Monthly Archives: June 2009

Finding the Next Sam Walton

mungerWe’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.

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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.]