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

Common stock investing is inherently risky, and those risks cannot be divorced from the rewards that come with them. Often, it isn’t easy to separate the speculative from the investment component of a common stock commitment. On this topic, Ben Graham, author of the classic The Intelligent Investor, has written most clearly:

Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing;  (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

With that caveat, here’s Wellcare Group (WCG), a stock that has a reasonable chance of going higher once its legal problems are resolved and its earnings normalized. As such, it may present an intelligent speculation.

First, a quick background. Wellcare is a healthcare management organization focused on Medicare and Medicaid, government-run entitlement programs for the elderly and low-income population. It has over 2.5 million members enrolled in its programs nationwide, with a large portion of them in Florida.

Its stock hovered around $120 per share when in October 2007 about 200 FBI agents raided its Tampa campus. The stock collapsed to $40, wiping out $3.3bn in shareholder value. The uncertainty was large; there was no official word of what the FBI raid was for, although newspaper reports stated that one of Wellcare’s subsidiaries had overbilled the government by $35m. In this context, the share price collapse was wildly overdone.

A quick resolution of the problem didn’t happen. Instead, the company went “dark,” not filing its quarterly and yearly financial statements and risking stock exchange delisting for its non-compliance. Periodic SEC filings kept shareholders apprised of the slow progress, but it wasn’t until early 2009 that things became clearer. The company finally filed all of its late financial statements and set a shareholder’s meeting – the first since the FBI raid – for July 30.

Wellcare is well capitalized. As of 12/31/2008, it had about $1.2 billion in cash and $153 million in debt. This debt proved to be another Achilles heel for the stock. When the company reported in 2008 that it was in technical default for not having filed its financial statements, the price dropped precipitously yet again. Fairholme Capital, which owns nearly 20% of the stock, bought a majority of the debt, likely in a move to protect its equity investment.

Throughout this misadventure, the stock has swung wildly, hitting a low of $6.12 in November and $6.23 in March of this year. Yet Wellcare’s core business remains sound, generating substantial free cash flows. The exact number for 2008 involves reversing a goodwill write-down and removing a non-recurring $103m in litigation expenses, but a normalized estimate of $4 in free cash flow per share is probably on the conservative side. While there is significant regulatory uncertainty surrounding its Medicare and Medicaid businesses, at the current price of around $13.80, it’s hard to find a way to lose.

Yet all of these uncertainties – particularly those surrounding the FBI investigation – are still large, which is where the speculative component of this investment comes in. There might be a probability of the government’s penalties being larger than expected. The company is also facing various lawsuits related to its illegal activities, including a class-action lawsuit. Defending against these will cost management’s time and shareholders’ cash.

On the other hand, Wellcare may soon begin conducting conference calls with shareholders and analysts, may soon settle with the government by paying a fine, and may ultimately get sold to a larger competitor, such as UnitedHealth Group. After it fired its disgraced former management, the board brought in Charles Berg, formerly a UnitedHealth executive, Oxford Health Plans CEO and “deal guy.”

With these factors in mind, and taking into account Graham’s three points above, Wellcare may seem like an intelligent speculation after all.

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

Ebay burst onto the scene as a public company on September 23, 1998, at the then-lofty price of $18 per share. The stock opened at $53.50 and euphoric “investors” (Ben Graham would call them “speculators”), bid it up to the incredible price of $354.25 within six months, before a 3:1 split. Not bad for a company that would report $0.00 in earnings per share a year later.

Perhaps these investors were counting on rapid growth. Indeed, eBay was growing at a blistering pace. Between the second quarter of 1997 and the fourth quarter of 1998, revenues grew from a mere $604 thousand to $19.5 million.

In the book The Perfect Store: Inside eBay, Adam Cohen relates the beginnings of what was then still called AuctionWeb. In 1996 Pierre Omidyar, the founder, had a tough problem: so many envelopes stuffed with payments arrived by mail that he didn’t have time to open them all, so they just piled up, unopened. Ebay – still in its infancy – already seemed to be a perpetual cash machine.

Today, eBay’s stock price hovers around $12.50, so the prices above look extraordinary. But the stock split 24 times since the IPO, so it turns out that if you bought at around, say, $54 per share, you’d be sitting on a 19% gain, compounded, to today’s price, compared with a compounded loss of 2.2% for the S&P index during the same period. Indeed, even if you had bought the stock at its pre-split peak, you’d still be better off than the market. Maybe those investors weren’t so wrong after all.

How could this company have created so much value?

It turns out that eBay’s is a sticky and addictive business model, and is very cash generative. Revenues grew to $8.5 billion in 2008, and in aggregate, eBay has generated almost $13 billion in cash from operations, $9 billion of that in free cash flow even after deducting stock-based compensation.

Where has all the cash gone?

Of the nearly $13 billion, $1 billion has gone to stock-based compensation, and $3 billion to capital expenditures. The $9 billion in free cash flow have been spent in acquisitions or ended up as cash and equivalents on the balance sheet.

As with many technology companies, eBay has benefited from its expensive stock price and old GAAP accounting rules. These old rules allowed “pooling of interest” accounting in certain cases, whereby an acquirer used its bloated stock price as currency. The acquisition generated no goodwill, which didn’t have to be amortized over 40 years, and thus didn’t depress earnings. Companies would regularly “game” their acquisitions to fit the criteria allowing this accounting treatment.

In 2001, FASB eliminated the rule and instead forced all acquisitions to use purchase accounting; goodwill no longer had to be amortized, but instead tested for impairment yearly. This is what led eBay to charge $1.4bn against earnings in 2007 as a write-off of goodwill from its Skype acquisition, for which it massively overpaid.

Another interesting point – again common with tech companies that issue lots of stock for compensation – is that buybacks at eBay have been largely a mirage. In the past three years, eBay has spent $5.3 billion in buybacks. Sounds great, right? Except that since 1998, it has issued $4.2 billion in stock for compensation and acquisitions. Stock-based compensation ran $350m in 2008 alone.

So how is the market looking at eBay today? At its recent price of $12.50 per share, the company is selling for $16 billion. Net out cash and equivalents plus short-term investments of $2.3 billion, and arrive at an enterprise value – your net “out of pocket” cost to buy the entire business – of $13.7 billion.

Now, eBay is generating about $2 billion per year of free cash flow. These are the “owner earnings,” or cash you could pocket entirely since it takes into account taxes, capital expenditures, even stock-based compensation. This last one is important – as we saw, companies issue stock to employees as compensation, which then must be bought back using the company’s cash. This is a real hit to free cash flow.

The $13.7 billion you’re paying is about 7x current free cash flow. In order to understand what this means, it helps to think about how to value any asset, whether we’re talking about an apartment building, a bond, or a stock.

The value of an asset to you – we’ll call it “intrinsic value” – is the sum of all future free cash flows, discounted to present value. Discounting is important because $1 a year from now is less valuable than $1 in your hands today. Let’s say that 10% is an appropriate discount rate, one that would make us indifferent between $1 today and $1.10 a year from now.

Figuring out the intrinsic value is thus a two-step process. The first step is critical: estimating what those future free cash flows will be. This is very hard to do for most businesses, but easier to do for those whose revenues and incomes don’t fluctuate wildly. Ebay is reasonably protected by its network effects in its various businesses, so it’s unlikely that future free cash flows will suddenly fall off a cliff.

Let’s assume, for now, they don’t grow or decline. In this case, our second step would be to add up those future free cash flows:

It turns out that this series of sums converges to a simple formula, current free cash flow times 1 / r, where r is the discount rate. So in this case, we’d be willing to pay $19.6 billion for eBay’s future free cash flows.

This should give you the idea that, perhaps, eBay is cheap today, since you’re paying less than you’d get. But we left out a critical piece: growth. What would happen to our estimate of eBay’s intrinsic value if its free cash flows grew at, say, 2% per year?

Growth may be a distant memory in a recessionary environment, but remember that growth will one day return. Populations will expand, incomes will rise, and eBay will penetrate new markets. Last – and perhaps most important – an inflationary environment would benefit eBay, since it collects a percentage of transactions it processes both on its marketplaces and PayPal.

Amending our formula to 1 / (r – g) takes growth into account. At 2%, we’d be willing to pay 1 / (10% – 2%) or 12.5x free cash flow for eBay. But let’s instead invert our thinking: what would happen if eBay shrank?

Plugging in a negative growth rate of 4.3%, for example, would get us to 1 / (10% + 4.3%) or 7.0x free cash flow. This brings us back to eBay’s current stock price. It turns out that the market seems to think eBay will shrink 4.3% per year, forever.

This is a pretty Draconian assumption. Embedded in eBay are some fast-growing businesses, like PayPal and Skype. The new CEO, John Donahoe, has plans to cut $2 billion in costs by 2011, which should further juice free cash flow. But PayPal is only 16% of operating income, and Skype a mere 4%. The slow-growing marketplaces segment is 80% of the total. Time will tell whether management’s recent improvements to eBay’s core business will bear fruit.

But because forecasting is a fool’s game, paying a modest amount for future free cash flows should afford the investor a decent margin of safety. In fact, at 7x free cash flow, quite a few things could happen and you still wouldn’t lose money. For example, free cash flow could decline 20% in 2009, and another 15% in 2010 and 2011, before resuming a conservative 2% growth, and you’d still break even.

In the past, eBay hasn’t been very cheap. In fact, only recently has the stock fallen below 10x free cash flow. The chart below shows the de-rating in eBay’s stock from high flyer with a sexy multiple into an also-ran with a stock price that makes it look like road kill:

The red lines show the yearly high and low stock prices divided by per-share free cash flow (actually, they show the enterprise value, which is stock price less net cash). Over the years, eBay’s valuation has compressed, and reached the all-time low of 5.4x free cash flow in early 2009. Over those same years, free cash flow grew from $192m in 2001 to nearly $2 billion in 2008. The drop between 2005 and 2006 is accounted for by an increase in capital expenditures and a 10-fold step-up in stock-based compensation.

One of the biggest risks with eBay is that management will repeat mistakes of the past, namely, overpaying for acquisitions. The company doesn’t pay a dividend, and stock repurchases – which now should be in overdrive mode – have completely dried up in Q408. Why should we expect management to be any different than the average panicked investor? In any case, at the right price, it’s hard to pass on this deal.

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

Atticus Lowe & Lance Helfert at the 3rd Annual New York Value Investing Congress reported by Marcelo Lima.

Atticus Lowe & Lance Helfert of West Coast Asset Management began their talk with a list of 10 signs of a strong company:

1. A simple business model – Dell vs. Wrigley
• Understandable, focused
2. A wide-moat competitive advantage – Cisco Systems vs. Microsoft
• Barriers to entry, pricing & buying power, sustainability
3. Recurring revenue – ADP vs. Toll Brothers
• Long-term contracts, repeat clients (razor blades)
4. Low inventory risk – Starbucks vs. Circuit City
• Don’t get stuck with inventory – quick turnover
5. Alignment of interest – National Home Health Care vs. ATP Oil & Gas
• Ownership, motivations, per share value, compensation
6. A healthy culture – General Electric vs. Johnson & Johnson
• Ruthless vs. selfless, ethical, lead by example
7. A flat organizational structure – Kodak vs. Contango Oil
• Fewer layers better, lean environment, close to customer
8. Low reinvention risk – Apple vs. Tootsie Roll
• Product life cycle, predictable, hit or miss, uncertainty
9. Low capital requirements – General Motors vs. Google
• Flexibility, resilience, generate cash vs. consume
10. Favorable demographics – Tribune vs. Angiotech
• Population characteristics – digital, baby boomers

They presented Noven Pharmaceuticals, of which they own 14%. Noven has a patented drug patch – a proven concept – which is much smaller than previous patches, and can administer a huge variety of drugs in a less intrusive way.

The company’s enterprise value is $270m, which is particularly attractive given that aside from their product portfolio and pipeline, there’s a JV with Novartis which alone is valued by WCAM at approximately $350m.

Overall, they believe a base case for the stock is $21.60 per share with potential to reach $30.80.

Marcelo Lima is a securities analyst for the Flexor Fund, at Miami-based Horn Eichenwald Investments. He focuses on running a concentrated value-oriented portfolio.