Monthly Archives: April 2009

Hopping Happenings at eBay

logoebay_x45Rumors and news about eBay are popping onto the business newswire these days. Whatever they’re sizzling in their pan, it smells and looks like a new recipe. For a corporation with two excellent, high margin, wide moat businesses—auctions and Paypal—shareholders would welcome and do deserve a “dish” with better capital allocation in the years ahead.

So what’s the news? For one, Skype’s founders want to buy their creation back, though eBay denies that they’re close to a deal. Also, today, StumbleUpon’s founders disclosed that they had brought their baby back home, which they had sold to eBay for $75 million two years ago. And lastly, eBay appears close to purchasing a 34% stake in Korean online auction operator Gmarket.

One discerns the trend in these moves—increased concentration on auctions, retailing, and payment processing, and a decreased interest in Web 2.0 and 3.0 technologies. Originally eBay had expected more synergies with Skype, using VOIP as a new delivery channel for its auction and retailing site. But at their recent analyst day, eBay’s management acknowledged that such plans were unsuccessful. Going forward, eBay said it was content to cultivate and grow Skype into a great standalone business; of course, it now appears that they could be tempted to part, for the right price.

All this movement should make investment bankers salivate. Though we don’t yet know the final sale price for StumbleUpon, it is unlikely that eBay commanded much more than its purchase price. For Skype, rumors place a likely sale price at $2 billion; this for the business that garnered $2.6 billion from eBay four years ago.

The waste of time, talent, and resources on these two acquisitions is paradigmatic of eBay’s capital allocation over recent years. Though some cash has gone to repurchasing shares, more went to overpriced acquisitions—acquisitions for which there was no natural home in their fragmented bureaucracy. In the months ahead, shareholders should hope that this new recipe bears little resemblance to the old.

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

Buffett’s Berkshire Letter for 1980

warrenbuffettcharlierose1980 saw an actor nominated for the Presidency of the United States. Children and adults, flocking to video arcade games, became seduced for the first time by Pac-Man. Art lost a lyricist outside The Dakota building in New York City. And the S&P 500 Index finally lurches free from its range-bound antics around 100, finishing the year over 135.

Over at Berkshire, “operating earnings improved to $41.9 million in 1980 from $36.0 million in 1979, but return on beginning equity capital (with securities valued at cost) fell to 17.8% from 18.6%.” Yet, Buffett quickly notes that accounting practices far understate Berkshire’s share of its common stocks’ earnings. For those businesses that Berkshire owns less than a 20% stake, only dividends show up on the earnings statement; since dividend payouts represent only a small fraction of their earnings power, much of Berkshire’s value as an owner doesn’t find its way onto its balance sheet. In fact, were Berkshire to sell all its equities and pour the proceeds into tax-free bonds, Berkshire’s reported earnings would nearly double, adding at least $30 million annually.

Nowhere is this discrepancy between reported earnings and “true” earnings more clear than GEICO. Berkshire’s stake cost them $47 million, but at GEICO’s current dividend rate, Berkshire only reported earnings from GEICO of a little over $3 million annually. But, given their ownership stake, Buffett estimates their share of GEICO’s earnings power to be “on the order of $20 million annually. Thus, undistributed earnings applicable to this holding alone may amount to 40% of total reported operating earnings of Berkshire.”

But shouldn’t Buffett want a greater share of GEICO’s earnings annually deposited into Berkshire’s coffers? Absolutely not. As Buffett observes, “we should emphasize that we feel as comfortable with GEICO management retaining an estimated $17 million of earnings applicable to our ownership as we would if that sum were in our own hands. In just the last two years GEICO, through repurchases of its own stock, has reduced the share equivalents it has outstanding from 34.2 million to 21.6 million, dramatically enhancing the interests of shareholders in a business that simply can’t be replicated. The owners could not have been better served.” Despite relatively difficult economic conditions, GEICO bought back more than a third of its shares. Compare that to others’ recent performance.

Much of Buffett’s remaining reflections cheerlead his various managers and eulogize his friend and banker Gene Abegg, past owner of Illinois National. At National Indemnity, business looks lighter with industry-wide premiums softer, but Buffett sounds content—“while volume was flat, underwriting margins relative to the industry were at an all-time high. We expect decreased volume from this operation in 1981. But its managers will hear no complaints from corporate headquarters, nor will employment or salaries suffer.”

Over in reinsurance, Buffett forecasts ominous clouds rising soon over the horizon. With “the magnetic lure of [reinsurance’s] cash-generating characteristics, currently enhanced by the presence of high interest rates… the reinsurance market [has transformed] into “amateur night”.”

All told, Buffett says little about competitive advantages at this, the dawn of the Eighties. Berkshire’s mills, a high capex and low margin business, has trimmed its workforce and idled some looms. Inflation, torturous demon of prudent capital allocation, slowly stripped Berkshire of some of its relative value as an investment vehicle. “In a world of 12% inflation a business earning 20% on equity (which very few manage consistently to do) and distributing it all to individuals in the 50% bracket is chewing up their real capital, not enhancing it.” For even the best businesses, with the best competitive advantages, consistently high inflation requires abundant managerial skill while at the same time crippling investors’ real returns.

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

Where have the Buybacks Gone?

A stock represents an ownership stake in a business. But why should that stake ever be worth anything? In the worst cases, imprudent management funnels future earnings back into unprofitable endeavors and overpriced acquisitions, and your stake could become worthless. In the best cases, prudent management deploys capital where it can provide productive returns—either by growing the business organically, making acquisitions, paying dividends, or repurchasing its outstanding stock.

In recessionary periods, attempts to grow a business organically often do not meet with immediate success. However, if a recession depresses the market value of your business, buying back temporarily cheap shares becomes an interesting—albeit fleeting—opportunity. The sharp market declines in the fourth quarter of 2008 created one such opportunity. Yet, as a S&P report recently revealed, members of its S&P 500 spent $48.1 billion in stock repurchases in the fourth quarter, a 66% decline from the $141.7 billion spent during the fourth quarter of 2007. This, despite the fact that cash levels stand at record highs.

So why the pause? Howard Silverblatt, Senior Index Analyst at Standard and Poor’s, attributes the cash conservation to uncertainty about future cash flows. And for a company like Alcoa, such uncertainty seems warranted, for the company recently came to the market with an equity offering at $5.25 per share. This, after spending 2007 buying back the same shares near $40.

These billion dollar mistakes should not be taken lightly. Of course, saying it sounds obvious, but little outrage seems present within Alcoa’s shareholder ranks. If such mistakes are repeated consistently enough, the shareholder will find herself left with a piece of paper destined for the toilet.

And so today’s recessionary times illustrate what may be the most important component of a business’ economic moat—rational capital management. When management directs capital to its most productive endeavors, one finds stagnant textile mills blossoming into global insurance empires. Yet, for most business managers, this discipline seems so rare that a Randian would be tempted to call it heroic; even wide moat businesses like Moody’s, with its long history of stock buybacks, seem to lose their best habits in uncertain times.

If only a select few can manage capital well in uncertain times, the investor must use these times to scout for demonstrations of rational management. As the S&P report shows, Exxon led the way in the fourth quarter, followed by Microsoft and Oracle; included also are such stalmarts as GIS, JNJ, PG, PM, and PEP.

To become a stock owner of a great business does not guarantee investing success; nor does buying a great business at a bargain price. No, investing success requires owning great businesses purchased at good prices whose capital consistently finds its highest and best use, especially in times of economic uncertainty.

Disclosure: No Position.

Buffett’s Berkshire Letter for 1979

800px-warren_buffett_ku_visit1979 saw the Shah of Iran depart his homeland for Egypt, enabling Ayatollah Khomeini to return to Tehran after fifteen years of exile. Chrysler went begging to the U.S. government for $1.5 billion in loan guarantees. The S&P 500, like 1977 and 1978, spent the majority of the year trading within 10 points of 100.

Over at Kiewit Plaza in Omaha, Chairman Buffett reported operating earnings on shareholder capital of 18.6%. Though the tally fell short of the performances of 1977 and 78, the total approached within a few percentage points their best record. Buffett clearly describes the relevant metrics that shareholders should use to assess Berkshire’s annual performance—“we continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance.” Over the longer term, owners should also assess the market value of its security investments. Speaking most generally, Buffett concludes that “the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”

During 1979, worries about inflation permeated everyday discourse. With the consumer price index increasing more than 10% annually, mortgage rates seemed to have no ceiling, and hording necessities appeared the best “investment.” And Buffett noticed the new competition with his characteristic frankness—“if we should continue to achieve a 20% compounded gain… your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash… We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.” In an economy with double-digit annual inflation rates, even the best capital allocators struggle to tread water.

And all this from a man who had the pleasure of owning some great businesses, like See’s Candies and Illinois National Bank. How much more is the misery of the mediocre business operator. Far wiser to be in a very good businesses with solid long-term prospects, like insurance, which “tends to magnify, to an unusual degree, human managerial talent – or the lack of it,” than to acquire new textile mills in Waumbec. As Buffett sums, “both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”

Lastly, Buffett concludes with some particularly useful comments about making bond investments. Observing that insurance competitors had given up one-year policies because of the inflationary environment, Buffett highlights the inconsistency expressed by their willingness to purchase long-term bonds. In short, “having decided that one year is too long a period for which to set a fixed price for insurance in an inflationary world, they then have turned around, taken the proceeds from the sale of that six-month policy, and sold the money at a fixed price for thirty or forty years.”

Inspired by Polonius, Buffett lays out what looks to be an absolute rule for bond investments: “neither a short-term borrower nor a long-term lender be.” For “even prior to this [inflationary] period, [Berkshire] never would buy thirty or forty-year bonds; instead we tried to concentrate in the straight bond area on shorter issues with sinking funds and on issues that seemed relatively undervalued because of bond market inefficiencies… Our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years.”

Here again we see Buffett’s reticence in projecting the earnings power for any business for any period longer than a decade. In his email conversation with Jeff Raikes of Microsoft, he insinuated that very few businesses are sufficiently predictable to submit to long-term forecasts about their earnings potential. And observers see this played out again and again in Buffett’s investments—in equities or fixed income. Berkshire will rarely give money away for longer than ten years, and it will rarely pay today for the discounted value of more than a decade’s earnings.*

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

* The one important and notable exception here is Coca Cola.

[This post continues our series on Warren Buffett’s letters to Berkshire Hathaway shareholders.]

Moody’s Intrinsic Value

moodys-logo2008 was a tough year for Moody’s Corporation, with free cash flow (FCF) levels falling to 2003 levels, or $450 million. In our previous analysis, we argued that Moody’s economic moat has shrunk over the last couple of years, as its credit ratings for structured finance products proved unreliable for predicting distress and default risk. So far though, Moody’s credit ratings for municipal and corporate debt have been reliable. The question for today—what price would Moody’s Corporation command from a private buyer in light of recent events?

In the past, we have introduced Seth Klarman’s three methods for valuing a business—by determining its liquidation value, the net present value (NPV) of its future cash flows, or its value relative to similar businesses trading in the public markets. Since Moody’s has a negative book value and has no comparable standalone competitors in the public markets (Standard & Poors is embedded within The McGraw Hill Companies), the NPV approach here is appropriate. And with the help of Morningstar’s FCF data, a NPV analysis is not a difficult exercise.

Since 2001, Moody’s has grown its FCF from $291.5 million to $450 million (FY 2008). As many know, in order to value future cash flows, an investor must make a reasonable estimate what they will be. In Moody’s case, estimates could vary widely, as its FCF in 2007 was $802 million. If we use past growth rates of FCF to estimate Moody’s future, we will get very different growth rates using the FCF data from 2002-2007 vs. those from 2001-2008. The former period shows a FCF growth of 20.4%, and the latter 6.4%.

For today’s analysis, I will use the latter—a 6.4% FCF growth rate—as it likely better approximates Moody’s business prospects over the next decade. Following upon a period of robust growth in its structured products ratings division—a division whose revenue has now fallen by half YOY—it is hard to imagine Wall Street’s structured products returning to their previous levels in the near future, much less to grow at their past rate.

Assuming then that Moody’s will grow its FCF from 2008’s $450 million at 6.4% per year for the next decade, and then assuming that it will continue to grow at 3% for the following decade, Moody’s should throw off $16.3 billion over the next two decades for its owners. If we discount those cash flows at 9% (an estimate of average stock market returns over the long-term), the NPV of those sixteen billions should be $6.578 billion. However, if today’s buyer offered $6.578 billion, he would be assuming a business with nearly a billion dollars in negative book value. Knocking $994 million off the expected purchase price would value Moody’s equity and future cash flows at $5.583 billion. With 235.2 million shares outstanding, the prospective buyer should be willing to pay $23.74 per share for Moody’s.

Of course, at $23.74, the buyer’s assumptions better be correct, because he’s paying fair value for the business and its earnings power. For investors like Warren Buffett, paying fair value typically does not offer a sufficient margin of safety; to warrant investment dollars, Buffett wants to buy dollars for fifty cents. Here a 50% margin of safety would suggest that the investor only purchase Moody’s below $11.87 per share. As of Tuesday’s close (4/7/09), Moody’s traded close to its intrinsic value, at $22.20 per share.

Disclosure: No position

Buffett’s Berkshire Letter from 1978

buffett1978 saw Menachem Begin and Anwar Sadat sign the Camp David Accords between Israel and Egypt. Resorts International (now Resorts Hotel and Casino Atlantic City) became the first casino on the East Coast. And Norman Rockwell took this year to be his last.

Over at Berkshire Hathaway, Warren and Company generated operating earnings on shareholder equity (exclusive of capital gains) of 19.4%–within a fraction of their 1972 record. Mr. Buffett of course dallied with his typical modesty, attributing the gains to his operating managers and a “bonanza period for the insurance industry.”

In this year, Berkshire breaks out each of their four business lines for special scrutiny—textiles, insurance, banking, and retailing.

As in 1977, textiles returned meager capital, given the cost of past investment; with $17 million invested, $1.3 million returned. Buffett sounds a bit exasperated as he recounts management’s attempts to improve the business: “obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc.” Yet, suit liners are difficult to differentiate, and too many are willing to produce them. And so, “the textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage.”

In insurance, the “bonanza period” from 1976-1978 generated an abundance of float for Buffett to put to work, but not all was bliss. Over at National Indemnity, they had been struggling with losses in their California Worker’s Compensation division. Frank DeNardo was tasked with finding a solution in the spring of 1978, and the solution he found was writing 75% fewer policies. For those looking for a lesson in insurance underwriting, take this case study as your first lesson. When business is soft and premiums low, follow DeNardo and write fewer policies. Of course, the required discipline is extremely rare; how many insurance companies do you know that are willing to tolerate 25% of last year’s business volume? I suspect none.

Lastly, Buffett gives his shareholders insight into how he conceives of equity investments. By year’s end 1978, Berkshire Hathaway’s insurance companies held nearly one million shares of SAFECO, another publically traded insurance giant. To some, this purchase may seem odd; why not just compete with SAFECO straight up and steal their market share?

As Buffett notes, “SAFECO is a much better insurance operation than our own…, is better than one we could develop and, similarly, is far better than any in which we might negotiate purchase of a controlling interest. Yet our purchase of SAFECO was made at substantially under book value. We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions. And there is no way to start a new operation – with necessarily uncertain prospects – at less than 100 cents on the dollar. Of course, with a minor interest we do not have the right to direct or even influence management policies of SAFECO. But why should we wish to do this? The record would indicate that they do a better job of managing their operations than we could do ourselves. While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management. Because, quite clearly, if one controlled a company run as well as SAFECO, the proper policy also would be to sit back and let management do its job.”

I would contend that such a statement is unprecedented in the recent history of American capitalism. Have you ever heard a manager say that a competitor provides a superior product, and that it is a more prudent use of capital to buy the competitor’s company in the stock market than to spend capital in an attempt to unseat them? To be this impartial and rational is remarkable, and sets a high bar for others to follow. One over which very few can jump.

In closing, I leave you one more Buffettism worth a smirk–“Our experience has been that the manager of an already high-cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.” So remember, being “resourceful” is not necessarily a compliment.

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

[This post continues our series on Warren Buffett’s letters to Berkshire Hathaway shareholders.  Part I is here.]

Moody’s Shrinking Moat

moodys-logoMoody’s Corporation is “a provider of (i) credit ratings and related research, data and analytical tools, (ii) quantitative credit risk measures, risk scoring software, and credit portfolio management solutions and (iii) securities pricing software and valuation models” (10-K from 3/2/09).  They operate their business in two segments—Moody’s Investor Service (MIS), which primarily rates debt securities in the global capital markets, and Moody’s Analytics (MA), which provides “quantitative credit risk scores, credit processing software, economic research, analytical models, financial data, securities pricing software and valuation models, and specialized consulting services” (10-K from 3/2/09). The foremost competitor for MIS is Standard and Poor’s, owned by McGraw-Hill Companies, though Moody’s also shares the ratings market with Fitch, Dominion Bond Rating Service Ltd. of Canada, A.M. Best Company Inc, Japan Credit Rating Agency Ltd., Rating and Investment Information Inc. of Japan and Egan-Jones Ratings Company.

The consensus view among stock market participants is that Moody’s Corporation has one of the widest economic moats around. Having provided credit analysis for a century now (going back to founder John Moody’s 1909 Analyses of Railroad Investments), and proven its value in predicting potential distress, the credit rating from MIS has become a necessity for large public companies seeking capital in the debt markets. The particular beauty of Moody’s business is that its standard credit analysis relies upon formulas back-tested against deep deposits of credit data from a wide variety of economic environments. Their value comes not from innovative analysis, but from having the most reliable and demonstrated tools in the room. Even if a competitor had access to such a database, and even if they found a better set of predictive metrics, few would pay to take their views seriously until they had acquired a history of predictive analysis.

Of Moody’s two segments, MIS clearly brings in the majority of Moody’s revenue ($1.2 billion for MIS in 2008 v. $1.755 billion total). Moody’s Analytics (MA), despite robust revenue growth in 2008 (14.9%), offers some products for which competition is stiff—consulting, economic research, and financial data. Though Mark Zandi’s economic analysis at may add insightful commentary, his voice does not add enough to command meaningful revenues for Moody’s. The best part about the MA business is that it is easily scalable; all the content is already prepared, so incremental revenue yields much fatter profits. Though MA may not offer an indispensable product like MIS, its growth prospects and its easy fit with its primary business appear to provide Moody’s owners with desirable returns on invested capital.

Ultimately though, the crucial aspect of Moody’s economic moat is their reputation for providing a useful and predictive judgment about credit risk. So how wide and deep does their reputation currently extend? In short, not as wide and deep as five years ago.

As many know, in recent years, Moody’s expanded its credit ratings to include structured finance products (e.g., RMBS, CDO). Given their relative novelty, and their concentration in excessively levered, overpriced “assets” (i.e., houses), Moody’s ratings proved unreliable for predicting distress and default rates. And their reputation as a whole took a significant hit. As they acknowledge in their 10-K, “Moody’s reputation is one of the key bases on which the Company competes. To the extent that the rating agency business as a whole or that Moody’s, relative to its competitors, suffers a loss in credibility, Moody’s business could be adversely affected.”

Here today, it is difficult to assess how damaged Moody’s reputation may be. Though structured finance made up the largest share of MIS revenues in 2007 ($873 million), it still composed less than half of their overall revenues ($1.78 billion). In other segments—corporate finance, financial institutions, and public finance—MIS credit ratings have not yet proven unreliable indicators. Yet, with their recent mistakes in structured finance, Moody’s has created an opening for a new competitor with better (or even passable) tools to steal share.

Later this week–Moody’s Intrinsic Value

Disclosure: No position

Buffett’s Berkshire letter for 1977

800px-warren_buffett_ku_visit[Today we start a recurring series that will progress through some of Buffett’s Berkshire letters, gleaning what wisdom we can.]

1977 was the first year that saw the President Jimmy Carter, an immature Luke Skywalker, and a small start-up by the name of Apple Computer Inc. The S&P 500 spent the year oscillating within ten percentage points of 100.

For Berkshire, 1976 brought earnings of $16.07 million and a return on equity of 17.3%. 1977 proved even better, with earnings of $21.9 million and a return on equity of 19% (equity capital had increased 24% YOY). Record earnings, but that was not the chosen headline.

Buffett, teacher as he is, reminds us that record earnings, in themselves, should not please shareholders, for if earnings increase 5% YOY at the same time that equity capital has increased 10% YOY, the business has actually used owners’ capital less efficiently than the previous year. Anyone can return more with more, but for Buffett and the business owner, optimal management should return the most with the least—that is, provide the best return on equity.*

However, a few paragraphs later, Buffett admits that Berkshire will not always pursue optimal returns, particularly if that means dispensing with the textile workers in New Bedford and Manchester. You see, by 1977, it was clear to Buffett and observers that Berkshire’s textile operations were not capable of producing the same returns on equity that its other businesses could. Despite this realization, Buffett was still willing to retain some capital for investment in textiles. Why? First, “our mills in both New Bedford and Manchester are among the largest employers in each town, utilizing a labor force of high average age possessing relatively non-transferable skills. Our workers and unions have exhibited unusual understanding and effort in cooperating with management to achieve a cost structure and product mix which might allow us to maintain a viable operation.” And second, “management also has been energetic and straightforward in its approach to our textile problems.”

In spite of Buffett’s reputation as a capitalist, examples like this remind the investor that a myopic concentration on ROE is not a prerequisite for investing success. Pushing capital around is a wholly human endeavor, with its attendant harms and benefits. And some of the harms Buffett was unwilling to accept, at least in the short term.

Of course, Buffett made this decision with eyes wide open, and he concludes that in the textile business “even very good management probably can average only modest results. One of the lessons your management has learned—and, unfortunately, sometimes re-learned—is the importance of being in businesses where tailwinds prevail rather than headwinds.” Although Buffett does not prudently and hastily cast textiles aside, he cautions others against similar mistakes.

Finally, in this letter, Buffett offers some insight into the insurance business, concluding–most simply—that it does not have an economic moat. As he writes, “Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition.” In such businesses—where competitive products fail to differentiate—the only durable moat is offering the lowest price. Mr. Buffett, may I introduce you to Geico?

* Buffett acknowledges that equity on capital is best “except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values).” David Einhorn has made a similar point, which we observed here.

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

Gambling before Bankruptcy

Much toil and time is given to the study of markets and businesses.  New insights can be interesting; the characters we encounter entertaining; and the bargains rock bottom. For the rainmakers out there, the latter are likely most useful, as every field needs a periodic downpour.

Yesterday it was the bondholders of Nova Chemicals Corporation that got the rain, as their $250 million in outstanding 7.4% medium-term notes were paid in full (cusip: 669936AA4). On the surface, the event may not strike you as noteworthy, but the story gets more interesting when you realize that these very bonds were trading at 58 cents on the dollar during the week of February 16th. Worried that Nova would not be able to pay these notes off or obtain the requisite financing by April 1st, buyers left Nova’s market deserted. Despite a book value of $750 million at December 31, 2008, the equity sellers on February 20th valued the company at less than $150 million.

Nova’s savior arrived though on February 23rd, as International Petroleum Investment Co. of Abu Dhabi came bearing the gift of $6 per common share, and a $250 million credit backstop. Nova’s debt and equity holders danced in the rain.

Reflecting on this scenario, let’s speculate about the relative attractiveness of Nova’s equity and bonds during the week of Feb. 16th. Imagine that we could go back in time; what would the expected value of each investment to be?

Looking at the equity then trading at $1.50 per share, let’s say you estimated the likelihood of bankruptcy (and an equity value of zero) at 40%. Then put a 40% likelihood on a successful debt refinancing, while positing that—in that scenario—the equity would trade marginally higher to $2 per share. And last, take the likelihood of a $6 per share buyout at 20%. All told, the expected value for the equity buyer would be (0*.4+2*.4+6*.2), or $2 per share—not at all a bad return (33%) in six weeks’ time.

How about the debt though, trading at 58 cents on the dollar? In the worst case scenario—bankruptcy—estimated at 40%, the court would have to order a restructuring, and the return to bondholders could vary widely. Authors Van de Castle, Keisman, and Yang have found the median recovery rates for defaulted senior notes to be near 43%. Since Nova has relatively abundant debt at this time (with 1.36 billion in long-term debt as of 12/31/08), let’s estimate that the recovery rates in bankruptcy would be lower than average, say 30%. Again, we’ll put a 40% likelihood on a successful refinancing, which would return 100 cents on the dollar, and the same return would follow from the 20% chance that Nova is acquired. Here the expected value for the debt holder would be (30*.4+100*.4+100*.2), or 72 cents on the dollar. On a purchase price of 58 cents, this would represent a 24% return—again, quite impressive for six weeks’ work.

In sum, either security looks favorable, given these assumptions. However, it is clear that a few small changes in our assumptions will much more negatively impact the equity’s expected value. For example, if the chance of a buyout were only 10% and bankruptcy instead 50%, the equity purchase would have a negative expected value, while the bond would still provide positive returns (30*.5+100*.4+100*.1). Therefore, in similar situations, I suspect that the prudent buyer of the debt will bear far fewer costs for any mistaken assumptions. Better to make rain with the debt holders, unless one’s assumptions are firm.

Disclosure: No position at the time of this writing.

Be the Dumber Guys in the Room

yesBusiness, most simply, is the practice of persuasion with the aim of making money. And the wise, worldly investors like Charlie Munger have done well in large part because of their familiarity with basic incentives and common methods of persuasion. One of Munger’s favored guides in his study has been Dr. Robert Cialdini, and in particular, his book Influence: Science and Practice, now in its 5th edition [see our previous discussions here, here, and here].

Dr. Cialdini, with Noah Goldstein and Steve Martin, has recently co-authored a shorter, more accessible account of social psychology’s established findings on human persuasion, entitled Yes! 50 Scientifically Proven Ways to Be Persuasive (Free Press, 2008). All told, it offers 50 brief vignettes that describe effective tactics of persuasion. Though the reader will find some reprises from Influence, I found much of interest and use.

For example, the authors describe the danger of being the brightest person in the room, or in one’s field. James Watson and Francis Crick are well-known as the discoverers of the double helix structure of DNA, even though Rosalind Franklin was the most intelligent scientist working on the problem in those days. Presumably like Franklin, Watson and Crick had clearly identified the most important problem to probe, dedicated their minds fully to its pursuit, and were passionate about their work. Yet, their advantage was their collaboration. Whereas the most brilliant tended to work alone, Watson and Crick sought advice and insight from all resources.

And more recently, behavioral scientists Patrick Laughlin and his colleagues have confirmed the value of collaboration, finding that “the approaches and outcomes of groups who cooperate in seeking a solution are not just better than the average member working alone, but are even better than the group’s best problem solver working alone” (100). Multiple minds working together stimulate more creative solutions and command wider knowledge and perspectives. Further, multiple actors can work on specialized tasks, expediting progress and enabling “parallel processing.” However, despite these benefits, Goldstein et al. argue that decisions made completely by committee are “notorious for sub-optimal performance” (101). Hence, their ultimate recommendation is that information be gathered and accessed collectively, but that decisions are made by a leader.

What lessons can we take from this knowledge of our patterned behavior? In investing, collaboration has clearly produced unprecedented returns for the team of Buffett and Munger. Yet, neither is shy in admitting that Buffett makes most of the buying decisions—at times, not even consulting Munger. Practically speaking, as one gathers information about a potential investment, there is a temptation to myopia, particularly if one is initially inclined to buy or sell. Data that confirms our inclination stands bold; disconfirming data melts into the mess. Crucial then is the intentional act of building and weighing the case against the proposed action. For each security one buys, he must achieve equal fluency in the case for selling. And vice versa. Only amid the trial of contending voices can the decisive agent invest intelligently.

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