Value Investing Congress Blog

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

The Mortgage Crisis
Whitney Tilson and Glenn Tongue of T2 Partners kicked off day 2 with a sobering look at the mortgage crisis. For his part, Tilson believes that we have not yet seen the worst. His extremely detailed presentation (“The Latest on the Mortgage Crisis and Implications for Certain Financial Stocks”) paints a very bleak picture, suggesting that all things housing and mortgage related will get much worse before improving. Tongue and Tilson put their money where their mouth is with short positions in monoline insurers AMBAC and MBIA, Washington Mutual, and a long position in Fairfax Holdings (which has gained and may gain further in the mortgage crisis due to its credit default swap holdings).

Glenn Tongue gave an excellent overview on Berkshire Hathaway, making the bullish case based on:
• Over –capitalization
• In a great position to take advantage of opportunities this market presents
• Remains the premier capital allocator
Tongue Valued Berkshire on:
• Investments/share ($90,342)
• Plus PV of future pre-tax eps (excluding investments)
• Intrinsic Value of $156,000- $159,000, a 20% premium to current price
We can only hope that Whitney and Glenn are wrong on the depth of the mortgage crisis (wishful thinking) and right on Berkshire’s valuation.

Aaron Edelheit- Sabre Value Management
One of the very pleasant surprises this year was newcomer Aaron Edelheit, whose passion for value investing was very apparent in his presentation. Edelheit pointed out the outstanding returns from the small cap value area of the market since 1970 (16.2% annualized), but noted the disinterest here from many investors. He cited the following reasons for this situation:
• Small Cap Value can be very boring to investors
• There may be long periods with no news
• Illiquidity associated with SCV companies scares investors
• Too much volatility
• Little or no analyst coverage
One of Edelheit’s favorite ideas is Hemisphere GPS (HEM CN), formerly CSI Wireless. This misunderstood company is his largest holding.
• Hemisphere operates in the agricultural GPS arena, offering “auto steering” technology to farmers, which allows for more efficient use of tractors and thus their acreage, seed and fertilizer
• Pricing of HEM’s products are very favorable
• He forecasts rapid sales and earnings growth on the horizon

Jonathan M. Heller, CFA
*Author does not own any securities mentioned

The afternoon session was chock full of practical value investment techniques, applicable to real situations. Here are just a few of the highlights:

Washington Mutual
Having already stated their belief that the mortgage crisis is not over yet, Whitney Tilson and Glenn Tongue presented a negative view of WAMU (they have a short position):
• The concern centered on HELOC exposure (home equity lines of credit), junior liens, and option Arms. In the case of option ARMs, 62% of exposure came from two of the most challenged markets: California (49%) and Florida (13%).
• Tongue expected the company to lose $5 per share this year
• Significant shareholder dilution occurred when the company issued $7 billion in stock in April
• Tongue stressed the importance of doing your homework -and having a working model to assess true exposures -when taking a position (either long or short) in a company such as WAMU.

Retailers:
Tilson suggested that although now is not the appropriate time to be long a basket of retailers given the current economic situation, there are some bargains out there. He presented a bullish (and compelling) case for Target (TGT):
• buying back stock ($10 billion buyback program)
• selling credit card ops—(interestingly enough, the news of the sale of 47% of this business to JP Morgan for $3.6 billion broke during the conference)
• Owns a large percentage of its land and buildings—real estate alone may be worth 70-80% of current market cap
• Potential $5.00/share eps 3 years out (stock currently $53)

Tongue presented the bullish case for Sears Holdings (SHLD):
• Repurchased 33 million shares the past 3 years
• Sum of the parts potentially worth a great deal more than current market cap ($13 billion)
• Real estate alone- 250 million square feet- currently being valued at less than $10/sq ft assuming conservative $11 billion valuation of business units
• Trading at significant discount to current $100 price

Other Highlights:
• Bearish on Allied Capital (ALD -short position)—company surrounded by controversy, and may be a house of cards ready to fall.
• Bearish on Crocs (CROX- short position)—which may be a textbook version of a fad stock—explosive growth, unsustainable margins, and no competitive advantage, all of which is a road to nowhere.

Tilson and Tongue put on a great seminar—well worth the price of admission, and highly recommended to anyone who wants to learn practical applications of value investing taught by successful professionals who practice the art each and every day.

I’m back in Southern California for my second Value Investing Congress West (May 6th and & 7th), and this year I’m also attending the Pre-Congress Workshop, An Advanced Seminar on Value Investing, taught by T2 Partners’ Whitney Tilson and Glen Tongue.

As a CFA Charterholder with an MBA, a small financial advisory practice, and 20 years in the business, I’ve been in my share of classrooms over the years.

Tilson and Tongue’s detailed, fast moving, but equally understandable instruction style make this pre-Value Investing Congress session well worth attending.

Morning Highlights McDonald’s
An excellent case study on the fate of McDonald’s (MCD) following the company’s 2003 bottom opened today’s session. Tongue recounted a previous analysis of the company which argues against viewing McDonald’s as merely a quick service restaurant company, preferring to characterize it as a Brand business (including real estate and franchises) and a restaurant company with more than 8000 company owned stores. This is the way that we, as value investors, are trained to think. A little reinforcement here is never a bad thing.

The restaurant business is much more complicated than one might think, and Tongue and Tilson’s insights on the industry as whole, and a few of the players, were extremely valuable.

Berkshire Hathaway
Tilson and Tongue are still unapologetic Berkshire proponents, and put the current intrinsic value of the A shares at nearly $180,000 per share, a 40% premium to the current price. (Interestingly enough, the audience at today’s session was polled, and at least half were at last week’s Berkshire annual meeting!)

The Mortgage Crisis
For his part, Tilson believes that we have not yet seen the worst of the mortgage crisis. His extremely detailed presentation (“An Overview of the Mortgage Crisis and the Structure of CDO’s”) paints a very bleak picture, suggesting that all things housing and mortgage related will get much worse before improving. Tongue and Tilson put their money where their mouth is with short positions in monoline insurers AMBAC and MBIA, and a long position in Fairfax Holdings (which has gained and may gain further in the mortgage crisis due to its credit default swap holdings).

Jonathan M. Heller, CFA