Review: ‘Why Are We So Clueless about the Stock Market?’

Are you clueless about the stock market? Or perhaps better, could you admit to being clueless? For myself, as much as I purport to know about businesses, the stock market frequently baffles the mind. Reflecting the investing world’s immediate hopes, fears, beliefs, and dreams, the movement of prices seemingly offers a window into the shallower parts of our soul. Even for the seasoned observer, the market’s waves of euphoria and despair cast him reeling for clues–a narrative, a story–that can explain and predict its moves.

In the midst of the storm, Mariusz Skonieczny of Classic Value Investors offers the interested observer a map—Why Are We So Clueless about the Stock Market? (Investment Publishing, 2009)

Written with the beginning investor in mind, Skonieczny provides a compact, readable introduction that teaches how to analyze financial statements, value businesses, discern competitive advantages, and scout for bargains in the stock market. Skonieczny also puts his tools to the test by surveying four excellent businesses with durable competitive advantages—Burlington Northern Santa Fe, Thor Industries, Wells Fargo, and Moody’s. These case studies alone are worth the price of admission.

Throughout, I appreciated Skonieczny’s persistent attentiveness to economic moats and competitive advantages. Following Pat Dorsey’s The Little Book That Builds Wealth (Wiley, 2008), economic moats derive primarily from four sources—a) intangible assets, like brands, patents, and regulatory licenses, b) high switching costs, like that enjoyed by Alcon’s ophthalmological surgery equipment, c) network effects, enjoyed by services like Match.com, and d) cost advantages. While these four competitive advantages are rarely quantified on balance sheets, they provide a consistent tailwind for future business returns, particularly when measured over years and decades.

Of course, those same advantages—once fully utilized and recognized by the market—may encourage industry leaders into sloth. And sometimes the sleepy stumble and fall.

If I had one quibble with Skonieczny, it would be with his rather sanguine analysis of Moody’s. As we’ve worried about here and here, despite Moody’s regulatory imprimatur, network effects, and switching costs, their future looks much less certain than anytime since the 1930s. Whether too sleepy or greedy, Moody’s foray over the last decade into all manner of Wall Street’s structured financial products has tarnished its reputation, and perhaps more importantly, its cash flows. As late as 2007, structured finance ratings provided near half of Moody’s Investor Service’s revenues. And until the structured finance markets return (and assuming that they will), Moody’s will not be able to grow their earnings at the 10-20% that they—in the past—easily have.

All told, I enjoyed Why Are We So Clueless about the Stock Market? and would readily introduce it to family and friends interested in thinking about stocks as shares of a business.

Disclosure: None

Three Cheers for Tucows?

In the past, we’ve profiled a handful of microcap companies (FNET, KSW, LIMC, RMCF), either with discernible competitive advantages, particularly rational management, or an imminent catalyst for unlocking shareholder value.

We continue in that vein today by profiling Tucows, Inc. (TCX), an ICANN-accredited internet domain registrar based in Toronto that manages email services and over nine million web domains. Through its subsidiary Butterscotch.com, it also owns one of the oldest and most popular software download sites on the Internet. At present, its principal shareholders include: Lacuna, LLC, which controls 17.7% of outstanding shares (as of 3/23/09), Diker GP LLC (13.7%), and Fertilemind Capital Fund I, LP (5.7%).

About two-thirds of Tucows’ revenue derives from its wholesale domain registration services, being the third largest ICANN-accredited registrar in the world and the largest publicly traded. And like other domain registry servicers (e.g., Network Solutions, GoDaddy), its business model is characterized by non-refundable, up-front payments, which generate predictable, positive operating cash flows. More specifically, Tucows receives payment for the annual registration fee prior to providing the full cost of the service, yet it is required to book those payments and costs incrementally. Looking at its balance sheet, one sees what—at first glance—may appear to be a highly-levered, capital-intensive business with nearly $97 million in assets and $75 million in liabilities. Yet, the bulk of these assets and liabilities pertain to prepaid fees and deferred revenues for their domain registry business. In truth then, Tucows is a cash-rich and largely unlevered business that fills its checking account faster than its earnings statement would indicate. In a way, its revenue resembles an insurance premium—non-refundable, and paid up-front—and enables Tucows to keep its cost of capital very low and perhaps even negative.

However, it is not only the balance sheet that masks Tucows’ virtues. In 2008, Tucows took initial steps to divest non-strategic assets and concentrate energies on its most profitable businesses. This process has complicated its cash flow statements and masked its significant free cash flow growth. For example, in 2006, depreciation and amortization charges of $3.9 million were less than capital expenditures ($4.6 million); in 2008, depreciation and amortization charges of $4.8 million far exceeded capex ($2.1 million). Because Tucows has significant amortization expenses—deriving from the intangible assets of previous acquisitions (i.e., customer relationships)—it has far more cash coming into the company today than its reported earnings reveal.

Lastly, Tucows has raised more cash in the last year by liquidating its $7.5 million equity stake in Afilias and a portion of its domain name portfolio. In their second quarter results (coming out in mid-August), Tucows will book a $2 million pre-tax gain on a portion of its Afilias stake; an additional $2 million pre-tax gain will also follow later this year.

Perhaps most interesting though is where all that cash is likely to go. In the last year, Tucows has used some cash to pay down its long term debt, repurchased 4.2 million shares (about 6% of those outstanding) in a “Dutch Auction” tender offer in March 2009, and repurchased an additional 1.1 million shares in a second “Dutch Auction” tender offer in July 2009. And to date, Tucows has ample room remaining in its $10 million stock repurchase program. Though the future capital allocation decisions are difficult to predict, the chains of habit are not easily tossed aside.

All told, Tucows strikes me as a relatively low margin business with low (and perhaps negative) capital costs that has deployed its retained earnings profitably for shareholders in recent years. Though GoDaddy is the dominant player in the sector, Tucows has added customers and concentrated its business lines. If Tucows continues to divest its non-strategic assets and contain its costs, I would not be surprised to see them earn more than $7 million this year ($4.5 million from operations and $2.5 from after-tax sale of investments). With a market cap of $29 million (as of 7/30/09), management and the Board should have an opportunity to buy back shares quite cheaply.

That is, unless enterprising investors find it first.

Disclosure: I, or persons whose accounts I manage, own shares of Tucows at the time of this writing.

Buffett’s Berkshire Letter for 1992

In 1992, the United States watched its most successful third party candidate since Teddy Roosevelt garner nearly 20 million votes, or 18.9% of those cast. Bloomington, MN became home to an American temple, with its gargantuan coffers poised to receive the tribute of her mallrats. Over in the stock market, the somnolent S&P 500 opened the year near 417, made a few attempts to rise, but ultimately closed the year near 435.

Over at Berkshire, book value per value increased 20.3%, to $7745. Since Warren and Charlie took up textiles, book value has grown from $19 to $7,745, or at a rate of 23.6% compounded annually. Look through earnings came in at $604 million. Despite all of Warren’s warnings, Berkshire’s performance has consistently been able to outpace his stated goal—to grow intrinsic value at 15% per annum.*

On Acquisitions

In this year’s letter, Buffett bears all, as he discloses his most exhiliarating activity at Berkshire—“the acquisition of a business with excellent economic characteristics and a management that we like, trust and admire.” And Buffett knows he is not alone, for “in the past, [he’s] observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations. Initially, disappointing results only deepen their desire to round up new toads.”

What sets Buffett apart from other spirited suitors is his patience. And 1992 saw his patience rewarded, purchasing 82% of Central States Indemnity, “an insurer that makes monthly payments for credit-card holders who are unable themselves to pay because they have become disabled or unemployed.” A family owned business, Central States is based in Omaha and has annual premiums are about $90 million and profits about $10 million.

On Insurance

By 1992, the Berkshire shareholder is surely accustomed to hearing the Chairman warn that future returns will lag those of the past, primarily because its swelling capital base demands larger businesses to produce significant investment returns. In order to grow “look-through” earnings by 15%, or $100 million, Berkshire would likely have to lay out at least a billion. Yet, the amount of excellent businesses that could absorb such an investment is relatively small.

One viable candidate though is super-catastrophe insurance. Looking ahead, Buffett can see that Berkshire’s future earnings growth will increasingly depend on its insurance businesses, and as usual, he wants its shareholders to calibrate appropriate expectations beforehand. In short, super-cat insurance—though likely profitable over the long term—may produce abysmal results for any single year. Pricing in particular is difficult to determine, for “catastrophe insurers can’t simply extrapolate past experience. If there is truly “global warming,” for example, the odds [for potential losses] would shift, since tiny changes in atmospheric conditions can produce momentous changes in weather patterns.” Even worse, occasionally, the unthinkable happens. “Who would have guessed, for example, that a major earthquake could occur in Charleston, S.C.? (It struck in 1886, registered an estimated 6.6 on the Richter scale, and caused 60 deaths.) And who could have imagined that our country’s most serious quake would occur at New Madrid, Missouri, which suffered an estimated 8.7 shocker in 1812.”

“Furthermore, in recent years there has been a mushrooming of population and insured values in U.S. coastal areas that are particularly vulnerable to hurricanes, the number one creator of super-cats. A hurricane that caused x dollars of damage 20 years ago could easily cost 10x now.”

Pricing for the unexpected and adjusting for lifestyle changes represent two prongs of Berkshire’s strategy. The last—conservative accounting. “Rather than recording our super-cat premiums on a pro-rata basis over the life of a given policy, we defer recognition of revenue until a loss occurs or until the policy expires… because the likelihood of super-cats causing us losses is particularly great toward the end of the year. It is then that weather tends to kick up: Of the ten largest insured losses in U.S. history, nine occurred in the last half of the year. In addition, policies that are not triggered by a first event are unlikely, by their very terms, to cause us losses until late in the year.”

“The bottom-line effect of our accounting procedure for super-cats is this: Large losses may be reported in any quarter of the year, but significant profits will only be reported in the fourth quarter.”

On Buying General Dynamics

Of course, all the work in writing reinsurance could be for naught if the capital it provides were not profitably deployed. In common stocks, Berkshire acquired a large new position in General Dynamics. Initially Buffett purchased the shares to take advantage of an arbitrage opportunity (General Dynamics was repurchasing 30% of its shares via a Dutch tender), but the more he uncovered about the business and the CEO Bill Anders, the more impressed he was: “Bill had a clearly articulated and rational strategy; he had been focused and imbued with a sense of urgency in carrying it out; and the results were truly remarkable.”

So Buffett dropped the thoughts of arbitrage and “decided that Berkshire should become a long-term investor with Bill. We were helped in gaining a large position by the fact that a tender greatly swells the volume of trading in a stock. In a one-month period, we were able to purchase 14% of the General Dynamics shares that remained outstanding after the tender was completed.” [NB--In less than two years, Mr. Market re-appraised Berkshire’s stake at more than four times its 1992 price.]

On Buying Growth or Value

As always, Buffett uses his annual letter as a lectern to dispense his investing lesson for the day. And 1992 saw him distill wisdom from contemporary financial jargon. To both his fellow investment professionals who pursue “value” stocks, and those seeking “growth,” Buffett notes that John Burr Williams, some 50 years ago, set forth the proper equation of value, as “the value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” Stated so, it is clear that investing—no matter one’s emphasis—will be most successful insofar as one can determine future cash flows and the remaining life of a given asset.

Growth “is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” And what is investing except the seeking of value sufficient to justify the price paid? “Value investing” then is redundant.

Yet, “whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.”

The investor then should not settle comfortably in this jargon, for growth projections can soar to the moon, and discounted assets can still be priced too dear. Focus on cash flows, while keeping in mind, that “the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.”

On Health Care Liabilities

Even among smart and hard-working stock analysts, one can find negligent disregard for off-balance sheet liabilities—pensions, health care benefits, SIVs, etc. One only needs to look to today’s Washington to see the difficulties of reserving money for tomorrow’s health care.

Thinking as an insurer, Buffett notes that “no CEO would have dreamed of going to his board with the proposition that his company become an insurer of uncapped post-retirement health benefits that other corporations chose to install. A CEO didn’t need to be a medical expert to know that lengthening life expectancies and soaring health costs would guarantee an insurer a financial battering from such a business.” Given the rate and cost of health care innovations, population demographics, and the United States’ love for perceptions of egalitarianism, it is indubitable that health care costs relative to GDP will be much higher than they are today. To insure against this eventuality would require more chutzpah than any insurer would care to muster.

Yet, “many a manager blithely committed his own company to a self-insurance plan embodying precisely the same promises – and thereby doomed his shareholders to suffer the inevitable consequences. In health-care, open-ended promises have created open-ended liabilities that in a few cases loom so large as to threaten the global competitiveness of major American industries.”

And Buffett is not afraid to place blame, for “the reason for this reckless behavior was that accounting rules did not, for so long, require the booking of post-retirement health costs as they were incurred. Instead, the rules allowed cash-basis accounting, which vastly understated the liabilities that were building up. In effect, the attitude of both managements and their accountants toward these liabilities was “out-of-sight, out-of-mind.”

“Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: “How many legs does a dog have if you call his tail a leg?” The answer: “Four, because calling a tail a leg does not make it a leg.” It behooves managers to remember that Abe’s right even if an auditor is willing to certify that the tail is a leg.”

Conclusion

All told, 1992 was a year with much to say. Beyond these lessons, Buffett highlights the advantages of purchasing securities in the secondary market (rather than initial offerings), the lack of correlation between high corporate overhead and business performance, and the true cost of stock options. And last but not least, learn from Mr. Buffett’s mistake; be not too incautious with your 89 year old employees. Some, like Mrs. B., just may rekindle the fire to compete. At 99, Buffett finally got her signature on a non-compete.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

* Of course, growth in book value and intrinsic value often diverge significantly, and in extreme cases, show no correlation. In assessing Buffett’s performance in 1992, we feel comfortable taking him at his word: that Berkshire’s book value is a useful, albeit conservative, proxy for valuing the business.

[In more recent years, this same assessment would look increasingly foolish, as one of the largest components of Berkshire’s intrinsic value today is the value of its insurance float, which has grown significantly, relative to Berkshire’s book value, since 1992. In 1992, Berkshire had 2.3 billion in float vs. about 7.5 billion in equity; in 2008, it was 58 billion in float vs. 109 billion.]

Let’s Get Ready to Rumble

It is our daily habit to take a stroll through the recently filed Schedule 13D’s and 13G’s.  On rare occasions we uncover a viable investment with an activist pushing to catalyze sedentary management.  On rarer occasions we find agitated investors angling for a fight.

In the recent 13D filing for Peerless Systems Corporation (PRLS), its Chairman Timothy Brog expresses some frustration with Highbury Financial’s (HBRF) current Board and management:

Gentleman,

Peerless Systems Corporation owns 1,197,673 shares of Highbury Financial Inc. (“Highbury” or “HBRF”) common stock (“Common Stock”) and 1,525,241 warrants (“Warrants”) exercisable into a like number of shares of Common Stock.  As the holder of these securities, Peerless is one of the largest shareholders of Common Stock and together with our warrant ownership (assuming the exercise thereof), we are the largest shareholder of Highbury.

As you are aware a meeting took place in Chicago on July 1st (the “Chicago Meeting”) between the largest four non-management shareholders of Highbury (in the aggregate such shareholders own approximately 60% of the outstanding Common Stock) on the one hand, and management and the Board, on the other hand…  We have been patient to date, but we are disappointed that after almost three weeks since the Chicago Meeting you have continued to ignore your shareholders.  With no response, our patience has run out and our resolve is strong to take ALL available actions that a shareholder in HBRF possesses.

The audacity and self-serving behavior of corporate board of directors has always amazed us.  Almost every time we interact with a new board we hope for the best and prepare for the worst.  One of our favorite parts of dealing with boards is hearing them state that they always act in the best interest of their shareholders, they do not need the money from board fees and they have no desire to serve on a board if they no longer have the support of shareholders.  However almost invariably, shortly after making such statements, they take all possible measures to entrench themselves, waste corporate assets to achieve such purpose and hang on to their positions as board members for dear life.  Their attitude is “Damn the Shareholders, Full Speed Ahead.”

You gentlemen, the Board of Directors of Highbury, did not disappoint us.

Since Messrs. Cameron, Ammidon, Leary and Riordan refused to attend the Chicago Meeting they may not be aware of what transpired.   Several shareholders traveled thousands of miles to attend the Chicago Meeting, but other than Richard Foote no other Director attended even a portion of the 3½ hour meeting.  Since Bruce Cameron and his pals Messrs. Ammidon, Riordan and Leary did not have the “testicular fortitude” to participate in the Chicago Meeting in person, nor attempt to attend all or even a portion of it telephonically, nor even bother to explain their absence to shareholders, let us make it clear to each of you what you missed.  We stated in the conclusion of the meeting that management of Highbury should immediately resign and the Board should be reconstituted to include a representative of each of the five largest shareholders.  The other three large shareholders at the meeting, who, again, together with Peerless own in the aggregate approximately 60% of Highbury’s outstanding common stock (for those directors who want to disregard this fact, that is more than a MAJORITY), each individually reached the same conclusion and stated so…

I can assure you, it is not standard fare to find corporate executives musing publicly about the virtues (or vices) of another’s anatomy.  Thankfully, no women serve on Highbury’s board.  Of course, that could have made for an interesting retort.

Disclosure: None

Invest Like a Dealmaker

What’s the old bromide—never judge a book by its title? In the case of Christopher Mayer’s Invest Like a Dealmaker: Secrets from a Former Banking Insider (Wiley, 2008), my mind conjured up understuffed chairs in a sleepy room filled with Donald Trump, Wallace Wattles, and a confused Hank Paulson. Perhaps my imagination runs further than others.

In truth, Invest Like a Dealmaker is less about deals, secrets, and banking insiders, and instead a readable and useful introduction to valuing companies and uncovering undervalued securities. Author Christopher Mayer, who edits two newsletters Capital and Crisis and Mayer’s Special Situations for Agora Financial, surveys the analytic tools used by prominent investing gurus and peppers his text with interesting tales of underappreciated characters in the field.

Most simply, Mayer argues that investors should value a business by what a control investor (the mythical “dealmaker”) would pay for the whole thing. Relatively immune from the vagaries of technical charts, macroeconomic issues, earnings reports, earnings forecasts, and dividend rates, the mature investor concentrates on the “dealmaker’s ratio”—that is, enterprise value (EV) to earnings before interest, tax, depreciation and amortization (EBITDA). And for certain industries, asset values deserve attention and scrutiny. By scouring the newspaper and SEC filings, the investor can observe the business valuations that dealmakers use in acquiring their targets, and then can apply those valuations to other businesses trading publically.

Like Jay Gould, dealmakers never have the habit of selling what’s gone down and buying what’s gone up (3). Like Seth Klarman, dealmakers concentrate on tangible assets, which “usually have value in alternate uses, thereby providing a margin of safety.” (41) Like James Tisch, dealmakers invest where other fear to tread—in his case, in empty tankers trading for scrap value (49). Like the seventeenth century Josef Penso de la Vega, dealmakers opportunistically take advantage of panicky sellers (56). Following Marty Whitman, dealmakers realize that “the most inefficient tax way to create wealth is to have reportable operating earnings… the most efficient way… is to have unrealized appreciation of asset values.” (64).

With the principles in hand, where should the investor prospect for targets? For one, Mayer’s “all-time favorite hunting ground” is tracking the recent purchases of successful investors—Seth Klarman, Bill Miller, Marty Whitman, and the like. Second, net tangible asset screens have consistently produce valuable ideas. And third, taking his lead from Joel Greenblatt, Mayer closely tracks spin-offs and employs the “Magic Formula” screen (which ranks stocks with high returns on investing capital and low earnings yields).

All told, Mayer offers a useful and readable introductory text for the relatively green investor with some business sense. Unfortunately, there is little here that the more experienced investor or analyst will find original. Though it offers a few brief vignettes describing Mayer’s investing successes, the student of investing will desire more detail and deeper analysis. Here familiar investing principles and rules abound, yet many readers may wish that Mayer was more candid in showing how he used those principles to better his own work.

Disclosure: I requested and received a complimentary review copy of this book from the publisher.

Limco-Piedmont to Delist

Limco-Piedmont (LIMC), which we previously profiled on May 1st, has filed to delist.  The shareholder meeting was scheduled for 10 am today (July 2nd), and shareholders were to vote on a plan of merger with its majority owner TAT Technologies (which holds over 60% of outstanding shares).  TAT has offered 1/2 share of its stock for each share of LIMC.

On the day we profiled Limco, its stock closed at $2.54 per share.  Today, TAT trades between $7.6 and $8 per share.  During that span, the S&P 500 moved from 878 to 919 (yesterday’s close).

Disclosure: I, or persons whose accounts I manage, own shares of Limco-Piedmont at the time of this writing.

What was Sam Saying in 1977?

Over the last couple weeks, I’ve spent some time getting acquainted with the “young” Sam Walton. Walmart’s website reproduces annual reports going back to 1972, and some of the early ones include letters from the entrepreneurial Chairman. Let’s take 1977 as a case study.

In their fiscal year 1977, Wal-Mart increased its store count from 125 to 153 (or 22.4%), while at the same time growing sales from $340 million to $479 million (40.9%) and earnings from $11.5 million to $16.5 million (43.5%)—more stores, producing even more sales, and even better earnings.

If those look like outstanding numbers, you need not make an appointment with your optometrist. As Walton narrates, “your Company again achieved record highs…” [notice the possessive] Comparable same store sales increased 19%–“to my knowledge, no other general merchandise retailer in the United States came close to equaling this figure.” And expenses remain low, “… classified as one of the lowest in the industry.” Since 1974, the total expense structure fell from 21.1% of sales to 20.8%.

Yet, even with Wal-Mart’s rapid growth, dividends increased 25%, from .08 to .1 per share. And this should be the norm, for “our Board of Directors has a stated policy of continuing to increase dividends proportionate to our increase in earnings.”

Rest does not find the able though, for ambition demands activity. In the year ahead, Wal-Mart “will be striving to achieve our sales goal of $100 per square foot of gross store space. Last year, we hit a new high of $88 a square foot in sales, which was well above the industry average.” So continues the challenge of “developing Wal-Mart into one of the leading retailers in the United States.” I wonder whether Sears Roebuck got a copy of the letter?

Of course, the investor’s question remains. Would you want to be partners in the discount retail business with the ambitious Arkansan? The trends look promising—consistently selling more, and earning more, with relatively meager capital investments. If you’re game, what would you pay to partner with Walton? By January 1977, he’s using assets with a book value of $66.2 million and earning $16.5 million. For an average business, one might pay 10x earnings plus book value. But a discount retailer who just grew earnings 43.5%?

In early 1977, that partnership would have cost you less than $12 per share—a price that implied Walmart’s value to be $163 million. More recently, the market values the founder’s business near $188 billion.

Disclosure: No position

Finding the Next Sam Walton

We’ve banked a few posts for the upcoming week, so expect a more regular schedule again for a while.

For today, enjoy some of Charlie Munger, discussing “The Art of Stock Picking.”

There he provocatively highlights the stunning success of one Sam Walton:

“It’s quite interesting to think about Wal-Mart starting from a single store in Bentonville, Arkansas against Sears, Roebuck with its name, reputation and all of its billions. How does a guy in Bentonville, Arkansas with no money blow right by Sears, Roebuck? And he does it in his own lifetime ‑ in fact, during his own late lifetime because he was already pretty old by the time he started out with o­ne little store….

He played the chain store game harder and better than anyone else. Walton invented practically nothing. But he copied everything anybody else ever did that was smart ‑ and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.

He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great record so he could be in the finals and make a big TV hit. So what did he do? He went out and fought 42 palookas. Right? And the result was knockout, knockout, knockout 42 times.

Walton, being as shrewd as he was, basically broke other small town merchants in the early days. With his more efficient system, he might not have been able to tackle some titan head-on at the time. But with his better system, he could destroy those small town merchants. And he went around doing it time after time after time. Then, as he got bigger, he started destroying the big boys.

Well, that was a very, very shrewd strategy.”

Later Munger opines that “were [he] a young man,” he might concentrate his investing energies of finding great companies with stellar management when they are just starting out.  In that vein, we’ll be doing a little research on the young Sam Walton and his retailing tricks over the next few weeks.  If you have any resources you’d recommend, or would like to contribute, please pass them along.

Disclosure: I, or persons whose accounts I manage, own debt of Sears at the time of this writing.

An XTENT-ed Lesson in Shorting?

On May 15th, the Board of XTENT, Inc. (XTNT) announced that it had approved a plan of dissolution. Since liquidations often involve significant uncertainty—particularly concerning distribution timelines—I have found them a fruitful place to look for market inefficiencies. Prior to the announcement, the stock traded at about $1 per share, a price which valued the company at $23.3 million. After the announcement, the stock plummeted to .30 per share, or about $7 million.

Looking through XTENT’s financial statements, one could find relatively meager resources, no sources of revenues, lavish operating expenses, and a host of off-balance sheet liabilities. In fact, in the first three months of the year, the company burned $9.9 million of their $20 million in current assets on operating expenses (remember—no revenues). As of March 31, 2009, the company had $12 million in cash left to burn.

Upon hearing the announcement about dissolution, the prospective investor’s question was: how much will XTENT likely distribute? And when?

By management’s estimation, shareholders would likely receive 11 to 40 cents per share. Yet, if XTENT’s intellectual property could be sold, distributions could be higher.

However, my glance at XTENT’s assets and preliminary proxy suggested that management’s estimates may have been excessively optimistic. Their annual 10-K showed substantial off-balance sheet liabilities that looked well-defined, making management’s “high range” estimates an unlikely scenario. In the month of April, the company had burned $1 million in current assets, suggesting that any delay in the dissolution process would be expensive. Most simply, management’s “low range” estimate of 11 cents per share looked far more likely than their “high range” of 40 cents.

The remaining unknown was the potential sale of XTENT’s intellectual property. Honestly XTENT’s drug eluding stent systems are outside my circle of competence; I had no good sense of how much they were worth. What was clear was that XTENT had hired Piper Jaffray & Co. to help the company explore strategic alternatives in January 2009, and since that agreement, no desirable alternatives had arose. Perhaps the value of intellectual property could be realized, but I doubted that someone would recognize it after the plan for dissolution who happened to miss it before. In fact, most of XTENT’s major competitors in stent technology—Boston Scientific, Johnson & Johnson, Abbott Vascular and Medtronic—had viable stents of their own. I concluded that any value to the intellectual property was most likely nominal.

All told, I thought that XTENT, trading at 30 cents per share post announcement, was likely a much better short candidate than long. It seemed much more likely that XTENT would return less than 30 cents, and over a very long period—perhaps as long as three years. I didn’t short XTENT because it was hard to borrow with my favored broker, and the upside didn’t seem worth the risk.

Of course, some may know how this story ends. Yesterday (June 4th), XTENT announced that the U.S. Food and Drug Administration has granted conditional approval of the Company’s pivotal clinical program for its Custom NX Drug Eluting Stent System. And the stock has soared the last two days—all the way up to $2.69 per share. Though it remains to be seen whether this conditional approval will yield additional interest for XTENT’s intellectual property, XTENT shareholders have enjoyed a stunning 900% gain.

Lesson confirmed—deal with biotech shorts very gingerly, if at all. The FDA is always good for a long “Hail Mary.”

Disclosure: No position.

Buffett’s Berkshire Letter for 1991

1991 saw Scuds and Patriots battle over desert skies. Cracks became fissures, and the brittle Union of Soviet Socialist Republics finally dissolved. In the stock market, the S&P 500 launched from the gate—rising from 325 to 380 in the first quarter—only to chortle along for the remainder, and close with a two week sprint to 417. Including dividends, the 500 gained 30.5% for the year.

Over at Berkshire, net worth rose to $2.1 billion, or 39.6% YOY. In its most recent 27 years (i.e., since present management took over), per-share book value has grown from $19 to $6,437, or at a rate of 23.7% compounded annually. “Look-through earnings” declined from $602 million in 1990 to $516 million.

For Buffett, the goal of each investor should be to create a portfolio that will deliver the highest possible look-through earnings a decade from now. Successful investing requires the investor to think about long-term business prospects rather than short-term stock market prospects. It is crucial then that an investor competently distinguish companies with long-term “economic franchises” from mere businesses, those companies with wide moats from those with none.

An economic franchise “arises from a product or service that: 1) is needed or desired; 2) is thought by its customers to have no close substitute and; 3) is not subject to price regulation.” These conditions enable a company to “regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”

A mere “business” earns exceptional profits “only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”

In Berkshire’s stock portfolio in 1991, Coca Cola, Gillette, and Guinness PLC meet Buffett’s definition of an economic franchise. Only a few years prior, The Washington Post Company and Capital Cities/ABC would have also sat in this class. However, in recent years, “the economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate.” By 1991, newspaper, television, and magazine properties now resemble businesses more than franchises in their economic behavior. GEICO and Wells Fargo represent mere businesses, albeit ones which are some of lowest cost providers in their industry. Each has superior management—as Buffett often notes—but were mismanagement to arrive, costs could quickly escalate, and their moats erode.

Given Buffett’s lecture, one may be surprised to find that Berkshire acquired another “business” in 1991—H.H. Brown Company, a shoe manufacturer. Candor reigns, for “shoes are a tough business… and most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables. In this kind of environment, only outstanding managers like Frank Rooney and the group developed by Mr. Heffernan can prosper.”

What distinguishes H.H. Brown’s management? For one, their compensation system is one of the most unusual Buffett has encountered: “key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners.” Unlike most compensation schemes which are “long on carrots but short on sticks,” the system at Brown has served both the company and managers exceptionally well, for “managers eager to bet heavily on their abilities usually have plenty of ability to bet on.”

Ultimately, the best investments are those with favorable long-term economic characteristics, honest and able management, and a fair price. With H.H. Brown, Buffett shows that two out of three is sufficient to pass his tests.

In light of our contemporary economic environment—with new government equity stakes in highly competitive industries with questionable economics—Buffett offers a final and interesting coda. Recall that a few years back, Berkshire bought convertible preferred stock in a notoriously bad “business”—US Air. On Berkshire’s balance sheets, Buffett and Munger valued this stock at a significant discount to its par value, to reflect the risk that “the industry will remain unprofitable for virtually all participants in it, a risk that is far from negligible.”

1991 was a “decimating period” for airlines, as Midway, Pan Am and America West all entered bankruptcy. Continental and TWA followed some months later. And the risk to the entire industry was further heightened by the fact that “the courts have been encouraging bankrupt carriers to continue operating. These carriers can temporarily charge fares that are below the industry’s costs because the bankrupts don’t incur the capital costs faced by their solvent brethren and because they can fund their losses—and thereby stave off shutdown—by selling off assets. This burn-the-furniture-to-provide-firewood approach to fare-setting by bankrupt carriers contributes to the toppling of previously-marginal carriers, creating a domino effect that is perfectly designed to bring the industry to its knees.”

[If history serves as precedent, keep an eye out for GM and Chrysler promotions in the months and years ahead. And you really thought Ford could survive?]

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]