5th Annual New York Value Investing Congress Day 1: Part 2

David Einhorn, Chairman, Greenlight Capital
Liquor Before Beer, In the Clear

Einhorn opened his presentation with his thoughts on the importance of learning from bad decisions.  He cited his 2005 IRA Sohn conference presentation on the merits of homebuilder NBC Holdings, which ultimately fell 40% as the homebuilding sector collapsed.  Although the rest of the sector fell much further, an average of 70%, Einhorn learned the following:

• It is not reasonable to be agnostic about the big picture,  a macro view is vital
• Even given the above statement, you can still be a stock picker

Einhorn went onto give a stirring speech about what he believes to be the current macro risks:

• The government is too focused on the short-term, too focused on getting re-elected.
• Too much focus on special interests (protection of banks, for one)

Einhorn believes that the lesson of the Lehman collapse, a company that he very successfully shorted, is that companies should not be so big that their collapse can jeopardize the entire financial system.

He went onto state that he has changed his view about the validity of owning gold, given its propensity to perform well not just during inflationary times, but when monetary policies are poor in general.  In terms of form of ownership, Einhorn owns physical gold, believing that to be even more efficient than the ETF.

Joel Greenblatt, Managing Partner, Gotham Capital
Formula Investing with a Value Mindset

Greenblatt, author of “The Little Book That Beats the Market”, presented a re-cap of his concept of the “Magic Formula”, which utilizes earnings yield and return on invested capital as the criteria to select stocks that will outperform. While he admitted that historical return on capital is backward looking, he stated the importance of estimating future ROC. 

Greenblatt described two periods of underperformance by the strategy:

• 2/1/2006 through 12/1/2008 (34 months)
• 5/1/2002 through 6/1/2003 (13 months)

Despite his somewhat self-deprecating depiction of the Magic Formula, the returns utilizing the strategy have been outstanding.  For instance, using back tested data, the strategy returned 291% or 14.6 % annualized, for the 10-year period ended 5/30/2009.  During the same period, the S&P 500 Index was down 2% (-0.2 % annualized). Furthermore, the Magic Formula has outperformed the market for ten of the past eleven years, through 9/30/2009.

Despite the simplicity of utilizing the Magic Formula, Greenblatt’s data suggests that it is not a good candidate to use for identifying short candidates.  For instance, going long the top decile of Magic Formula companies and short the bottom decile substantially increases portfolio volatility, and does not enhance return.

Jonathan Heller, CFA

5th Annual New York Value Investing Congress Day 1: Part 1

David Nierenberg, Founder, D3 Family Funds
D3 War Stories:  Practical Lessons About Building and Protecting Shareholder Value by Improving Corporate Governance

David Nierenberg, who has appeared at several other VIC’s including Pasadena this past May, led off the first day of the Congress.    Nierenberg typically invests in busted microcap growth companies.  His average holding period is 7 years, and there is a 5 year lockup for investors.

The focus of this presentation was the importance of corporate governance.  Nierenberg believes that much of the activism occurring these days is focused on the wrong things.  He believes that putting a board in place that is capable and independent, focused on the real issues, and properly incented for the long-term can greatly improve potential company success.

Nierenberg highlighted three companies, including Move Inc (MOVE), Brooks Automation (BRKS), and Heartland Payment Systems (HPY).  D3 currently has holdings in these companies, including 18.2% of Move, and 7.2% of Brooks.

Nierenberg believes that Heartland, a credit and bank card processor which currently trades for around $14.00, may ultimately be worth more than $40.  Nierenberg cited the company’s strong management, solid compound annual growth rates in revenue, EBITDA and EPS, and an overreaction to a security breach that sent the stock plummeting. 

Nierenberg concluded with 3 points:

• Investing is not all about the numbers, it’s also about people and process
• Selling is not the only exit option (change can be brought about by major shareholders)
• In microcaps, large block positions and knowledge about governance can protect and build shareholder wealth.

Sean Dobson,  CEO, Amherst Securities
Fishing in a Poisoned Pond

Frequent VIC attendees have become accustomed to their bi-annual dose of bad news on the mortgage and housing front, and I am among many that are thankful for the honest portrayal.  For the past two years, that somber topic has been delivered by Glenn Tongue and Whitney Tilson, authors of “More Mortgage Meltdown”.  Today, it was Sean Dobson’s turn.

Dobson’s expertise and analysis was a critical component of the book, and his candid portrayal of the continuing difficulties facing the residential mortgage market was sobering.

Among Dobson’s more frightening observations (and there were many):

• There are 8 million homes currently not paying their mortgage
• Once a borrower has missed 2 mortgage payments, foreclosure is all but inevitable
• The rate of recoveries is still declining
• The resolution process is grinding to a halt

The amount of bank-owned real estate is falling, but that’s primarily because of a slowdown in the foreclosure process

• 29% to 50% of modified mortgages re-defaulted within six months
• 79% of all defaulted loans have a current loan to value (LTV) ratio above 120%

If there was any good news, Dobson reported that loss severities (recovery rates) have stabilized in all states.

Dobson concluded that:

• Loss severity will not increase substantially
• Losses will take longer to realize
• Loan modifications/Government programs to address the situation will evolve

Jonathan Heller, CFA
Positions:  MOVE

Thursday, May 14, 2009

William Waller & Jason Stock-M3 Funds
The U.S. Banking Sector: Chaos & Opportunity

M3 was founded in 2007, and invests (long and short) in small and mid cap names in the US bank and thrift sector. There are 1300 publicly traded banks, and 93% have market caps less than $500 million.  Stock presented his view of the current state of the banking sector:

• Significantly undercapitalized
• Credit quality still deteriorating
• More bank failures
• Unemployment rate will continue to rise
• Commercial real estate is in trouble

Stock believes that there will be in excess of 150 bank failures in 2009.  Still, he and Waller are still finding opportunity on the long side, and look for the following:

• Low Price/Tangible Book
• Excess capital
• Low loan/deposits
• Attractive markets
• Bearish management team
• Share repurchase plan
• Attractive deposit base

One long name Waller and Stock like: First of Long Island (FLIC: $21.00)

• 140% of tangible book
• 11 times LTM earnings
• Excess Capital; 8.5% tangible equity/assets
• 68.5% loan to deposit ratio
• $1billion high quality deposits with 1% cost
• Positive credit quality, just .01% non-performing loans
• Hidden value in branch ownership
• Near-term catalyst- R2000 index addition
• Could be worth twice current price

Scott Klein-Beach Point Capital Management
Opportunities in Stressed and Distressed Credit

Beach Point, which has $3.75 billion in assets, specializes in high yield bonds, distressed debt, and other credit related strategies. With the high yield market currently yielding 15-16%, Klein believes that the distressed market is currently offering opportunities of a lifetime.

Despite the acknowledgement that defaults will continue to rise, Klein sees this as a lagging indicator, and believes that continued forced selling of distressed bonds will create continued opportunity in an extremely inefficient market.

According to Klein, the high yield market has gained an average of 35% in the 2 years following monthly declines of 5% or more. Such declined have only occurred four times, with the latest, and most severe in late 2008.

With the average high yield bond trading at 70 cents on the dollar, with an 8% coupon, Klein sees ample opportunity in this area, even if the worst default scenarios we’ve ever experienced (Great Depression) are repeated.

J. Carlo Cannell – Cannell Capital
Hydrodamalis Gigas

Carlo Cannell always manages to surprise, and this Congress was no different. He brought with him a co-presenter, Karthik Panchanathan, a graduate student in Biology from UCLA who very articulately presented interesting examples of animals that had become extinct, or were on their way there. Before the audience scratched their head in wonder, Cannell very interestingly tied these situations to companies and industries that had followed a similar path.

Who knew that Hydrodamalis Gigas (the presentation title) is actually the scientific name for the Steller Sea Cow, a huge manatee-like animal that went extinct in 1741? Cannell tied the plight of this animal to that of the restaurant business: both had trouble adapting to environmental changes, the Steller Sea Cow faded into oblivion, and so have many restaurant chains.

The main point of Cannell’s presentation was that the laws of nature also apply to Wall Street, and investors would be wise to look for the “cockroaches” of companies – those that can survive nearly any situation. Look for businesses less prone to predators or extinction, says Cannell.

Currently, Cannell finds the following industries attractive: Oil and gas, agriculture, death care, precious metals, energy service.

Whitney Tilson and Glenn Tongue-T2 Partners
An Update on the Mortgage Crisis and a Discussion of Wells Fargo

The conference concluded with Whitney Tilson and Glenn Tongue.

Last year, conference co-founder Tilson and Tongue, his partner at T2, hit the nail squarely on the head with their bleak outlook for the housing and mortgage markets; it was one of those sobering presentations that you hoped would not come to fruition. But it did, and the T2 guys were astonishingly accurate both with their macro views, and list of shorts and longs.

This year they put it in print with their book More Mortgage Meltdown: 6 Ways to Profit in These Bad Times, which was the basis for much of their presentation. If their scenario continues to unfold as suggested, there is much more pain to come in housing land.

The reams of statistics and data they presented seem difficult to dispute, and they put it all in such easy to understand terms that they are well on their way to becoming the de facto experts on the crisis.

All is not lost though; this will not morph into the Great Depression in their view, and they still see opportunities in the markets, both on the long and short side.

Tongue presented the bullish case for Wells Fargo (WFC), which they were short earlier this year. Now they are long WFC:

• Capable of earning $3.35-$4.26/share, $17.1-$20.1 billion net
• Worth $40-$50/share at a multiple of 10-12
• Business has enormous yield spreads
• Buffet bought for his personal account
• The Wachovia portfolio already significantly marked down

Incidentally, waiting for the 10:35 flight back to Philly post Value Investing Congress West has become one of my opportune times to catch up on some reading. Last year, it was David Einhorn’s Fooling Some of the People All of the Time, a VIC giveaway, that I could not put down. This year it was Tilson and Tongue’s just released book (the giveaway at his year’s VIC). With all of the confusion about the genesis of the housing crisis, this book is a must-read.

*The author does not have positions in any of the companies mentioned. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only.

Jonathan Heller, CFA

One of the more interesting revelations in Alice Schroeder’s biography of Warren Buffett, Snowball, is that the Oracle used coattail-riding as a strategy early in his career. For a notably independent thinker, this is surprising. Yet the book also reveals how often Buffett relied on friends and colleagues to collect information on his many investments. In a sense, Buffett had been coattail-riding since the very beginning, learning the craft from Ben Graham at Columbia University and studying his mentor’s every idea, the most successful outcome of which was GEICO.

In Schroeder’s chapter “Spaghetti Western,” Buffett is riding the coattails of Gurdon W. Wattles, who ran a closed-end investment company called Century Investors. Buffett explains:

“He did this chain thing where he would be buying stock in a company at a discount, which would be buying stock in another company at a discount, which would be buying stock in another company at a discount.

[…]

For ten or fifteen years I followed him. He was very Graham-like. Very Graham-like. Nobody paid any attention to him except me. He was sort of my model as to what I hoped to do for a while. It was so understandable and so obvious and such a sure way of making money. Although it didn’t make you huge money necessarily, you knew you were going to make money.

You don’t have to think of everything, you know. It was Isaac Newton who said I’ve seen a little more of the world than others because I stand on the shoulders of giants. There’s nothing wrong with standing on other people’s shoulders.”

Buffett eventually surpassed Wattles in making Russian doll-type investments, all of which ended under the umbrella of Berkshire Hathaway.

Nearly five thousand miles away across the Atlantic, the enigmatic Belgian billionaire Albert Frère has been doing something similar.

Born in the small Belgian town of Fontaine-l’Evêque on February 4, 1926, Frère came into a family of nail and chain merchants. At the age of four his father died of pneumonia, leaving his mother, Madeleine – then 44 years old and devoid of one eye – to take over the family business.

From these humble beginnings, Frère has built a fortune worth over three billion Euros by quietly buying and selling stakes in European companies. His background and the corporate history of his holdings are extremely colorful, and have been chronicled well in a recent Bloomberg profile and a New York Times article. If you read French, you can also try his biography.

At the sprightly age of 83 today, Frère still heads or controls at least three publicly traded investment vehicles: Groupe Bruxelles Lambert (GBL), Pargesa Holding S. A. and Compagnie Nationale à Portefeuille S. A. (CNP). All three have holdings in common, with CNP having the most diverse set of assets. GBL and Pargesa, however, tend to trade at wider discounts to NAV and have very easily ascertainable values, given that their holdings are a handful of publicly traded European stocks.

There is probably no easy explanation for why the web interlocking these and other companies is so complicated, much the same way Wattles’s Century Investors or Buffett’s Blue Chip Stamps came to be after years of deal making. But if you were yearning to find a modern example of the complex holding structure reminiscent of the diagram in Snowball’s pages 412-413, just take a look at page 2 of this PDF on GBL’s website.

Pargesa is particularly easy to understand, however. It holds stakes in six public European companies and publishes NAVs weekly on its website (there are really seven holdings but the seventh, Iberdrola, is so small as to be immaterial). Pargesa’s shares trade on the Swiss Stock Exchange and are quoted in Swiss Francs. If you would like more details on the six main holdings, which range from oil and gas exploration and production to a worldwide leader in the spirits business, you may want to look at GBL’s latest annual report.

On Pargesa’s website you’ll find that the shares sell at a 20% discount to NAV. But knowing this is probably not enough. A disciplined investor will want to know what multiple of free cash flow he’s paying for the underlying businesses.

Here’s a recent diagram of Pargesa’s shareholdings:

Notice how the economic interest Pargesa holds in each company is multiplied by 50% in each case, because of its ownership of half of GBL (with the exception of Imerys).

Using conservative estimates of free cash flow for each of the six holdings, I arrived at a consolidated estimate – in Swiss Francs – of about CHF 8.6 per Pargesa share. Given that they currently trade for about CHF 70.75, the shares are available for just about 8.2x free cash flow. If you believe that a 10% discount rate is an appropriate indifference level between today’s and tomorrow’s cash flows, a multiple of 8.2x implies a perpetual decline of 2.2%. Given the quality of the businesses Frère has invested in, this is unlikely.

Keep in mind the risks: many of the holdings are companies that currently have a lot of debt. Lafarge and Pernod Ricard – both particularly debt-laden – have just issued rights offerings. This is when a company offers its shareholders the right to increase their stake in the business, usually at a discount to the current market price of the shares. This issuance of stock dilutes a shareholder’s ownership by increasing the number of shares outstanding, unless that shareholder participates fully in the rights offering. GBL, being a large shareholder of both Lafarge and Pernod Ricard, bought all the shares to which it had rights, thereby maintaining its economic interest intact.

Like every great investor, Frère has also made mistakes. But this is a good opportunity to ride the coattails of a savvy operator and pay nothing for the privilege.

Marcelo P. Lima is a securities analyst. He may be reached at MPL4@cornell.edu

If you walk into a Tuesday Morning store, you might not be all that impressed.  It’s the epitome of closeout stores, a kind of higher-end Big Lots, or rich-man’s Family Dollar. The merchandise in this case is typically upscale home furnishings, house wares, gift items, some toys, and a very limited selection of sporting goods, to name a few.  But, this retailer, which is not small with more than 840 stores in 47 states as of last June, continues to chug through this recession.  What’s more, the company is a net/net.

It was a net/net 5 weeks ago when it hit a low price of $.51, and it’s still a net/net today, despite the fact that it’s up 319% since then.   The company was profitable on a trailing twelve month basis through December, although that’s likely to change when the company reports final third quarter numbers on April 27.

Yet shares have surged, due in part to a rising market tide, perhaps a light at the end of the economic tunnel, and the fact that Q3 sales dropped a better than expected -6.4%, while same store sales fell 9.5%.  The company, although light on details until the earnings call (other than that sales fell to $167 million from $178.4 million for the quarter; and earnings will be in the -$.15 to-$.17) also announced that trends and customer traffic appear to be improving.

With current assets of $278 million and total liabilities of $118 million, Tuesday morning’s net current asset value of $160 million is far in excess of its $91 million market cap.  Although operating in a treacherous retail environment, the company carries just $2 million in long-term debt.

Of course, retailers that don’t own their real estate, as is Tuesday Morning’s case, typically have operating leases, which don’t show on the books.  Tuesday Morning currently has $190.5 million in operating leases, which can’t and should not be ignored.

But, at its current price of $2.10, Tuesday Morning is trading more or less as a call option on what was once a pretty decent business; a call option on a pickup in the economy and consumer spending. It’s certainly not for the faint of heart, but net/nets, especially retail net/nets usually aren’t.

Tuesday Morning
Ticker: TUES
Price: $2.10
Market Cap: $91 million
Net Current Asset Value (NCAV): $160 million
Mkt Cap/NCAV: .57
P/E: 74 (through December)
Cash: $5.8 million
Debt: $ 2 million
Enterprise Value: $80 million
Locations: 842 (June, 2008)
Price/Book: .37

Jonathan Heller, CFA
Position:  Long TUES