Achtung Baby’s Monday News & Notes

Twenty years ago this week, U2 released their seminal album Achtung Baby.  After the failure of the film and accompanying double album Rattle and Hum, U2 ventured to post-Wall Berlin to record and ended up reinventing themselves.  The album sold more than 18 million copies and led to the massive Zoo TV tour setting the stage for the multimedia spectacles favored by pop acts today. Its hard to believe now but in the 90s, U2 was the Apple of the music world- enormously popular but also on the cutting edge. Achtung Baby led to more experimental projects like Zooropa and Passengers: Original Soundtracks 1. The band has since settled into a comfortable Microsoft-like existence selling millions of decent, but predictable albums in the 2000s. But today we salute U2 for creating one of the all-time great LPs in rock history.

Once again, Germany is center stage for a reinvention of sorts- that of the European Union. As Greece and Italy teeter on the brink of default, volatility has been the norm for the stock market. Where can values be found? Check out these links for ideas.

Of potential concern for the U.S. is the level of debt maturing over the course of the next five years…
Compared to many other countries, the percentage of short term debt maturing in less than five years is largest for the U.S.


After scaring us with the debt crisis post, Horan Capital gives us some ideas on places to look for some protection.  Thanks guys!

… or a well-capitalized value play. Some very good value investors are sniffing around materials stocks.  If you’re starting research into that arena, Andrew’s detailed report on Eagle Materials is a great place to start.

A reader of my blog asked me what I think about shipping companies.  Like housing related businesses, they will come back. Where I struggle when I look at these is figuring out when we get back to normal. Richard Beddard’s article (the 2nd link) has some nice historical info on timing the cycle.

there’s a decent chance that at some point in the future the financial system as a whole is going to get its act together and put together something which actually works and which people are happy to adopt. At which point, the online ad industry will face a major threat.

I’ve been looking at publishers and advertising agencies recently and found both of these articles very interesting. What once were some of the widest moat industries around now face potential threats everywhere.  How much will their stock prices need to fall to make up for the deteriorating competitive advantages?

Growing up as a gadget nerd in the 1990s, there was no brand as exciting as Sony. Yes, Apple made great computers, and that’s what we used. But almost everything else, I wanted from Sony.

Speaking of deteriorating moats… The picture of the Discman brings back memories though.  In fact, I think I first listened to Achtung Baby on that exact same piece of hardware.

Finally our elected officials can be good for something. Forget sifting through 13Fs for ideas, we should just follow the top Congressional picks.

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Notes from the Cincinnati CFA Value Investing Panel- 10/11/11

On Tuesday, October 11th, I attended a Value Investing Panel sponsored by the CFA Society of Cincinnati.  The event, moderated by Chris Meyer of the Fund Evaluation Group, featured renowned small cap investor John Rogers of Ariel Investments and James Thompson, senior analyst at Southeastern Asset Management. While less known than Rogers, Thompson has spent 12 years under the tutelage of the legendary Mason Hawkins at Southeastern (you can see the holdings of Rogers here and Southeastern here).  The session covered everything from investment philosophy to choosing portfolio managers to finding value in today’s market.  My notes are below, broken down by category. I used quotation marks for any direct quotes. Any errors in the notes are mine.

Continue reading

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ITT: Three Good Companies, One Low Price

In February, I wrote a post on the conglomerate ITT (ITT)and its spinoff plan into three separate companies, Defense, Water, and Industrial Products.  The market loved the announcement, sending shares of the company from $51 to a high of $64. When I wrote about ITT I felt that because of the run up it didn’t quite offer the margin of safety I was looking for.

On October 17th the spinoff will be complete. For each share of ITT, investors will receive one share of Defense and one share of Water. Additionally, the remaining ITT shares will be reverse split on 1:2 basis. The Defense business will be called Exelis, Water will go by Xylem, and the industrial products division will creatively be christened ITT.  Since the initial announcement, the company has performed well, growing revenues and profits despite the uncertain economic environment and the certain distraction the corporate restructuring causes. The market on the other hand has traded its excitement in the spinoffs for the gloomy outlook and valuation of other companies, sending shares into the low $40s and giving investors an opportunity to get 3 very good companies with a margin of safety. Value investors like Michael Price are also interested in the company.

Due to the company’s restructuring and shifting of assets, liabilities, and revenues between the three new companies, some of the top line numbers in my original valuation have changed. For example, management now projects Exelis to have about $200M less in revenue, while Xylem will add around $150M versus my February estimates.  While the numbers may have changed, what is important is that ITT currently sells for $8B in market cap and the three new businesses are worth more than that.

Exelis will suffer from US defense spending cuts.  Other defense contractors have seen their share prices drop significantly due to these concerns. Though we are certain to see cuts from drawdowns in Iraq and Afghanistan, I am skeptical of the alleged demise of the military-industrial complex, and defense may have even benefited from the recent debt deal.  Either way, Exelis (XLS) isn’t tied to any huge, legacy program. Their core products are communications and GPS technologies, which will still be needed even with major cuts in the Pentagon budget.  The company has a strong history of returns, a good balance sheet, and low capital intensity.  Margins will drop as the demand declines and the product mix shifts to more maintenance and service contracts. Management forecasts long-term operating margins at 11% versus the current 11.5%.  Even if margins drop further, in line with the larger defense contractors at around 8%,  Exelis should still be able to average at least $360M in free cash flow over the next five years. Based on that,  I valued Exelis between $3B-$4B, or $16-$21 per share, using a discounted cash flow model under various declining revenue scenarios. Historical acquisition activity in the defense industry also justifies the valuation.

Xylem (XYL), the water business, provides water transportation (think pumps, not trucks), testing, and treatment products. Xylem has the potential to be a great business.  Their products are crucial, relatively inexpensive parts of much larger systems. For example, once a pump is installed in a municipal water system, it is unlikely the water utility will replace the pump with a competitor’s, requiring reconfiguration of other parts.  Having these types of products allows Xylem to obtain maintenance and parts contracts, something their large, global distribution network is setup perfectly for.  Rising urban populations require updated water infrastructure, so even in a slow economic environment, the industry has the wind at its back. Xylem is expecting organic revenue growth in the mid single digits and low double digit growth after acquisitions.  Xylem enters the spinoff with $1B in net debt but with 2010 free cash flow of $300M, this is a manageable amount.  Using conservative estimates, my valuation of Xylem comes to around $5B, or around $27 per share.

At its recent $43 share price, the pre-spinoff conglomerate is trading for about the value of Exelis and Xylem, giving no value to the remaining industrial products company. In fact, the new ITT has generated return on assets of 10-12% and operating margins around 12% over the last 5 years.  Making a variety of industrial pumps, valves, shocks, and control devices for just about every major industry, ITT will benefit from an economic rebound (60% of the company is tied to early and mid-cycle economic activity). The new ITT will also have a pristine balance sheet with arond $675M in net cash. I feel comfortable in saying that the new ITT is worth more than zero, thus justifying an investment in the pre-spinoff company.  Using normalized earnings and previous M&A valuations, I peg the new ITT’s worth between $2B and $3B or $11-$16 per share ($22-$32 after the reverse split).

A weakening global economy will hurt all three of the new companies. Defense budgets will likely be cut, water infrastructure projects may be delayed, and overall industrial activity could slow. Because of these fears, an investor can now buy the water and defense business and get the industrial products company for free. All three of the companies boast good balance sheets, global capabilities, and competitive advantages to survive another slowdown. Once the economy turns around, these companies should trade for a lot more than the current quote.

Disclosure: Long ITT

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Printing Dollar Bills For 60 Cents at Lexmark

A few weeks ago I opened a position in Lexmark International (LXK).  At around $30 per share, I think the company is ridiculously cheap. Despite having a market cap of over $2B, there really aren’t many people writing about the company, so I posted an analysis at Seeking Alpha.  Frank Voisin also wrote recently about the company, so check it out while you’re at it.

Disclosure: Long LXK

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Warren Buffett and Bank of America: Don’t Try This At Home

So, Warren Buffett just invested $5 Billion in Bank of America (BAC), should you? This latest Buffett deal  should come with fineprint “Performed by World’s Greatest Investor, Do Not Attempt At Home”.

I’m not sure if Buffett’s investment (or “capital infusion”) says anything about his own view on BAC’s intrinsic value. Like his previous deals with GE and Goldman Sachs, Buffett’s terms are extremely favorable. In today’s low interest rate environment, this is a pretty easy way for Berkshire Hathaway’s (BRKB) insurance subsidies to get a 6% return. BAC on the other hand gets the much needed confidence and credibility boost of having the Oracle of Omaha’s backing.

The real benefit to Buffett and Berkshire shareholders come from the warrants.  According to the press release, the deal gives Berkshire 10 year warrants to purchase up to 700M common shares of BAC at $7.14. The stock closed Thursday at $7.65, so any jump in BAC stock over the next decade, even if temporary will add significant icing to Buffett’s cake.

I am sure that Buffett did a lot of due diligence on BAC before making this deal. However, investors should be warned before copying Buffett, since some of his sweetheart arrangements have not led to strong returns for the coattail riders. If you are considering buying stock in BAC on this news, research the company and come up with your own intrinsic value to determine if investing makes sense.  To me, BAC, like most large banks, is a black box. Their 252 page 2010 annual report is exhibit number 1 full of references to unknown legislation and litigation and opaque insights into loan quality. Today, Vitaly Katsnelson put it best when he said “BAC is like a hot dog you don’t really know what goes into it. Buffett with his investment just put a Kosher sign on it.”

For further insight, watch the video of Buffett on CNBC.

One final thought on the Buffett BAC investment. Some commentators believe this deal is politically motivated, given that Buffett met with President Obama earlier this week. Anyone who has followed Buffett’s career knows this is ridiculous. This is a man who won’t even wager on holes of golf with his friends, saying “I never break my discipline”. For investors considering following Buffett, remember to stick to yours.

Disclosure: Long BRKB

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Some Updates and Links from the Gyrating Market

I’ve been very busy at work over the last two weeks so I haven’t had a chance to comment on this crazy market volatility.  When will it stop? Will the EU collapse? Will we have to convert to a barter system? Will Warren Buffett ever pay higher taxes than his secretary? I don’t know. What I do know is that times like these separate the wheat from the chaff. This is the time to look for bargains in the market. Has anything hit your buy price? In markets like these when everything is correlated, the price could keep coming down, so patience when buying or nerves of  steel when holding becomes absolutely necessary.

This is also a good time to review your current holdings. I’ve received a few emails from readers asking if they should sell something they own. My responses have generally been along the lines of “as anything changed with the companies?” and “Are your value estimates still roughly correct?” The next few quarters may be bad, but the key is the outlook for the long term fundamentals of the business. If you bought with a large margin of safety, it helps protect the downside, but when Mr. Market goes crazy, you can have a (paper) loss on your investment.

I have bought a few stocks in the last couple of weeks and I hope to write a detailed analysis on a couple of them soon.  One that I won’t be writing about is Berkshire Hathaway (BRKB).  Its probably been analyzed and written about more than any company in America and nothing I write could add much to the debate (The Rational Walk’s analysis  is the most thorough report I’ve ever read on Berkshire-anyone considering a purchase should read it).  All I can say is that I was able to buy a phenomenal group of companies managed by the world’s greatest investor at very close to book value.  While it may not be a multi-bagger, I feel better in this investment than most mutual funds out there.

Here are some interesting links for you:

  • The Reformed Broker has some advice on surviving a crash.
  • Whopper updates us on AEY‘s quarterly earnings.  I agree with his conclusion. I also think that with the telcos invading their turf, cable companies will need to increase capex sooner rather than later benefiting AEY.
  • Frank reminds us to always watch your rear.
  • For those of you starting out or veterans needing a refresher on value investing, Richard Beddard has a great series, starting here.


Disclosure: Long BRKB and AEY

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It’s The End of The World As We Know It (and I Feel Fine)’s Friday News & Notes

Wait- Michael Stipe had hair?

There’s nothing like a 500 point down day in the Dow and an 11% nine day decline in the S&P 500 to get a value investor’s blood pumping! I’ve been waiting for a pullback, but when the dipshits in Congress got it together and passed a debt ceiling deal, I thought the bleeding would stop for a while. I was wrong, and very few sectors or stocks were spared. Even gold and silver took a hit. Should we have just defaulted? Anyways, where do we go from here? I’m never good at the macro thing (if you’re looking for that, check out TBP or TRB; both are fairly bearish right now) but whenever there are selloffs like these, bargains are bound to be found. Plus, the bond market is looking good, unlike in 2008.

So how do you deal with volatile markets? Take a breath, don’t jump out the window, and check out what I’m reading:

  • Speaking of finding bargains, one of the best places to look for  contrarian plays are heavily shorted stocks. Bespoke has a list of the S&P 500 components with the highest short interest and no surprise there are some value investing favorites on the list, including GME, SVU, and WPO.
  • Is Berkshire Hathaway a contrarian play? Its at its lowest price/book ratio since the market bottom in March 2009.
  • Another good place to look for bargains and ideas? Your own portfolio and companies that deal with them.
  • Vitaly Katsnelson, author of The Little Book of Sideways Markets, has some excellent advice for  evaluating companies and markets. For readers who have not followed Vitaly, he has a very interesting background as well. His site and latest book are must-reads.
  • Remember that even in the worst of markets there are winners. A few months ago, The Frog’s Kiss featured Allied Healthcare International. It was a ridiculously cheap stock beaten down for all the wrong reasons. Well, last week it accepted a buyout at a pretty big premium. Congrats Andrew on a great call.
  • While you are out there looking for cheap stocks, its vital you avoid mistakes. Frank Voisin posts on AMSG and its overstated cash flow while Saj Karsan writes about a net-net that just realized its high potential downside.
  • We all need to read non-investment related material to take our minds off of things. As a die hard music fan, I appreciated the 5 albums test by Steve Hyden and agreed with most of his findings, but c’mon Radiohead doesn’t pass the test (even though King of Limbs sucks)? Wilco and Spoon the same band? Kanye gets by with an autotune album (808s & Heartbreak)? Now I really am worked up.

Finally, whats the best advice when there is panic? As Ravi at Rational Walk tweeted “Did anything that happened today change your (intrinsic value) estimate? If not, who cares?” Invest like your buying a business and move on. Happy hunting!

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Merger of Rivals Gives CVS Caremark Advantage in Drug Wars

The recently announced merger of Express Scripts (ESRX) and Medco Health Services (MHS), two of the largest pharmacy benefit managers (PBMs) provides an excellent opportunity for CVS Caremark (CVS) and their investors.

As I wrote previously, I think CVS is undervalued on a sum of the parts basis. The proposed merger adds credence to my case. ESRX is purchasing MHS for 13x EV/EBIT while by my estimates, the market is valuing the Caremark segment as low as 5x EV/EBIT.  If the merger is completed, ESRX-MHS will have a 40% market share compared to around 16% for Caremark.

While the emergence of a larger rival may seem like bad news for CVS, it does provide opportunity on several fronts. Earlier this year, CVS won several big contracts from MHS and the pending merger (and management attention focused on the integration) may drive clients to look elsewhere.

The best opportunity for CVS is the pressure the merger puts on their fiercest retail rival, Walgreen (WAG).  WAG is currently embroiled in a public dispute with ESRX, and if a deal isn’t worked out by year end ESRX clients and their employees will be unable to fill their prescriptions at WAG. With the pending merger and a 40% market share, ESRX now has a lot more leverage in the dispute.  No matter what the outcome, CVS should be able to pressure WAG for major price concessions.  The same holds true for small pharmacies as well, meaning the CVS retail stores could benefit from better pricing negotiated by the Caremark division.

The future looks bright at CVS with demographic trends and the competitive environment providing tailwinds. At a recent $37, there still looks to be some upside for investment gains.

Disclosure: None

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Michael Burry: A Risk-Averse “Risk Taker”

Michael Burry, ex-investment blogger,  former hedge fund manager at Scion Capital, and the hero of Michael Lewis’ “The Big Short” appeared on Bloomberg TV on Tuesday night. The show is titled “Risk Takers” but as one hedge fund manager says, Burry is very risk-averse, more so than many other professionals.

Burry left investment management after making millions off of credit default swaps. He now manages his own money, without the second-guessing and pressure from outside investors.

If you haven’t seen the show check it out here.

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Bill Smead’s Wednesday News & Notes

When deciding on the title of today’s post, I wanted to stick to the business and investing theme of this blog and honor a person or event with significance to capitalism or capital markets that relates to July 20th. I debated intensely on whether to honor Ford Motor Company, who celebrates the 108th anniversary of their first automobile shipment today, or the 47th birthday of Kool G Rap, who MC’d the LP Roads to the Riches, which certainly inspired budding entrepreneurs of the mid 1980s everywhere.  However, I was reading an article on the upcoming Amazon tablet and its potential impact on Apple when I came across this brilliant analogy by Seattle money manager Bill Smead (emphasis added):

“At the margin, maybe they can make some money selling a tablet. But Amazon is really doing it to support their core business,” said Bill Smead, chief investment officer of Seattle-based investment firm Smead Capital Management. “If you sell a new bong once in a while and keep the water clean, people will keep smoking more pot.

Smead follows timeless value investing principles and obviously provides unique insights into business outside the realm of traditional money managers, so this post goes out to you Bill Smead! (By the way, are there any publicly traded bong makers? That business could be pretty lucrative if decriminalization/legalization occurs). Now onto the notes:

  • In a previous post, I mentioned Research in Motion (RIMM), the maker of Blackberry. While RIMM’s corporate business has a strong moat, it is being encroached on, and any potential investor has to form an opinion on how long that moat will last and if the current stock price is underestimating its strength.  This article demonstrates how management’s arrogance has put it behind its competitors. The key will be if the same management can see their mistakes before it is too late.
  • The media world is abuzz with the saga of Rupert Murdoch and News Corp (NWS). With all the negative publicity, is there investment potential? Dan Gross argues that there is a significant Murdoch discount and value investors at Gabelli & Co say there is a lot of untapped value in the global media holdings. As great as those properties are (WSJ, Fox, Times of London, Hulu, etc), at around 16x last year’s FCF, the stock would need to get much cheaper for me to bite, especially considering that the Murdochs likely aren’t going anywhere.
  • Speaking of investment potential, Elie at Valueslant has a phenomenal post on Providence Service (PRSC), a social services and health transportation company.  Elie makes a great case for buying the stock that has been hammered by a misunderstanding of the business economics.
  • ITT’s (ITT) breakup is moving forward and the new defense and water companies chose some interesting names. I’ve written about ITT before and despite their apparent fascination with the letter ‘X’ I think there is a lot of value in the company. I haven’t bought the stock yet, but  I just started digging into the Form 10 of the new companies and hope to report back something soon.
  • Since many investors get confused when looking for documents on the SEC’s website, Magic Diligence walks us through a basic document search.  Even many professionals don’t read the SEC reports thoroughly which can be a major mistake. Listen to Warren Buffett, and take the time to read the annual reports. Magic Diligence’s post is good for newbies and veterans who have started to cut corners a bit.
  • Finally, one of my investment heroes, Michael Burry, was on Bloomberg TV Tuesday. I missed the episode (I don’t have Bloomberg TV) but hope to see it online somewhere. Jacob at ValueWalk posted a brief transcript. I’m planning a series of posts on Dr. Burry and would love to see more of him in the spotlight.

Thats it for now. Stay cool- the heat is coming.

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