage.

He starts off explaining that value of a stock is the present value of its future earnings. There is a major focus by most on next year’s earnings estimate. Most questions (81%) on conference calls focus on the next 12 months. Only 19% are interested in focusing on the earnings potential beyond a year out.

Buy things that have short term problems and long term opportunities. The future is not knowable but it might be guessable.

The specific example presented is American Express (AXP). The normalized earnings beyond recession are about $4-5 per share. The secular trend is cash to plastic. American Express is the collective buying power of a pool of wealthy individuals.

Nothing has emerged to threaten their long term earnings power. Earnings in 2008, 2009, and 2010 could be potentially rough. Boykin estimates $30 billion could be gone on charge offs. If you do that for the next 3 years, earnings is estimated to go down to $2 per share for each of the next three years. How does this equate to folks only paying half as much today as they did last year for the same company.

Boykin doesn’t believe that large cap stocks are always efficiently priced. He agrees that there is not information arbitrage opportunities in these stocks. However, the time horizon of investors is often not rational. There is the wisdom of crowds but there is also madness of the crowds. With large cap stocks, one hedge fund can’t go in and move the price up and make it more rational.

Last year analysts 1-year price target went from $76.5 to $41.0 billion from 2007 to 2008. It is all based on multiples of 2009 earnings.

Why does the time arbitrage persist? Clients measure performance over relatively short periods. It makes going down 20% by being early difficult for funds. There are a also a few successful short-term strategies that also blow it up for others, since clients will pull there money and move to them. Also, short-term results are often preludes to the long-run.

Average monthly turnover has increased. Time arbitrage opportunities persist.

You can focus on long-dated call options to take advantage of time arbitrage. When they pay off they are extremely valuable. Examples right now include, Newfield Exploration (NFX), Microsoft (MSFT), and Comcast (CMCSA).

Newfield is a natural gas company. In the long-term, there is a huge incentive for the government and companies to build out natural gas filling stations. If tomorrow it is announced no one will ever use natural gas in cars, it won’t affect the stock price today.

Microsoft is being treated as a declining asset. The future for Microsoft could include their capability to provide synchronized both online and offline activity. If the company decided to stop investing in this, the stock would actually probably go up.

Comcast could in the future develop targeted television advertising, like Google provides online. Comcast’s distributed network of services might also be able to deliver customized content on demand in the future.

This strategy will make it tougher to raise capital and get started as a fund. There are also benefits, because it is intelectually stimulating. Once you are successful, you will better retain clients. It can provide a sustainable competitive advantage in an industry with very few.

Recent events hasn’t changed his strategy. There are a lot of opportunities out there. Just make sure the companies survive the recession. This could actually make the country stronger in two or three years. There is a huge shift in capital allocators from the reckless to the Warren Buffetts and Seth Klarmans of the world.

George
www.fatpitchfinancials.com

Carl Icahn just joined us at the Value Investing Congress. He’s speaking on the current financial crisis and the role of shareholder activism.

According to Icahn, the real problems with these financial companies are the Boards. The Boards do not in any way hold managements accountable. They take risks when they shouldn’t. When Boards work they then can become very dangerous.

First, the CDOs were dangerous. They created tulip bulbs, and here they were houses. Then you print mortgages and then you securitize them and then place them in mortgage backed securities. Then they take the lower traunches and put them in a CDO and they became really toxic but got AAA rating for diversification. What good is this diversification if everything in it is no good. The Boards did nothing about this. They hired the fox to guard the hen house.

He is announcing United Shareholders of America to address this problem with Boards. I’m not sure if this bit of news has been announced elsewhere yet.

Then Icahn discusses the history of his first proxy fight that lead him to be added to a Board. A big guy, Don, told him there is either to either agree or resign and not say anything. Icahn stayed quiet for several meetings until there was an issue associated with the acquisition of the garbage disposal unit factory. Then another Board member asked for Icahn for his opinion. Mr. Icahn then said that this was the worst deal in the history of America. That got some laughs. Then Icahn said he was voting against it and everyone else was going to be personally liable. Don never brought up the issue again and then he sold the company.

He saves tons of money with these actions. Then he provides the example of money saved at Imclone and Federal Mogul.

“The fault falls not on the stars but ourselves,” recalls Icahn from shakespeare.

We need to change the law that requires a Board to put an issue on a ballot.

This system blew up because we allowed ourselves to do these insane derivatives. There are some investment banks that made it through this because they avoided this things. The $10 trillion out there needs to be deleveraged. Its going to take a while to work through this. The scared money can panic and pull out. The Fed is going to need to come in and in again to keep lending them money.

He saw something similar in 1990 and Mr. Icahn bought up junk bonds but its nothing like today with all these banks tied up.

Finally, he is taking questions and asking the audience go to his blog and join United Shareholders of America.

In response to the first question, he warned to invest very carefully. There is opportunity in energy companies and pipeline companies. You have to have a lot of staying power to invest right now. Cash is very important to invest right now.

Icahn doesn’t understand accounting right now in response to a question on fair value accounting. We need to allow some leeway with accounting for these companies right now to do with massive right downs.

When asked about the change in leadership, Icahn brought up the cost of proxy fights. Yahoo (YHOO) spent $36 million to fight him and it cost Icahn about $5 million to respond. The laws need to be changed. Some hedge funds come along for proxy fights but mutual funds dither on issues. It can be argued that the system is completely disfunctional at this point and needs to be changed. Mr. Icahn believes most other countries are doing a better job on corporate governance than the United States, including Canada, United Kingdom, and Australia.

Updated: 9:55 PM October 6, 2008 to incorporate some edits and remaining Q&A comments that weren’t captured earlier due to my laptop running out of power.

George
www.fatpitchfinancials.com

John Burbank of Passport Capital is the next presenter. He is being patched in via video conference, which had a rough start due to technical issues. It added comic relief, which was welcome given the depressing morning presentation and current market numbers.

Passport Capital is targeting 30% annualize returns and the word here is that he is currently generating 40% annualized returns.

The presentation is focused on looking at the big sector changes. The presentation is themed to the Wizard of Oz of all things.

The market is now at Emerald City and the curtain on the Wizard is parted and the U.S. is now exposed for what it is. Net foreign purchases of U.S. Treasuries are down. This has not been good for the wizard’s buddies, the U.S. financial banks.

Burbank believes Bernanke is making a huge policy mistake and not getting enough liquidity into the market. He believes less will be investing in the United States, foreign capital will be invested more in their own markets.

Burbank’s firm believes in peak oil. Oil exporters are highly liquid and are an area to look for opportunities.

EFG Hermes and other regional managers seem to provide great value. AUE government ownes 25% of the company. The forward P/E looks very compelling.

Another company in this sector is Shuaa Capital. Great sales growth at both of these.

Burbank also likes fertilizer minerals quite a bit, since the emerging markets need these inputs. The focus here is on Mosaic (MOS) and Potash (POT). The P/E for MOS is around 3 and the P/E for POT is around 4. Potash is like the Saudi Arabia of potash. The replacement costs for these companies’ capacity is high and not really factored into the price of stock.

Burbank is long farmers and foreigners and short a leveraged United States and General Electric. He seems to question Buffett on this.

Burbank believes the financial markets are in massive cardiac arrest. They need to cut rates tremendously and flood the market with liquidity. The rest of the world has the ability to flood the country with dollars and that is what has to happen.

George
www.fatpitchfinancials.com

Whitney Tilson and Glenn Tongue move on from their presentation on the housing bubble and credit crisis to their current stock picks. They present on EchoStar (SATS), Fairfax Financial (FFH), and Berkshire Hathaway (BRKa).

EchoStar

EchoStar Corp. is a spinoff of EchoStar Communications (DISH). They make set-top boxes, but also includes Slingbox. Also has satelites/broadcast business.

Sum of the parts analysis

Cash: 1.1 billion
Satellites/Broadcast: 1.2
$2.3 billion

Set-top box: 1.6-2.4
Technology (slingbox) 0.4
Investments 0.3-0.5
Total $2.3-3.3 billion (25.60-36.60/share)

EchoStar not buying back stock because they are seeing better deals for their stock.

Fairfax Financial

T2 use to be short Fairfax Financial when they were so weak one hurricane could take them out. Now Tilson is long as the company has strengthened. Fairfax Financial CDS portfolio has paid off nicely.

Should trade 1.3 to 1.5 book. Right now trading at around 1.25 book, but they have added 574.5 in realized cash proceeds from selling CDS in the third quarter so adjusted P/B is more like 1.16.

You are getting a great CDS portfolio but there is a high short interest ratio. The company is buying back stock and their behavior does not indicate they are likely to be crooks.

Berkshire Hathaway

T2 estimate of Berkshire Hathaway’s intrinsic value is $157,000/share and forward value of $178,000/share. Berkshire Hathaway is apparently down 5% today.

Questions

Tilson doesn’t believe the Community Reinvestment Act and Fair Housing Act was a major contributor to this problem. Fannie Mae and Freddie Mac were some of the only lenders to maintain standers. Their problem was that they got sucked into increasing leverage too much.

What’s your outlook for consumer exposure? They regret being early. They were long retailers, but short real estate broad index and retail real estate REITs. Therefore, they are not down as bad. They want the best companies in the worse out of favor sectors. They are looking at buybacks being made by retailers. Sears is buying back lots of stock with their cash.

Tongue discusses Target (TGT) thinks they will be a relatively strong company as they survive this crisis. They will loose a year of cash flow but it won’t materially impact the DCF for Target.

Will there be a great bust in municipal bonds? A big question and Tilson doesn’t invest much in bonds. Tongue responses to the analogy of the Great Depression and doesn’t think with the appropriate action we will end up in that position. Will they need a bailout? They will likely get one if they need it. The example here is the California general revenue bond. Tilson expects default rate for municipalities will increase, but not be widespread like a Great Depression.

George
www.fatpitchfinancials.com

I’m at Value Investing Congress in New York City this morning. I’ve already caught up with Todd Sullivan of Value Plays and Vitaliy Katsenelson from Vitaliy’s Contrarian Edge.

Whitney Tilson and Glenn Tongue are giving the first presentations on the housing bubble and credit crisis. Tilson steps through the historical data on housing and borrowing. Some of the data was just updated late last night for this presentation.

Subprime mortgages were still a small part of the debt. Repackaging loans was one of the most profitable businesses at Wall Street, but volume of product was needed. Lenders became lax because they assumed the underlying assets would remain strong. Defaults in a strong real estate market were not really a concern.

Foreclosures are accelerating with no signs of a let up. New home sales are still strong but inventory has increased to 1 year. Home vacancies are at an all-time high. Quadrupling of the number of homes selling in foreclosure has occurred recently and regular existing home sales has declined. 42% of homes in August in California for sale has been in foreclosure.

You can still borrow 5 times your income, a 39% decline, but still much higher than the historical level.

Home prices down almost 20% based on Case-Shiller index. Home prices are about half way down the predicted decline according to Tilson. Home prices versus income ratio however might indicated that the housing market has finished declining. Good news is that mortgage rates have started declining as a result of Fannie and Freddie were nationalized. Nonconforming mortgages are disappearing. The rate of housing decline seems to have improved. However, April, May and June are seasonally strong house prices. Therefore, we might have another 12-18 months of home price declines. July housing price change has ticked back down in the latest month, July.

Glenn Tongue then continues the presentation. What does the future hold? It appears the subprime reset bubble is behind us, but the alt-ARM loans resets will surge in 2010-11. These could be a lot more painful to the borrower. There is close to $1 trillion in Alt-A loans.

What are Option ARM loans, also known as pick-a-pay loans? They are made to a prime borrower. They were low or no document loans (liar loans). Each month borrowers could pick one of three choices to pay: the fully amortizing interest and principal, the full interest, or an ultra-low teaser interest only rate (typically 2-3%). They looked really good on lenders books, but result in really “bad stuff.” People will typically default when they recast if the homes don’t appreciate.

There was not as much payment shock in subprime as base rates came down. However, the negative amortization of Option ARMs still causes a great payment shock when they recast.

HELOCs and closed-end second mortgages and the next thing to be discussed. They are effectively mortgage insurance. They are second to everything and there is no asset to lock onto during a default. MBIA agrees that defaults will cause 100% severity in HELOCs and closed-end mortgages. Many banks have large exposures to these.

The timing indicates that we are still in the early stages of the bursting of the great mortgage bubble. The scary scenario being presented is that we are only at the tip of the iceberg of an enormous wave of defaults, foreclosures and auctions in the U.S. housing market. This presentation paints a much scarier scenario than I’ve been contemplating. It is overwhelming and depressing.

Tilson comes back with some dramatic maps of the various loan levels since 2004. You can really see the reduction in lending standards in 2006. The default rates historically have been around 1% and are now shooting up to the high single digits, some even degrading before they reset.

Banks and brokerages have taken approximately $500 billion in writedowns and raised $353 billion. Tilson closes out the discussion by going over CDOs and other mortgage backed securities.

This presentation is available for download at this Value Investing Congress link.

George
www.fatpitchfinancials.com