A Thank You

I began blogging in the Spring and 2007 and have found it rewarding, both professionally and personally. I have made contact with other investment bloggers and have been able to expound on my investment philosophy and ideas. I now have 60 subscribers - more than I thought I would have after eight months of blogging. Thank you for being interested enough to read my blog.

Some stats for the record. I managed to write 134 posts this year. My average weekly unique page views was 311 for 2007, with my best week back in June when I had 3,051 unique weekly page views after I posted Sell Side Cliches, and it got mentioned in the Kirk Report.

I hope that in 2008, I will continue to reward you with interesting and lively content.

Sallie Mae (SLM) - The Conference Call from Hell

It will go down in history as the conference call from Hell, displacing Jeff Skilling and the famous Enron Call from 2001. I am referring, of course, to the conference call conducted yesterday by Sallie Mae (SLM) and Albert Lord, its CEO.

First, he slams down the ancient sell side practice of asking a "multi part" question to conform to the single question requirement of most managements. The victim was Jason Miller.

"All right. This is the last question I answer that’s more than one part. We will look at the dividend in the second half of the year.."

And then Lord begins to display either his total contempt for the analyst community or his total ignorance of the company he is running.

Analyst

"And you didn’t mention how much equity you were going to need to get back up to the single A rating."

Albert L. Lord

"You’re talking to the wrong guy. I don’t know that answer."

Then an analyst begins to question him about access to the pass through market.

Analyst

"Okay, but clearly you’ve been talking to the arranging banks and they must be telling you something."

Albert L. Lord

"I’m not sure what you’re talking about. I’ve been talking to whom?"

Analyst

"We’re trying to make -- we’re trying to figure out what your stock is going to be worth and you’ve got to give us some guidance, you’ve got to give us some numbers. I don’t even seea margin number here for the stuff that you’ve done. Can you give us some handle on what your stock is worth?"

Albert L. Lord

"You should give Steve a call."

Analyst

"But you’re the CEO. You’re the guy who just took over the company."

Albert L. Lord

"Yeah, that’s exactly right. I’m the CEO. You should give Steve a call. Next question."

And then the grand finale, after no more questions from the analyst crowd:

Albert L. Lord

"How good is this? Steve, let’s go. There’s no -- no questions. Let’s get the fuck out of here."

The Problem with Auction Rate Securities.

The reclassification by Palm Inc. (PALM) of $75 million in short term investments to non current raises the issue of auction rate securities again. So what is the problem with them?

They are actually long term securities, not short term, with the rate reset on a short term schedule using a Dutch Auction methodology. If the auction fails, then the holder can't get access to its funds until the next auction.

Also, the issuer does not conduct the auction, it is done by Broker dealers.

A Threat to Value Strategy?

One of the bedrocks of Value Investing is margin of safety, which is sometimes manifested by owning a company with a large cash balance relative to its market capitalization. Most investors lump cash and short term investments into one figure, owing to the alleged safety of these investments. What if that cash wasn't really cash?

The latest hint of this problem comes from Palm Inc. (PALM) which stated during its conference call that $75 million of its cash balance has been reclassified to non current due to a "limited market" for these auction rate securities. The full quote from management, courtesy of Seeking Alpha:

"We also reclassified approximately 75 million of our investments to non-current. These are AAA and AA rated auction rate securities that currently have a limited market and are not needed to meet all liquidity needs for at least the next twelve months. As a result, they have been reclassified to non-current."

This looks to be classified on the PALM balance sheet as "other assets" which is now at $92.2 million. I am not sure what the other $17 million is.

There were no questions about this during the call.

PALM a Net Current Asset Value Play?

A number of bloggers have been pushing Palm, Inc. (PALM) as a "cash equals current market cap" play. This is not correct. PALM did report $622 million in cash and equivalents as of 8/31/07 compared to a current market cap of $573 million. However, they recently received a $375 million investment from Elevation Partners, and then promptly paid out a $900 million dividend to shareholders.

I don't usually bash fellow bloggers, mostly because one day I will make a mistake and don't want to be bashed myself, but this PALM investment theme was reported on Silicon Valley Insider, the blog authored by Henry Blodget, the former Wall Street super star analyst.

Here is an excerpt:

"Yes, we think Palm sucks. But it's worth observing that the company is trading for cash value.

At $5.50 a share, Palm has a market value of about $550 million, and at the end of August, it had about $550 million of cash. Thanks to its disastrous quarter, the company will undoubtedly take a restructuring charge, but it will still have a meaningful pile. And the 10% holiday headcount reduction should stem any cash burn for a while.

So the question is this: Can Palm be salvaged? Can it blow out its incompetent management team and recruit a better one? Can it be taken over by Research in Motion, Nokia, Motorola, or another gadget maker desperate to have a chance to compete with Apple?

If you think the answer is "yes," now is the time to look at the stock. Now, when everyone else is filled with feelings of love and admiration for Research in Motion and Apple and disgust and loathing for pathetic Palm."

Bill Miller on Risk

I read a post this morning on Crossing Wall Street that quoted Bill Miller talking about the investor misperception regarding risk in the markets. I like the last paragraph, and I highlighted it in bold. Here is the full quote:

"You also know that rising stock prices mean lower future rates of return and falling stock prices mean higher rates of return. So I was much happier in the summer of '02 when you buy everything on sale than I was in the Spring of 2000 when a lot of things were super-expensive.

My view is that the evidence is overwhelming that most people are too risk averse. And that therefore they should be taking a lot more risk than they feel like is right.

The problem is that real risk and perceived risk are two different things. And that's where people get into trouble, because they perceive risk to be high when prices are low, and they perceive risk to be low when prices are high. That's the psychological problem that most people have."

Robert Toll on the Sub Prime Bailout

A few excerpts from the Toll Brothers fourth quarter conference call held last week courtesy of Seeking Alpha

Robert Toll had some interesting comments on the new plan announced by the Federal Government.

Comments on Sub Prime Loan Plan

"With respect to what do I think about the most recent announcements, to be a wise guy, not much. There is no such thing as a sub-prime loan. There’s a sub-prime borrower; that is a borrower who hasn’t got the credit, the respect for his credit in the marketplace that’s equal to what you would consider to be necessary, which we call now prime. A little misnomer in the use of the words."

"What I understand has been offered to the congress to consider and pass is a break for sub-prime. So if you’ve got -- sub-prime borrowers, so that if you are not credit worthy, we’ll give you five years at your present rate but the next door neighbor, who decided he liked the teaser mortgage and went for four for the first six months and six for the next six months and then according to an index with a differential, he would be pushed to eight and then to 10, he’s stuck because he had prime rating."

"I think what would have made more sense, if I were running the zoo, is I would have said we are going to stop teasers, not just sub-prime but for everyone at a rate and pick a number. If we think a -- we’ve done it in the past. The rates used to be regulated in this country up to the elimination of Regulation Q. I think that was in the ‘70s when disintermediation took place."

"I think it wouldn’t be a great feat for us to say that for the next two years, we are going to cap the rates for teaser mortgages at 8%, or 8.5%, which has been approximately the 40-year average rate that we’ve lived with."

Toll Brothers Conference Call

A few excerpts from the Toll Brothers fourth quarter conference call held yesterday courtesy of Seeking Alpha

Interesting that he said that 1974 was a rougher downturn than the current one.

Comments on Current Conditions

"By many measures, fiscal 2007 was the most challenging of the 40 years that Toll Brothers has been in business. 1974 was perhaps rougher, but the difficult times only lasted one year."

"Since going public in 1986, we’ve just reported our first quarterly loss this fourth quarter after 85 consecutive profitable quarters. The loss was driven by $315 million of non-cash pretax inventory related impairments and related write-downs."

"The creation of projections is difficult at any time. In the current climate, it’s particularly difficult to provide guidance for fiscal 2008, given the numerous uncertainties related to items such as sales paces, sales prices, mortgage markets, cancellations, market direction, and the potential for and size of future impairments. As a result, we will not provide earning guidance at this time."

Are We There Yet For Homebuilders - An Update?

In September we blogged about the dangers of using stated book value as a buy signal when evaluating Homebuilders for purchase. The original post is here at this link:

Are We There Yet for Homebuilders - Part II?

My advice was not to believe the book values being used in quarterly balance sheets.

"do not use price to book yet as a buy signal. Book value is in flux and will continue to go down quarter after quarter. The safest thing to do is take the latest quarters book value and write off 30% and then slap a .75 multiple on it and then buy them there."

Well, it seems that a 30% haircut is not enough. Lennar Corp filed an 8-K disclosing that it sold some of its lot and land inventory at a haircut of 55% off the book value that Lennar thought it was worth just eight weeks ago.

The full filing can be read here at the SEC site.

The relevant quote is:

"As of September 30, 2007, the acquired properties had a net book value of approximately $1.3 billion and the sales price was $525 million."

Random Thought of the Day - Nov 30, 2007

It doesn't matter what the Fed does to interest rates if lenders won't lend, so ride the rally up until the Fed cuts rates, and then get short. If you don't believe me then look at this study done by the Federal Reserve back in 2002.


Study

If it gets too dense then read the conclusion paragraph on Page 11 and 12

Thrift Capital Ratios

During the last significant recession in the early 1990's the thrift industry was ground zero for everything that was going wrong with the economy at the time, with hundreds of bank failures, etc. This time the problems seems to stem from the "smart money" bankers who have overextended themselves without regard to risk.

The Sept 2007 aggregate thrift financial report shows capital ratios actually getting stronger in September 2007, as measured on a year over year basis.



The full report is here.

Thrift Report

The Office of Thrift Supervision (OTS) just released its third quarter report on the state of the thrift industry. While the market and the media have been focused on the travails of the large cap banks and brokers, the thrift industry is just as important to our financial system as it has $1.57 trillion in assets and originated 30% of all mortgages in the most recent quarter. The full report is available here:

Thrift Industry

Highlights include:

1) Loan loss provisions increased to 0.92 percent of average assets in the third quarter, an increase from 0.22 percent in the third quarter one year ago and from 0.38 percent in the prior quarter.

2) Troubled assets (noncurrent loans and repossessed assets) were 1.19 percent of assets, up from 0.95 percent in the prior quarter and 0.64 percent a year ago.

Loan loss provisions as a percent of average assets are now at the highest level as far back as the report goes (1991).

Although these metrics are high, it can get a lot worse. If you look at page 11 of this report, entitled troubled assets, you can look at the peak back in the early 1990's.

Also, as the report notes, if you exclude the top ten thrifts who are active in originating loans for sale, the industry return on assets would have been much higher.

Highly Recommended

I just found a blog that is probably one of the best I have seen on Homebuilders and the related mess that is going on in that area. It is written by Reggie Middleton and is located here:

Reggie Middleton's Boom, Bust & Bling Blog

He brings a lot of insight into an area that is usually full of hyperbole. I would recommend subscribing to his feed.

No More Bloody Shoes

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is another scenario:

Citigroup, Inc. releases a press release at 2:00 AM on Sunday Morning on Thanksgiving Weekend. It is noteworthy for its simplicity and brevity. It reads:

"Citigroup, Inc., announced this morning that it will no longer provide credit support to the multiple Structured Investment Vehicles that have been carried off balance sheet. While Citigroup, Inc. previously supported these vehicles through various means in order to maintain market stability, the bank is under no legal obligation to do so, and has decided to use our capital for other purposes."

The silence is deafening - for a moment - as the market takes a couple of seconds to digest and understand the implications of this. At the close on Monday, the first money market fund "breaks the buck" and trades at less than a dollar a share. Panic sweeps the staid world of the money markets, accelerated when the great mass of individual investors finally realize that a dollar in a money market fund does not equal a dollar of cash.

How Many Shoes Can We Handle?

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is another scenario:

Citigroup, Inc., under pressure from the financial markets and shareholders decides to reduce its balance sheet risk, just in case. A memo goes out from the office of the new CEO. Long time commercial bankers call their customers. The conversation goes something like this:

Banker: Hey John. How are things going?

Customer: Oh good. How's the bank?

Banker: Pretty good. The reason I am calling is that the loan that is due next month. We're not going to be able to roll it over this time.

Customer: What?

Banker: Yeah, I'm sorry but I wanted to give you some notice so you can make other arrangements.

Customer: But we have always paid on time. I've had that loan with you for years. That bank was called First National City Bank when I first took it out. You can't do that.

Banker: Well I've got to go. I have some other customers to call. Bye John.

John decides then not to open that new store, or build that building, or expand into that new line of business.

The credit crunch spreads to Main Street.

The Next Shoe?

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is one scenario.

Ambac Financial Group, Inc. (ABK) is at a 10 year low. ABK insures billions of dollars worth of Municipal Bonds. Small investors basically treat this guarantee from ABK and other insurers as gold. It lets them sleep warm and comfy at night knowing that their nest egg is secured.

The Stock Market panics further and drives down the price of ABK even more after further disclosures on its exposure to risky securities, and ABK loses its ability to provide a AAA credit rating to the bonds it insures. Municipal Bond funds, some of which must hold only AAA or insured bonds according to its prospectus, start selling ABK backed bonds. There are few buyers for these bonds. The market for these bonds shows sharp declines in price since the Municipal Bond market is a fairly illiquid market. Auditors, not wanting to end up like Arthur Andersen, insist that the muni funds mark the bonds down based on the few forced sales out there.

The bond funds holler and scream but they price the bonds at the end of the month based on the few comparable sales out there and on the underlying credit assuming no insurance.

The retail investor opens the statement and sees its fund or individual bond marked down 5 to 10%. A wave of panic selling ensues as they call their stockbroker and tell them to sell. Prices decline even further. Since there is too much supply and not enough demand, public finance slowly grinds to a halt as States and Municipalities can't roll over existing debt or start new projects.

While this scenario sounds like a little bit of a stretch, who knows? If someone had told you six months ago that the largest bank and the largest brokerage firm in the United States would sack its CEOs, that would have sounded a little crazy also.

What the Heck Does This Mean?

Moody's put out a filing the other day and this little nugget stuck in my head:

Based on its review of the latest information available, in the opinion of management, the ultimate liability of the Company for the unresolved matters referred to above is not likely to have a material adverse effect on the Company’s consolidated financial condition, although it is possible that the effect would be material to the Company’s consolidated results of operations for an individual reporting period.

Here is the full text from the filing:


Item 1. Legal Proceedings

From time to time, Moody’s is involved in legal and tax proceedings, claims and litigation that are incidental to the Company’s business, including claims based on ratings assigned by Moody’s. Moody’s is also subject to ongoing tax audits in the normal course of business. Management periodically assesses the Company’s liabilities and contingencies in connection with these matters based upon the latest information available. Moody’s discloses material pending legal proceedings, other than routine litigation incidental to Moody’s business, material proceedings known to be contemplated by governmental authorities, and other pending matters that it may determine to be appropriate.

For matters, except those related to income taxes, where it is both probable that a liability has been incurred and the amount of loss can be reasonably estimated, the Company has recorded reserves in the consolidated financial statements and periodically adjusts these as appropriate. In other instances, because of uncertainties related to the probable outcome and/or the amount or range of loss, management does not record a liability but discloses the contingency if significant. As additional information becomes available, the Company adjusts its assessments and estimates of such liabilities accordingly.

For income tax matters, the Company employs the prescribed methodology of FIN No. 48, adopted as of January 1, 2007. FIN No. 48 requires a company to first determine whether it is more-likely-than-not (defined as a likelihood of more than fifty percent) that a tax position will be sustained based on its technical merits as of the reporting date, assuming that taxing authorities will examine the position and have full knowledge of all relevant information.

A tax position that meets this more-likely-than-not threshold is then measured and recognized at the largest amount of benefit that is greater than fifty percent likely to be realized upon effective settlement with a taxing authority. The discussion of the legal matters under Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contingencies”, commencing on page 30 of this quarterly report on Form 10-Q, is incorporated into this Item 1 by reference.

Moody’s has received subpoenas and inquiries from states attorneys general and governmental authorities and is cooperating with those inquiries.

Based on its review of the latest information available, in the opinion of management, the ultimate liability of the Company for the unresolved matters referred to above is not likely to have a material adverse effect on the Company’s consolidated financial condition, although it is possible that the effect would be material to the Company’s consolidated results of operations for an individual reporting period. This opinion is subject to the contingencies described in Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contingencies”.

Citigroup Disclosures

The 10-Q filed by Citigroup yesterday has the following disclosures about the extent of its exposure to the continuing financial mess in the markets:

"On November 4, 2007, the Company announced significant declines since September 30, 2007 in the fair value of the approximately $55 billion in U.S. sub-prime related direct exposures in its Securities and Banking (S&B) business. Citi estimates that, at the present time, the reduction in revenues attributable to these declines ranges from approximately $8 billion to $11 billion (representing a decline of approximately $5 billion to $7 billion in net income on an after-tax basis)."

"Citi also announced that, while significant uncertainty continues to prevail in financial markets, it expects, taking into account maintaining its current dividend level, that its capital ratios will return within the range of targeted levels by the end of the second quarter of 2008. Accordingly, Citi has no plans to reduce its current dividend level."

Breakdown of $55 billion

$11.7 billion of sub-prime related exposures in its lending and structuring business.

*$2.7 billion of CDO warehouse inventory and unsold tranches of ABS CDOs.
*$4.2 billion of actively managed sub-prime loans purchased for resale or securitization at a discount to par primarily in the last six months.
*$4.8 billion of financing transactions with customers secured by sub-prime collateral.

$43 billion of exposures in the most senior tranches (super senior tranches) of collateralized debt obligations which are collateralized by asset-backed securities(ABS CDOs).

*$25 billion in commercial paper principally secured by super senior tranches of high grade ABS CDOs

*$18 billion of super senior tranches of ABS CDOs as follows:

*$10 billion of high grade ABS CDO.
*$8 billion of mezzanine ABS CDOs.
*$0.2 billion of ABS CDO-squared transactions.

The $18 billion in super senior tranches are being valued apparently using the new level 3 asset guidelines. These securities are not trading at all. There is still significant risk in these holdings due to the uncertainty described below.

"These super senior tranches are not subject to valuation based on observable market transactions. Accordingly, fair value of these super senior exposures is based on estimates about, among other things, future housing prices to predict estimated cash flows, which are then discounted to a present value."

Citigroup Capital Ratios

Here are the relevant capital ratios for Citigroup as detailed in the 10-Q filed this morning. These ratios are for Citigroup. The 10-Q has a second set of capital ratios for Citibank, N.A. The numbers for Citigroup are as of 9/30/07:

Core capital (leverage) ratio 4.13%
Tier 1 risk-based capital ratio 7.31%
Total risk-based capital ratio 10.61%

My assumption is that these capital ratios don't take into account the latest write offs that hit the tape this morning. The 10-Q states that "to be well capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 Capital Ratio of at least 6%, a Total Capital Ratio of at least 10%, and a Leverage Ratio of at least 3%, and not be subject to an FRB directive to maintain higher capital levels."

Here are the actual numbers as of 9/30/07 in billions (add six zeros):

Total Tier 1 Capital $ 92,370
Total Tier 2 Capital $ 41,453
Total Capital (Tier 1 and Tier 2) $ 133,823

Ratio Calculations

Tier 1 risk-based capital ratio of 7.31% is calculated by dividing $92,370 by total Risk-Adjusted Assets of $ 1,261,790.

Total risk-based capital ratio of 10.61% is calculated by dividing $ 133,823 by total Risk-Adjusted Assets of $ 1,261,790.

Core capital (leverage) ratio of 4.13% is calculated by dividing $92,370 by adjusted average assets.

Slow and Steady Wins the Race

Last Thursday was a brutal day for the market, and especially for financial stocks. However, there were a couple of banks that were up on Thursday after reporting earnings for the quarter. Neither of these banks are well known, or covered by analysts, or could care less.

One is a cult bank stock that happens to be located in the fulcrum of foreclosure land - Southern California. The other is located in North Carolina and consists of one branch office. Both are Bulletin Board stocks that trade by "appointment" only.

Farmers & Merchants Bank of Long Beach has been in business for 100 years and operates 22 branches in Southern California. It has been controlled ever since by the Walker Family. It traded 2 shares yesterday at $6,575 per share, up 2.65%. Ninety percent of its loan portfolio is tied to real estate, mostly commercial, but the bank did not report any charge offs during the quarter, nor any losses on its investment portfolio. And in case you are worried about insolvency, you should know that its total capital to risk weighted assets is an astounding 39.22% at the end of 2006. A bank is considered well capitalized if that ratio is in excess of 10%.

The bank web site is here.

Wakeforest Bancshares Inc. is a micro cap Savings and Loan located in Wake Forest, North Carolina. It reported earnings for the quarter that were down year over year from 9/06, and full year earnings were up $0.02 from 9/06. The stock traded up 8.55% to $22 a share. So how did they do it? Very simple - "the Company does not make sub-prime loans," according to the press release. Or to put it a little more colloquially - we don't do stupid things like make bad loans to people just to satisfy Wall Street's insatiable need to grow. We don't care if you laugh at us every year at the annual Bankers convention because who's laughing now. The web site is here.

I don't own either of these stocks. I did look into Wakeforest Bancshares Inc. a few months ago and passed because it wasn't "liquid" enough. It occurred to me that liquidity isn't always a good thing since it allows investors to react emotionally without regard to reason or rationality.

Things We Are Glad We Said but Wish We Had Listened To

California's Housing Market: How Much ‘Froth’ Is Out There?

A conference held in October 2005 sponsored by the Milken Institute.

"Angelo Mozilo of Countrywide Financial Corporation predicts that the market will slow and even decrease by a couple percentage points “so that incomes can catch up with the price of homes.” His concern reflects the historic low affordability level that prices many potential buyers out of the market unless they resort to creative financing, which is inherently riskier."

"With new-loan originations now being comprised of 60 percent adjustable-rate mortgages and 40 percent fixed-rate mortgages, Mozilo concedes that his company “may be selling products to individuals who can’t manage risk.”

Things We Wish We Never Said

California's Housing Market: How Much ‘Froth’ Is Out There?

A conference held in October 2005 sponsored by the Milken Institute.

"Although the market is cooling off, the demand for housing is real, and we will continue to see modest single-digit gains below 6 percent, he said."

-Emile Haddad, President, Western Region, Lennar Corporation

Remember the Good Old Days?

Do you remember the good old days when every bank investor only wanted to own banks that had deposits in Florida? That's where the growth was, and everything else was looked down upon with scorn. Things are a little different now judging by the latest crop of Bank earnings that have come out. The latest taste of too much growth comes from BankAtlantic Bancorp, Inc. (BBX) which reported earnings on October 25.

"Non-performing loans increased from $21.8 million at June 30, 2007 to $165.4 million at September 30, 2007 resulting primarily from the placement of eleven commercial real estate loans totaling $148.7 million on non-accrual status. As a result, the ratio of non-performing loans to total loans increased from 0.47% at June 30, 2007 to 3.53% at September 30, 2007 and the ratio of non-performing assets to total loans plus other assets increased from 0.94% at June 30, 2007 to 3.74% at September 30, 2007.

"The Bank's loss experience for the quarter ended September 30, 2007 was a net charge-off of $11.3 million compared to a net recovery of $0.2 million for the quarter ended September 30, 2006. Included in the $11.3 million net charge-off was $8.8 million related to the write-down of one 'builder land bank loan' and consumer net charge-offs of $1.6 million, representing primarily home equity lines of credit. ('Builder land bank loans' are characterized as loans made to borrowers with agreements to sell the underlying collateral to national and local home builders pursuant to option contracts.)"

The market has beaten the stock price down to $4 a share as of today, or a market capitalization of $238 million. BBX owns around 2.3 million shares of Stifel Financial Corp (SF) which is valued at approximately $136 million. BBX also has warrants to purchase more SF at $36 a share. If you have a strong stomach and buy this one you are practically getting the bank operations for nothing.

Beware, however, that its capital ratios may deteriorate further. At 6/30/07 the relevant capital ratios were:

Core capital (leverage) ratio 7.48%
Tier 1 risk-based capital ratio 10.62%
Total risk-based capital ratio 12.34%

An institution is considered well capitalized if its ratios exceed the following percentages:

Leverage Ratio > = 5%
Tier 1 Risk-Based > = 6%
Total Risk-Based > = 10%

The stock is now trading at only half of its book value, if you can believe the book value, as compared to 1.6 times back during the good old days.

Symetra Financial IPO - White Mountains Insurance

The long awaited initial public offering of Symetra Financial Corp. has finally arrived. An S-1 filed by the company this morning has put a price range of $18-20 per share on the 39.5 million shares being offered in the IPO. Symetra was created in 2004 by an investment group led by Berkshire Hathaway and White Mountains Insurance. Both entities own 26,887,872 shares of Symetra. WTM will be selling from 9,870,306 to 11,350,852 shares.

If we assume a pricing of $19 per share then WTM will receive from $187 to $215 million in the IPO. Its remaining stake in Symetra Financial, which will trade under the symbol SYA, will be worth $295 to $323 million.

Book value per diluted share for Symetra as of 9/30/2007 is $15.10, so the IPO is being priced at 1.25 times book value assuming a final price of $19 per share. In my blog post from June I used 1.5 times book value so the value comes in a little less than I thought.

This was still a good deal for White Mountains Insurance as the investment group purchased these assets from Safeco at less than book value in 2004, and they have also withdrawn capital since the original purchase. Here is the lead paragraph from the WTM press release in 2004:

"HAMILTON, Bermuda, Mar 15, 2004 /PRNewswire-FirstCall via COMTEX/ -- White Mountains Insurance Group, Ltd. (NYSE: WTM) announced today that it and Berkshire Hathaway Inc. are leading an investor group that will acquire the life and investments business of Safeco Corporation for $1.35 billion, subject to adjustment based on June 30, 2004 adjusted statutory book value.

Safeco Life and Investments, with headquarters in Redmond, Washington, focuses mainly on group insurance, individual life insurance, structured settlements, retirement services and mutual funds. As of December 31, 2003, the business had approximately $22.5 billion of total assets and $2.57 billion in GAAP book value ($1.74 billion excluding FAS 115). President Randy Talbot and his management team will continue to run the business following the acquisition."

The S-1 is here at the Edgar web site.

Bring Me the Head of Stan O'Neal

There was a movie made in the 1970's called "Bring me the Head of Alfredo Garcia." You can read about it here at the IMDB database. The movie starred Warren Oates as a bounty hunter, but maybe when they do the remake, they should be hunting the head of Stan O'Neal. Here are excerpts from his grilling by the analyst community courtesy of Seeking Alpha.

"If I can ask Stan, do you feel comfortable that there is not another shoe to drop and a lot more writedowns on the ABS CDOs?"

"We have tried to capture everything that we can capture at this point, in the market. The expectation for progression of these securities as of the date that we took the markdowns. I cannot tell you what the market trajectory might be from here, but as of the date that we took these markdowns, and even looking at it as we sit here today and observing the general environment, we are comfortable that we have marked these positions conservatively."

"How did you wind up with such a large concentration in the first place? I mean the number of employees is such a small fraction of the overall firm, and it results in results like this? I guess I am asking about risk management, and what went wrong and what happened in the last three weeks to wind up with $3 billion of additional charges?"

"The $3 billion in additional charges is taking a look at the methodology and going through the marking models, again, and coming to a conclusion that is still within the same range that we had before, but it was more appropriate to be at a more conservative end of the range than we had previously indicated. That is where the $3 billion comes from. Why do we have such a large position in the first place? We made a mistake. There were some errors of judgment made in the businesses themselves, and there were some errors of judgment made within the risk management function, and that is the primary reason why those exposures exist."

"On the $8 billion in losses, can you give us a feel for how much of that is realized versus unrealized?"

"I think we already said that we are not breaking that down."

"Can you give us some more comfort with your understanding of your current risk loss exposures? I'm having a little trouble with how you can feel that you understand your risk exposure, when September 28 marks deteriorated an extra 75% on you after the quarter closed?"

"It is because we have had some time to do a lot more work and we have reviewed the methodology, we have reviewed the pricing standards, we have reviewed the inputs and we have come to the conclusion that again, within the same range it is appropriate to mark it much more towards the more conservative end of the range."

All is Forgiven in Love and War and Energy

Energy is back again as investors seem to have a short memory and despite weakness in North America, they are banking on international growth to bail out the Sector. Sounds a little familiar doesn't it? Here are the rest of the highlights from the Schlumberger call that caused the 10% one day drop. The stock has now recovered half of the loss. Transcript courtesy of Seeking Alpha

Once management comments ended, they were hit with a blizzard of questions on the outlook going forward:

The bane of all cyclical industries - too much capacity coming on line.

"I think pricing deterioration is still single-digit compared to last year. I think it will accelerate slightly in Q-4; and where the bottom is, I really don’t know, because what we have is a situation very different from 2001, in that the bottom is going to be created by additional capacity and not by a drop in the rig count."

And exactly how much extra capacity?

"So what is going to change the pricing profile is the additional capacity. And, you know, we, I’m not quite sure where we stand in the additional that was coming on. But, you know, when we looked at it a few months ago, it was certainly an increment in the high double, in the high teens, if not more."

On the margin effect:

"The biggest effect on margins in the Q-3 in North America was the lack of operating days in the Gulf of Mexico, due to precautionary evacuations, not from land. There was a deteriorating on land but it was not the major part of it. And, in terms of the pricing of services, other than pressure pumping, we have not so far seen the noticeable effect."

This next excerpt might have really panicked the street as Schlumberger almost seemed to be backpedalling on its growth forecast that it headlines at the beginning of every conference presentation.

"What I’m saying is that we won’t get a high teen growth rate in North America in 2008. Everywhere else, we probably will not be that far from it; but in North America we’re not going to get it. Now, what happens through the end of the decade, I, you know, I can’t speculate yet on North America specifically. The rest of the world, I’m perfectly confident."

And then they refused to confirm where the bottom is in North America:

"Overall, do you think that the North American EBIT in ’08 is going to be above, below or in line with the ’07 contribution?"

"Well, I don’t think I’m ready to answer that yet Geoff; but obviously, you know, if there is a big pricing impact on land, then it will have an effect."

"So a decline is a possibility?"

"It’s not excluded, no."

Private Homebuilder to File Bankruptcy

Another one bites the dust.

"Neumann Homes, one of Chicago's largest homebuilders, announced on Monday that it intends to file for bankruptcy.

The company said in a press release at 5 p.m. that it had been "unable to procure adequate funding" to operate its business. Marketing director Jean Neumann said that despite other published reports, the bankruptcy had not been filed, though "it will be done shortly."

The company, ranked among the top 10 in Chicago, also builds in Wisconsin and Colorado. Company CEO Kenneth P. Neumann said in the statement that "significant downturn in the Detroit, Chicago and Denver housing markets resulted in this situation. ... Even after the significant help we have received from our lenders this year, the company can no longer weather this storm."


Neumann Homes Bankruptcy

Is the Energy Cycle Over?

I know its heresy to even suggest that a hot sector has seen the peak and I will no doubt be greeted by a chorus of cat calls and boos from the rafters, but is it possible that the Energy Cycle is rolling over? The market was down big on Friday, but the Energy stocks really got hit hard, spooked by an earnings report by Schlumberger. The market bounced back on Monday but Energy did not share in that rebound.

So what spooked the market so badly? Here are some excerpts from the call courtesy of Seeking Alpha:

First up were management comments on the North American market:

"North America pre-tax margin declined 427 basis points sequentially, to 26.9%, due to weather-related disruption in the Gulf of Mexico, the continued erosion of pressure pumping stimulation pricing on land in the US, and a reduction of exploration activity in the Alaska, partly compensated by re-bound in Canada after the second quarter Spring break-up. In North America, activity increased in Canada, but this was off-set by weaker pricing for pressure pumping on land in the US, and by a sharp revenue drop in the Gulf of Mexico, due to the departure of several rigs to overseas locations, and a loss of approximately 15 operating days, due to weather."

This wouldn't have caused a 10% decline in the stock. The market knew that pressure pumping pricing was weak and the down time from the Gulf was also common knowledge.

And then the first bombshell hits:

"In the immediate future, while there will be some recovery from the low activity levels in the Gulf of Mexico, natural gas activity in both Canada and the US is likely to stabilize, as production remains relatively strong and gas storage approaches winter at comfortable levels."

"As a result, pressure pumping pricing deterioration will continue. This situation, however, does not change our view that North American natural gas supply will require sustained activity to combat production decline, and advanced technology, to increase production rates from poorer-quality reservoirs."

I will post again tomorrow on the rest of the Schlumberger call. It will be interesting to see if the Energy Sector will catch a bid from the Apple earnings blowout from last night.

A Typical Energy Cycle

The Energy Sector is inherently cyclical and a typical cycle moves in this fashion (beginning at the top):

1. Companies are flush with cash due to great pricing, and/or high commodity prices. Earnings and price momentum is also superb, and everyone is happy. Most companies can't decide what to do with the excess cash - dividends, stock buybacks?

2. Customers begin letting rig contracts roll over as high day rates and service costs cause exploration to be less economical. Smart money starts to exit positions, while the economy weakens a little bit and demand for the commodity drops due to high prices.

3. Rig utilization and day rate declines start to show up in official reports as capital budgets of customers are cut back due to a further drop in commodity price, possibly due to an unexpected dip in demand. Smaller Exploration and Production companies cut back almost immediately as cash flow decreases. The larger independents swear that they will "drill through the downturn." Integrated oil companies adopt a wait and see attitude due to more diversified cash flows, secure balance sheets, and a more disciplined capital program. Stock prices begin to flatten and even decline in some cases.

4. Sell side begins marketing push to prop up stock prices in the sector during conference season, claiming that "valuations are compelling."

5. Stock prices weaken materially as the sell side begins to cut earnings estimates and commodity price assumptions.

6. Extra supply of oil or natural gas hits the market due to the high level of drilling activity in the preceding 12-24 months. Commodity price weakens further, leading to another round of estimate cuts. Stock prices “fall off the cliff.”

7. Sell side throws the towel in on the sector.

8. Utilization and day rates plunge as contracts rollover and are renewed at lower rates or not at all. Industry starts “cold stacking” rigs. Majors begin cutting capex budgets.

9. Commodity prices bottom and industry bumps along the bottom for six to twelve months as malaise sets in over industry. Drilling falls to an all time low. Late cycle companies (international and construction) see earnings peak.

10. Commodity prices begin to strengthen as demand recovers and little supply is added due to a lack of drilling.

11. Rigs begin to be put back to work again as cash flow improves. Day rates and utilization inches up.

12. Debate erupts as sell side breaks into two opposing camps: (1) Time to invest or (2) Is it too early?

13. Cycle is in full upswing as more rigs are put back to work which leads to increasing day rates for drillers and pricing power by service companies. Commodity prices strengthen further.

14. Majors begin to announce increases in capex budgets.

15. Companies start to beat earnings estimates, and momentum money gets into the stocks.

16. “Boom” mentality takes over in the industry. First articles are circulated claiming “we are running out of oil and/or natural gas.” Alternative energy companies begin to get a lot of press and attention.

17. Federal government announces “Energy Policy.”

18. Go to number 1.

So the two questions I have are - Where are we now in the cycle? And is it different this time?

Contrarian Thought of the Day - October 20, 2007

I have been in a particularly contrarian mood lately so I am going to publicly disagree with whatever conventional wisdom I happen to read about. I hate hearing and reading the same point of view all day with everyone saying the same thing over and over. Don't take this personally if you are on the other side of these issues.


The Structured Investment Vehicle (SIV) Bailout Plan

This is a good thing. Psychology and confidence is everything in the financial world. Do you have any idea how much actual cash a bank keeps on hand to back your checking account? How about nothing up to a maximum of 10%. No public money is being used in this bailout so what's it to you. "We bought the sandwiches, and that's it," a Treasury official was quoted in the Wall Street Journal. The real question is will it work? Or is this the 21st century equivalent of Richard Whitney's walking onto the floor of the New York Stock Exchange in October 1929 and announcing that he was buying stocks.

Don't Get All Giddy Now

Please don't get overexcited about Google. Remember the market isn't always right. It once told you that Nortel was worth a couple hundred billion also.



And then look what happened:



(Charts courtesy of Big Charts.com)

Crash of 1987

The popular media is full of reminiscing about the crash of 1987, replete with touching stories about what people were doing at that particular time. This is our generations version of where were you when Kennedy was shot. So here is my story.

I was working for Olde Discount at the time. Olde was the 1980's version of the pre Internet, low cost discount broker where they charged $40 a trade, a level that would be laughable now of course. They had just opened a new office on Long Island, and I was the only broker in the office, fresh from Series 7 school. It was a frightful day watching just about every stock ticker go down, while contemplating that maybe I had chosen the wrong career.

The second part of the reminiscing stories ask whatever pundit happens to be on TV the question - Could it happen again? The usual answer is no, because of "liquidity," and the regulation/circuit breakers that have been put in place since then. I will take the contrarian opinion, because, after all that is the point of this blog.

Yes, it could happen again. Liquidity is a specious argument. Liquidity can evaporate in an instance, as we saw over the Summer. Liquidity is there until its gone. There is nothing magical about it. It's like saying that humans can breathe because the earth has an atmosphere that contains a Nitrogen/Oxygen mix. Well, duh.

The second argument is also flimsy, as circuit breakers, while closing the market for various amounts of time, can actually accentuate the panic as sell orders queue up with nowhere to go. Also, more volume trades off the exchange now than in 1987 so the "market" will really not close at all.

I would say that it is not very likely that it will happen again.

Enough is Enough

I've had it with all this talk about emerging markets and how great they are and how nothing can go wrong. Everyday these markets make new highs. Everyday some other talking head is on TV regurgitating some Groupthink on the Emerging markets.

I lived through a previous era where pundits said the same thing about a different market. When I first started working on Wall Street, the Japanese and its markets were like gods. Nothing could go wrong. They were like Supermen destined to take over the world economy. They made marquis purchases of our domestic assets - Rockefeller Center and Pebble Beach, etc. The Japanese Stock Market hit a new high everyday.

I was working in Fixed Income at the time at Chemical Bank in New York City, selling short term money market products. All you needed was a Letter of Credit from a Japanese Bank and it was like gold to a customer. We had another unit at the bank that sold only two funds to retail customers - the GT Global Asia Pacific and the GT Global Japan Fund. Want to guess how those funds did once the boom ended in the late 80's?

Oh I know, it's different this time. I forgot.

Hunting Bargains

Some of the best bargains during the trough of the real estate cycle may come in the condo market in Miami, where the word overbuilding acquired a new meaning. It's too early so don't get lured in by these auctions yet, but here's a web site to keep track of the foreclosure sales going on in that city:


Miami Dade County Clerk

Are We There Yet for Homebuilders? - Part VI

Since I mentioned the California unemployment rate as it relates to Housing in my last post, I figured I would post it here. The chart is from Economagic, a great resource for economic data.




As you can see the unemployment rate has started to tick up, but it is nothing compared to the last downturn.

Are We There Yet for Homebuilders? - Part V

One fact that argues for investing now in Homebuilders is the strength of the general economy currently as compared to economic conditions back in 1989 to 1991. The chart below from Economagic shows the decline in non farm payrolls during the last great Housing crisis. The revision this morning to non farm payrolls for August from a previously reported loss of jobs to a gain, is more evidence of general economic strength. I seem to remember back in the early 1990's California had an unemployment rate around 9%.



Just think how bad things would be for Housing if another 2 million Americans lost their jobs.

Homeownership Rate

One of the symbols of the recent Housing Boom was the increase in the Homeownership rate to above trend levels. Some debated the cause of this increase. A recent study by Matthew Chambers, Carlos Garriga, and Don E. Schlagenhauf entitled "Accounting for Changes in the Homeownership Rate," published as a working paper in September 2007 by the Federal Reserve Bank of Atlanta, concluded that the main reason for this increase was the growth of exotic mortgage products, and not demographic reasons.

A copy of the study is here.

"We find that the long-run importance of the introduction of new mortgage products for the aggregate homeownership rate ranges from 56 percent to 70 percent. Demographic factors account for between 16 percent and 31 percent of the change."


What does all this mean? If this study holds up under peer review, it would argue for a more prolonged housing downturn for two reasons - this demand will not be coming back anytime soon, and houses purchased by this group will swell inventories.

Are We There Yet for Homebuilders? - Part IV

Another issue to grapple with when buying the Homebuilders is the number of new home sales relative to previous peaks. As you can see in the chart below, if you declare a bottom for housing at the current level, one of the assumptions that you are incorporating into your analysis is that you are comfortable with the fact that the number of new home sales will trough above the peak of the last cycle.

New Home Sales Monthly (January 1963 - August 2007)




This is an important decision because during the last three cycles, new home sales never went above a 900,000 annual rate. During this cycle, they went much higher and peaked at an annual rate of 1.389 million in July 2005. If this extra demand was real demand, due to higher population growth or a more affluent population buying second homes, then this is fine. If it is speculator demand, then we are in big trouble.

So it remains to be proven whether the trough of this cycle should be above or near the peak of the last three when referencing new home sales. Months supply of new homes solves this problem in some ways since it transforms the data into time. If that is the case then we may not be at the trough yet as months of inventory peaked at much higher levels at the troughs of previous down cycles. (9.4 in January 1991, and 11.6 in January 1980.)

Housing Conference

I just got an e-mail on an interesting conference coming up in December. I am hoping that it will be webcast. It is the 2007 National Housing Forum to be held at the National Press Club on December 3. Here is the agenda.

OTS National Housing Forum

Facebook equals Broadcast.com equals Geocities?

It was reported a few days ago that Microsoft is considering buying a minority stake in Facebook, the social networking site. The investment implies a value for Facebook of $10 billion. So what can $10 billion buy you these days?

Facebook, according to the Wall Street Journal, will have revenues of $150 million, and profit of $30 million in 2007. That gives us a multiple of 67 times sales and 333 times earnings. This assumes that the $30 million are actual “earnings” and not “adjusted” or “non-cash” earnings.

Growth you say. “Don’t forget about growth,” you scream at the top of your lungs. “I worship the god of growth.” Let’s do a discounted cash flow model and see what those earnings have to grow at, that when discounted to the present, justifies a valuation of $10 billion.

If we use the following assumptions

Growth Rates

Years 1-5 40%
Years 6-10 25%
Years 11-15 15%

Terminal Growth Rate of 2%
Discount rate of 7%

We get a present value of cash flows of $10.1 billion. Zuckerberg….take the money and run.

Lennar Stock Last Cycle

One problem with Wall Street is a lack of institutional memory. It seems that no one even remembers the last big downturn in housing that occurred in the late 1980's and early 1990's. I am posting a series of charts of different Homebuilders from that era. The first up is Lennar.

Two things are clear from this chart. First, this is not the first time that Homebuilders have gone down 75%, and second if you time this right on the upside, these stocks will be the buy of a lifetime.

It's hard to see in the chart but the stock looks like it bottomed out in October 1990 at around $0.55. This is down from the peak of about $2.05 in early 1987. Also, you will notice in the chart that there was a false rally after the crash of 1987. If you bought Lennar after the crash in October 1987 at $0.78 you saw your investment almost double in two years, before the stock fell to its true trough in October 1990. It would be interesting to see when the book value of Lennar stabilized in this downturn. Unfortunately, the SEC web site only goes back on line to 1994.

Are We There Yet for Homebuilders - Part III ?

New home sales were reported yesterday by the government. Aside from the obvious problems with this measure that I discussed here:

http://marketprognosticator.blogspot.com/2007/08/housing-depression-is-not-over-yet-part.html


It may be a useful exercise to see when this and other metrics bottomed relative to the stock prices of the Homebuilders during previous cycles. New home sales bottomed in January 1991, at a seasonally adjusted rate of 401,000. Months supply of new homes peaked at 9.4 months also in January 1991. This data was not reported until March 4, 1991, due to the lag time in collecting it. Also, at the time that the January 1991 data was released, an investor would not have known it was the bottom until several more months of data had been released. The chart below is a monthly chart of new home sales from 1963 to August 2007.



Lennar bottomed out in Oct 1990, and had risen significantly by March 1991. Other Homebuilder stocks have shown similar patterns of recovery.

The bottom line here is that if you wait until these metrics to bottom as your buy signal, you missed significant upside.

Are We There Yet for Homebuilders - Part II?

Are we there yet? Are we there yet? My kids yell this in the car all the time. So are we there yet for Homebuilders? Is it time to buy? First here is the damage to some of the Homebuilder stocks since the peak, which for most of the stocks occurred in July 2005.



I am going to spend a majority of my time figuring out when to buy Homebuilders, but for now here's a quick list of what you shouldn't do.

Don't listen to anyone on the sell side. Most of them told us for years that it would be different this time. Remember that tripe? Access to capital, immigration, consolidation in the industry, better balance sheets, yada, yada, yada.

Second, don't rush out and buy because you see a "cult" investor on CNBC talking the sector up, or a rumor hits the wire that another cult investor is buying. In July, rumors hit the tape that Buffett was buying shares of Hovanian. Let's hope he didn't because the stock was at $16 then and its now at $11. Do your own work. Don't blindly follow someone else. You'll feel a lot better afterwards. This does not mean you or I will ever be as smart or as rich as Buffett, but there's nothing worse than losing money because you listened to some talking head on CNBC instead of doing your own research.

I used to be an equity analyst at a bank and my boss wanted to buy shares of Arrow Electronics (this was late 1998). I took a look at the stock and felt like the trough had not yet been reached, and I told him that. He looked back at me with a sneer and said "What do you know that Bill Miller doesn't know."

So I said to myself, "Well why don't you go out and hire Bill fucking Miller as your analyst then." Instead I just looked at him dumbfounded and swore that I would never pick stocks the way he did.

Third, do not use price to book yet as a buy signal. Book value is in flux and will continue to go down quarter after quarter. The safest thing to do is take the latest quarters book value and write off 30% and then slap a .75 multiple on it and then buy them there.

Last, think about avoiding individual stocks and buying the ETF or index that tracks Homebuilders. It is likely that a few of these homebuilders may get into enough distress that the equity becomes worthless. There is a SPDR that tracks the industry under the symbol XHB. It's not a perfect substitute since it has Home Depot and Lowe's in it but it may be a safer option to play the industry.

What a Tool

I just listened to an interview with this tool who doesn't think there was a housing bubble. He uses the word correction. He also repeats the canard that home prices have never declined since World War II.

Mouthpiece for Housing Industry

Four Dumbest Things You Can Do on Wall Street

A hypothetical list of some of the dumbest things a newbie might do on Wall Street.

1. Go to the Berkshire Hathaway annual meeting next year in Omaha and during the question and answer period ask the following question in front of everyone to both Warren Buffett and Charlie Munger, “Can you please tell me what your EBITDA was last quarter and what is your earnings guidance for the upcoming year?”

2. Get an internship with Yahoo, and on your first day fly to Dallas and visit Mark Cuban and ask for the $ 4.5 billion back that Yahoo paid for Broadcast.com in 1999.

3. Cold call Stephen A. Schwarzman, the billionaire and CEO of Blackstone Group, and offer to consolidate all of his credit card debt into a Capital One credit card with a 0% APR for the first year.

4. Become a sell side analyst covering homebuilders, attend the annual meeting of the National Association of Homebuilders, give the keynote speech and start off by saying you anticipate a brief down cycle because “it’s different this time.”

Scary Chart of the Day

From a presentation at a conference yesterday in New York City.

Lennar Earnings Call - No Bottom Yet

I just got off the Lennar call and wanted to share these highlights regarding the housing markets. Management has not yet seen the bottom in the markets they build in.

During the call, Lennar said that they would need to see three things before there is a recovery or stabilization in the market:

1) Inventories of both new and existing homes will have to stabilize first and be absorbed.

2) Mortgage markets will need to settle.

3) Consumer confidence is going to have to be restored.

Lennar said that there was no sign during the quarter that any of these occurred, and that in fact they had deteriorated further during the quarter.

General Market Conditions

“These continue to be very difficult times for the homebuilding industry”

“Current market conditions are primarily defined by the overhang of inventory in those markets which is comprised of completed homes on the ground, spec homes that are back on the market and owned homes that are up for sale. The overriding sentiment in our reviews is that the market has continued to become more and more competitive as inventories are managed and there continues to be a great deal of downward pricing pressure through the use of incentives, price reductions and incentivized brokerage fees."

On Signs of the Bottom

“Overall the supply of homes to sell continues to climb in many of our markets and we are not able to get a good reading how quickly this inventory will be absorbed or whether it will continue to increase as foreclosures increase and add to inventory.”

Mortgage Markets

“Adding to the sluggishness on the demand side is the continuing deterioration of the mortgage market as an additional component of demand has been sidelined.”

“We have not yet seen stability in the mortgage market either.”

On the Arrival of Helicopter Ben

“While the recent cut in interest rates by the federal reserve will began a process of rebuilding confidence it will most certainly not be a panacea for conditions as they exist.”

Wilbur Ross Speaks and You Damn Well Better Listen

I just listened to a great interview with Wilbur Ross on Bloomberg which was brought to my attention by the people at Vinvesting


Wilbur Ross Bloomberg Interview

The interview is 25 minutes long and goes into good detail on the issues of the day, including the sub prime lending fall out, brokerage earnings, the growth of the hedge fund industry and the inherent weakness of quantitative "black box" investing.

Why I Hate EBITDA - Part III

The street has slowly shifted over time to using Enterprise Value to EBITDA (EV/EBITDA) as a measure of valuation for a stock. The ostensible reason given is that EV/EBITDA takes into account the entire value of the firm. The real reason is that since so many companies are unprofitable, there is no "E" to put in the price to earnings formula. Wall Street had to come up with another measure to use.

So what is wrong with EV/EBITDA? It gives a false sense of cheapness – I can still hear the voice of the sell side analyst ringing in my ear

"The stock only trades at 5 times EV to EBITDA – my god that’s cheap."

But is it really cheap. Here are two companies, which one do you think is cheaper?

Company 1

Mkt Cap $ 60.0
Bond Value $ 40.0
EV $100.0
EBITDA $ 13.0

EV/EBITDA 7.7

Company 2

Mkt Cap $ 60.0
Bond Value $ -
EV $ 60.0
EBITDA $ 6.0

EV/EBITDA - 10.0

Well come on Eric, you say to me, the first one is cheaper you idiot. Well look again below.

Company 1

EBITDA $ 13.0
Interest $ 8.0
Free Cash $ 5.0

Price to FC 12.0

Company 2

EBITDA $ 6.0
Interest $ -
Free Cash $ 6.0

Price to FC 10.0

It doesn’t really matter what the EBITDA is because we all know that what really matters is the cash a business produces after it reinvests to maintain its business.

Don't be fooled by EBITDA. Wall Street hates you. Don't ever forget that their job is to separate you from your money.

Why I Hate EBITDA - Part II

The second reason I hate EBITDA is a behavioral one. It gives management a crutch to lean on, and causes them to focus on the wrong measures.

“Well, we grew EBITDA last quarter.”

As a shareholder and long-term investor, I want to know what true cash flow you are retaining this year after investing in your business. That’s what counts.

Many companies also create incentive programs for management based on EBITDA - again incentivizing management to engage in deviant behavior.

Why I Hate EBITDA - Part I

I said in a previous post that I was convinced that there is a special place reserved in hell for EBITDA, and that one day, God willing, it will be there. I just wanted to write a little on why I believe that.

First, for those that don’t know the term – EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is used as a measure of financial performance by much of Wall Street. So why does it belong in Hell? It has many problems that are never talked about by the financial media or those who use the term.

EBITDA is calculated before interest is paid, so it gives an artificial view of the financial strength of a company. Analysts and managements love using this number, they usually put it in the headline of a press release. After that they can't leave it alone - it has to be "adjusted." How? Usually to exclude some expense that management found inconvenient.

However, at the end of the day, bondholders do need to clip their coupon every six months and get paid. Unless, of course, they were talked into buying a covenant lite or pay in kind bond.

You can bet that Worldcom and Enron had positive EBITDA...right up until the end.

The Final Straw

Is it possible that the previously untouchable Manhattan Real Estate market is about to be breached? Hovanian cut its prices on condos in West New York by 20%. Now those of you who don't know New York well may think that West New York is way out in the boonies near the Erie Canal and Niagara Falls, but it is not.

It is right across the Hudson River from the Big Apple, and if you look out the window of the condo you bought that just went down in price by twenty percent, you can see the glittering skyline of the unbreachable New York City market where you better damn well pay what they are asking and be glad to pay it.

New York City is the castle "keep" of Real Estate in the United States, so to speak, and this may be the residual effect of the Hedge Fund melt down the last two months as those bonuses become a trickle.

Struggling Hovnanian Offers Deep Discounts in Weekend Sales Blitz


NEWARK, N.J. (AP) -- Hovnanian Enterprises Inc., struggling like other home builders, is offering six-figure discounts on some of its properties this weekend as it attempts to draw interest in a slumping market. The sales blitz involves dropping prices by more 20 percent on some of its prime real estate. The largest discounts are on the most expensive homes, including a 3-bedroom condominium by the Hudson River in West New York, which has been reduced $240,000, or 22 percent, to $862,000 this weekend.


Full Story

Pink Sheets - Part V

I just realized that I need to come up with a more original title than the ones I have been using in this blog. Whenever I write on the same topic, I usually just put Part II or Part III. If anyone has any suggestions let me know.

Anyway, Part V of my slog through the Pink Sheets – or maybe if I could sub title it “liquidity isn’t everything,” has produced a company called Laaco, Ltd. The symbol is LAACZ. It last traded at $1525 a share, and the current market is $1550-$1610. The company is legally a partnership and has a yield around 3%.

Laaco owns several dozen self-storage facilities out West, but its most interesting assets are the Los Angeles Athletic Club and The California Yacht Club.

This is very much a family run operation. I counted six different people with the name Hathaway in the annual report, and a family controlled entity called Stabilty, LLC owns 70% of Laaco. Clearly the family knows what they are doing and have produced shareholder value. It's hard to see it in the chart below, but the stock has tripled the last 5 years.



The lastest annual report is here and is a fairly easy read. Click on where it says filings.

Pink Sheet Page

Pink Sheets - Part IV

Once again I have been scratching around the OTC bulletin board and Pink Sheet markets and found some outstanding and financially transparent stocks that deserve a deeper look.

The Burke-Parsons-Bowlby Corporation is a producer of wood products for various industries, including railroads and other industrial segments. It is headquartered in West Virginia and trades under the symbol BPAB in the pink sheets. The Yahoo page is here:

Yahoo Finance

but don’t expect much info there, go to the company web site at:


Burke-Parsons-Bowlby

I contacted the company by e-mail and they never responded so I assumed that another non-reporting pink sheet company was blowing me off, but two weeks later, to my surprise, the latest annual report showed up in my mailbox.

BPAB earned $2.93 in the year ending 3/31/06, and $3.34 in the nine months ending 12/31/2006. It looks like it has grown revenues for five straight years. One third of its sales are to four customers in the Railroad business. The chart below shows what a great investment it has been the last 5 years.

What is Value Investing? - Part III

I think it is generally known how the word Value Investing can be interpreted many different ways by investors. I have decided to compile a list of things that I don’t consider indicative of value investing.


“The stock trades at a historical EV/EBITDA value of 8.1 and now trades at a EV/EBITDA of 7.5. Therefore, it is now undervalued.”

True value investors hate the word EBITDA. It makes their skin crawl. Many investors use the term interchangeably with cash flow, or God forbid, free cash flow. It is a word made up by Wall Street to justify deals and confuse investors. I am convinced that there is a special place in hell reserved for EBITDA, and one day it will be there.

“The stock trades at a PE of 6 while the market is at 15 times earnings.”

A low PE does not always mean that a stock is undervalued. If earnings are peaking, then a low PE actually gives a sell signal. This is why Home Builders had such a low PE for a while. As earnings come down faster than the price, then the PE will soar giving a perverse type of buy signal.

"The PE is at 15 times earnings and it usually trades at a multiple in the 20's, just look at the PE chart."

Is it possible that the earnings that you are using in your denominator are no longer accurate because the company just missed its earnings for the quarter? The new earnings numbers haven't flowed into whatever data source you are using, or maybe the market is assuming that it will be a lot worse than you do? Either way, that PE is realistic.

What is Value Investing? – Part II

I think that it is safe to say that when William Ackman, the renowned Hedge Fund Manager that runs Pershing Square Capital, says that Target is “undervalued,” and when Warren Buffett, the equally renowned value investor says that Burlington Northern is “undervalued,” they mean two very different things. And yet both are very successful at what they do and very rich. So who is right?

Ackman is not your typical stereotyped “value investor,” and Target is not your typical stereotyped value stock. Target’s enterprise value is 9.5 times its trailing 12 month EBITDA. Its forward price to earnings is 15.5 times, while it trades at 3.5 times tangible book value. It is not cash rich, holding $550 million in cash, or about $ 0.55 per share according to Yahoo Finance. The performance has been great as well. Target is up 12.3% year to date and has beaten the S & P 500 by 700 basis points.

So what’s going on here? Why is the stock “undervalued?” according to Ackman. Well, in a sense there is the effect of what is known as “cult investing.” When a well-known and successful investor announces that he is buying a stock, the herd moves onto it en masse pushing up the price. Ackman enjoyed that effect as rumors hit the market a week before his filing was done on 7/16/2007.

Buffet and other traditional value investors look for a “great business selling at a great price” in his words. He doesn’t seek to change anything at the company he buys. In fact he wants nothing to change, that’s the entire point. Management usually stays in place.

Ackman wants the company to change, to restructure in some way. Not because it will help the company long term, but because the market will pay more for your company if it looks the way I tell you it should look. For Target, that means sell or spin off your credit card division and try to unlock the value of your real estate somehow. For other companies that are being targeted it might mean something else - sell the entire company, split in two, issue debt and use the money to buy back stock. He doesn’t really care if 2 or 3 years down the road Target is a weaker or stronger company because he probably won’t be a shareholder by then.

I hesitate to say that Ackman is price indifferent to what he pays, because everyone cares about what they pay for something but in a sense he is price indifferent. He creates value at the companies he owns not by making its business stronger or better, but by shuffling parts of the puzzle around. Call it financial engineering if you like. If earnings grow faster than they did before he got there, its not because he helped them become better at retailing, its probably because its share count will decline due to some huge buyback that the company announces. When Ackman sits down with Target management is he going to say that they should work on their merchandising or that they should cut back on the number of SKU’s at their stores?

The Ackman strategy then is this simply put –

1. Find a large cap stock where the market is valuing the stock exactly at what it should be valued at based on the company’s profile.

2. Quietly accumulate a large stake in the company over a period of several months.

3. Leak word on the street that you are building a stake in the company and receive the cult effect.

4. Make your public filing of ownership and send letter to management.

5. Meet with and pressure management to do what you tell them to do to get the stock price up.

6. Wait for management to cave in and see the stock rise even more.

7. Sell quietly in a few months after the general public piles into the stock.

8. Give part of profit to charity but only in years when Hedge Fund manager wealth is getting really bad press.

Now I am not criticizing Ackman for what he does. Everyone has to create value for their investors and if it can be done this way then so be it. I was only trying to demonstrate how two investors who are very different can utter the same word and do it with a straight face.

Jackass of the Day - August 31, 2007

"The program could play a very important role in saving from foreclosure American homeowners who have been taken advantage of by unscrupulous subprime lenders and brokers,"

Senate Banking Committee Chairman Christopher Dodd, D-Conn

And how will you tell them apart? Can you distinguish between greed and stupidity?

Quote of the Day - August 31, 2007

"It's not the government's job to bail out speculators or those who made the decision to buy a home they knew they could never afford,"

-President George W. Bush.

The Market is "An Ass"

"If the law supposes that,' said Mr. Bumble, squeezing his hat emphatically in both hands, "the law is a ass--a idiot."

Charles Dickens, Oliver Twist

8/29/2007 4:34 PM EDT

Stocks in the U.S. were solidly higher Wednesday following a two-session selloff, as traders bid up equities amid hopes for a rate reduction.

The Dow Jones Industrial Average jumped 247.44 points, or 1.9%, to 13,289.29. The S&P 500 added 31.40 points, or 2.19%, to 1463.76, and the Nasdaq was better by 62.52 points, or 2.5%, at 2563.16

8/28/2007 4:30 PM EDT

Stocks in the U.S. fell hard Tuesday after the minutes from the last Federal Reserve meeting failed to give investors any firm indication that the central bank is considering lowering interest rates.

The Dow Jones Industrial Average plunged 280.28 points, or 2.1%, to 13,041.85. The S&P 500 lost 34.43 points, or 2.35%, to 1432.36, and the Nasdaq Composite was weaker by 60.61 points, or 2.37%, at 2500.64.

Festival of Stocks - #51

Check out the latest Festival of Stocks hosted this week by Dividends Matter

Average Joe has some good contributions and I urge you to take a look at:

Festival of Stocks #51

The home page of the festival is here at Festival of Stocks. If you write a related blog, and feel like hosting, then contact George and sign up.

The Housing Depression is not over yet - Part VI

The headline used by the mass media, burdened with an insatiable need to oversimplify everything they touch:

New-home sales rise 2.8% to 870,000 pace in July

Reason number 6 you should ignore the headline - price does not reflect concessions.

The Commerce Department reported a slight increase in the median price to $239,500.

Builders don't like to lower prices, they usually throw in free upgrades or give away consumer items to buyers. At this point in the cycle, they may have no choice since they have bills to pay, but the Commerce Department has no way to measure the concession and admits it in its survey documentation


"The sales price used in the survey is the price agreed upon between purchaser and seller at the time the first sales contract is signed or deposit made. It includes the price of the improved lot. The sales price does not reflect any subsequent price changes resulting from change orders or from any other factors affecting the price of the house. Furthermore, the sales price does not include the cost of any extras or options paid for in cash by the purchaser or otherwise not included in the original sales price reported."

The Housing Depression is not over yet - Part V

The headline used by the mass media, burdened with an insatiable need to oversimplify everything they touch:

New-home sales rise 2.8% to 870,000 pace in July

Reason number 5 you should ignore the headline - a very tricky formula or how statistics can lie.

Months' Supply

The months' supply is the ratio of houses for sale to houses sold. This statistic provides an indication of the size of the for sale inventory in relation to the number of houses currently being sold. The months' supply indicates how long the current for sale inventory would last given the current sales rate if no additional new houses were built.

Investors love this formula, but it can shift suddenly if there is a sudden move in either part of the formula.

The numerator is houses for sale, while the denominator is houses sold. The government reported that in July 2007, the months' supply was at 7.5 months based on a seasonably adjusted annual rate. This translates to 533,000 homes for sale and 71,000 homes sold.

The severe contraction in residential mortgage credit has been underway all summer, but reached its peak in earnest in August. Now when August sales are reported next month, the numbers will show the effect of that contraction. look for the numerator to rise sharply as unsold homes pile up, and the denominator to fall as many sales fell through due to unavailability of credit.

A 10% move up in the numerator, and a 10% decline in the denominator would cause the months' supply to rise to 9.17. A 20% move would result in a months' supply number of 11.25. the 9.17 number would be the highest since 9.4 in January 1991, while 11.25 would be the highest since September 1981. The highest ever recorded was 11.6 in April 1980.

There may be some shenanigans going on with this data as homes for sale, seasonally adjusted, has been remarkably stable the last year.

The Housing Depression is not over yet - Part IV

The headline used by the mass media, burdened with an insatiable need to oversimplify everything they touch:

New-home sales rise 2.8% to 870,000 pace in July

Reason number 4 you should ignore the headline - Revisions.

Once again from the Commerce Department Web site:

Historical Revisions

Historical revisions are quite extensive, ranging from -10.8% to -0.2%, with an average of -4.9%. Geographically, the West is the most volatile with a range of -20.1% to -2.0%. Now in case you forgot, the West was the only region to show growth in the report today. Here is the table:



Here is a real life example of the effect of these revisions. The Commerce Department also estimated today in its release that July 2007 new home sales were 10.2% below the July 2006 estimate of 969,000. The media ignored this number, and instead focused on the month-to-month “increase” of 2.8%.

The problem is that when the July 2006 estimate was released on August 24, 2006, the number was initially reported as 1,072,000, not 969,000. That is the effect of the "final" revision. in that case, 100,000 homes. Our conclusion then is that the so-called 2.8% month-to-month increase is nonsense since the June 2007 data will be revised substantially over the coming months.

The Housing Depression is not over yet - Part III

The headline used by the mass media, burdened with an insatiable need to oversimplify everything they touch:

New-home sales rise 2.8% to 870,000 pace in July

Reason number 3 you should ignore the headline - Standard Deviation.

The range given for the data collected in the report is (+/-12.0%). In previous releases it has ranged as high as (+/-13.0%). The government itself admits that since the range encompasses zero then it is uncertain whether there was an increase or decrease during the month.

This raises the question that if the data is so unreliable and subject to revisions, why pay any attention to it except on an annual or even longer basis.

The Housing Depression is not over yet - Part II

The headline used by the mass media, burdened with an insatiable need to oversimplify everything they touch:

New-home sales rise 2.8% to 870,000 pace in July

Reason number 2 you should ignore the headline - An easy compare.

The report stated that by region, sales rose 22.4% in the West to 213,000, rose 0.6% in the South to 492,000, fell 24.3% in the Northeast to 53,000, and fell 0.9% in the Midwest to 112,000. The entire increase, therefore, came from the Western region.

If you look deeper into the data you will find that the June 2007 number for the West was 174,000 home sold on a seasonably adjusted annual rate. This was an extremely weak month and was down from 209,000 and 203,000 in May and June 2007, respectively.


So basically, the entire rise in sales was due to this weak compare since every other region was flat or fell.

The Housing Depression is not over yet - Part I

The headline used by the mass media, burdened with an insatiable need to oversimplify everything they touch:

New-home sales rise 2.8% to 870,000 pace in July

Why should an investor should ignore this data?

Reason number one - new home sales are overstated during a down cycle.

How do I know this?

I read it on the Commerce Department web site and reprinted it below:

Highlights

"The Census Bureau does not make adjustments to the new home sales figures to account for cancellations of sales contracts."

"The survey does not follow up in subsequent months to find out if it is still sold or if the sale was cancelled."

"Since we discontinue asking about the sale of the house after we collect a sale date, we never know if the sales contract is cancelled."

"If conditions are worsening in the marketplace and cancellations are high, sales would be temporarily overestimated."

Full Text

"The Census Bureau does not make adjustments to the new home sales figures to account for cancellations of sales contracts. The Survey of Construction (SOC) is the instrument used to collect all data on housing starts, completions, and sales. This survey usually begins by sampling a building permit authorization, which is then tracked to find out when the housing unit starts, completes, and sells. When the owner or builder of a housing unit authorized by a permit is interviewed, one of the questions asked is whether the house is being built for sale. If it is, we then ask if the house has been sold (contract signed or earnest money exchanged).

If the respondent reports that the unit has been sold, the survey does not follow up in subsequent months to find out if it is still sold or if the sale was cancelled.

The house is removed from the "for sale" inventory and counted as sold for that month. If the house it is not yet started or under construction, it will be followed up until completion and then it will be dropped from the survey. Since we discontinue asking about the sale of the house after we collect a sale date, we never know if the sales contract is cancelled or if the house is ever resold.

Therefore, the eventual purchase by a subsequent buyer is not counted in the survey; the same housing unit cannot be sold twice. As a result of our methodology, if conditions are worsening in the marketplace and cancellations are high, sales would be temporarily overestimated.

When conditions improve and these cancelled sales materialize as actual sales, our sales would then be underestimated since we did not allow the cases with canceled sales to re-enter the survey. In the long run, cancellations do not cause the survey to overestimate or underestimate sales."

Read the second reason you should ignore this data.

Read the third reason you should ignore this data.

Read the fourth reason you should ignore this data.

Read the fifth reason you should ignore this data.

Read the sixth reason you should ignore this data.