Investing Ideas

Here is a quote from Warren Buffett at the bottom of the Stock Market in October 1974.

Forbes : “How do you feel?”
Warren Buffett : “Like an oversexed guy in a whorehouse. Now is the time to invest and get rich.”

The US stock market has dropped 35% from its peak last year and the consumer recession is about to start and will last well into 09. Now is the time to start making your shopping list of stocks and to come up with prices that you dream you could buy those stocks at. You may very well get the chance to buy the investment of your dreams at a once in a lifetime price.

In Part 1 of my shopping list I want to list 25 companies I admire and would like to have in my portfolio. In subsequent posts I will detail what I like about the company and what I think its Intrinsic value is and what my dream price would be. I already hold some of these stocks (in bold) but i would like to buy more at the right price.

1. Berkshire Hathaway
2. Leucadia National
3. Brookfield Asset Management
4. Markel
5. Canadian Natural Resources
6. Chesapeake energy
7. General Electric
8. Johnson and Johnson
9. Pfizer
10. American Express
11. Coca Cola
12. Conoco Phillips
13. Proctor and Gamble
14. US Bancorp
15. Wells Fargo
16. J. P. Morgan
17. Goldman Sachs
18. Sears Holdings
19. Microsoft
20. Fastenal
21. CostCoI will edit this and add 4 more companies later

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Motorola peaked in 2000 at at about $60 per share, recently the shares traded as low as $9 giving it a market cap of just 20 Billion.

Value Trap?
Its easy to look at Motorola’s revenue and earnings and say that the company has performed badly. Motorola’s revenue dropped from 42.8 Billion to 36.6 Billion. Net earnings dropped from 3.6 Billion to a loss of 50 Million. Mobile Devices sales have dropped 33 percent. The company has not had a hit phone like its amazing Razr for quite a while. The handset business has fickle customers, people with no loyalty to a particular brand. Research and Development expenses are high and ongoing because a lot of people want a new, cool and better phone every couple of years (some change phones every year or less). Motorola has competition at the high end from Apple’s iphone and RIMMs Blackberry and at the low end there are more handset manufacturers than ever before.

Value Investment?
While the handset business has issues, thats not all Motorola does. It has two other business segments Home and Mobility networks and Enterprise Mobility Solutions. Click here to see the wide range of Motorola products and services. Since the company reports as a single entity most people miss how well the other segments are performing. This is why activist investor Carl Icahn has been pushing for Motorola to split the company. He wants them to either sell or spin-off the under performing handset division and Motorola has agreed. So lets value the company as two separate businesses? the handset business aka Mobile devices and everything else. While Motorola has been losing market share in the handset business but at the same time it Enterprise Mobility Solutions business is growing very rapidly.

Motorola’s business segments data from Motorola Q4 2007 Earnings Press Release and Financial Tables
1. Mobile devices. - For the full year 2007, sales were $19.0 billion, a 33 percent decrease compared to 2006, and the segment incurred an operating loss of $1.2 billion, compared to operating earnings of $2.7 billion in 2006.

2. Home and Mobility networks. -For the full year 2007, sales were $10.0 billion, a 9 percent increase compared to 2006, and the segment generated operating earnings of $709 million, compared to $787 million in 2006.

3. Enterprise Mobility Solutions. - For the full year 2007, sales were $7.7 billion, a 43 percent increase compared to 2006, and the segment generated operating earnings of $1.2 billion, compared to $958 million in 2006.

The Home and Mobility networks and Enterprise Mobility Solutions segments combined had operating earnings of 1.9 Billion, this gives Motorola an earnings yield of 9.5%. In my opinion at an earnings yield of 9.5% just these two segments of Motorola’s business are worth as much as the whole company. In addition Motorola has more Cash and Short Term Investments than debt and it has $3.8 Billion remaining under its current share repurchase authorization. Any value that can be extracted from the handset division is gravy. With Icahn winning seats on Motorola’s board I expect a lot of investor friendly changes in the coming months.

Full Disclosure: I own shares of Motorola which I bought at a higher price. I may buy some more.

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The first step to understanding deleveraing is to understand leveraging.

What is Margin?

Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the amount of one’s own cash used. This difference has to stay above a minimum margin requirement. This is to protect the broker against a fall in the value of the securities to the point that they no longer cover the loan.

Example: Universal XYZ trades at $10 per share and John has $200.

If the shares rise to $12
Without Margin: John can buy 20 shares of the company. If the shares rise to $12. John can sell his shares for $240 and make a profit of $40 with an investment of $200.
With Margin: John can buy 100 shares of Universal XYZ for $1000, using $200 of his own money, and $800 borrowed from his broker. The net value (share - loan) is $200. The broker wants a minimum margin requirement of $100. If the shares rise to $12 he can sell for $1200 and make a profit of $200 with an investment of $200. Five times what he made without margin. (He will have to pay some interest on the loan)

If the share price drops to $8

Without Margin: John can buy 20 shares of the company. If the shares fall to $8. John can hold his shares or sell for $160 for a loss of $40 on an investment of $200.
With Margin: John can buy 100 shares of Universal XYZ for $1000, using $200 of his own money, and $800 borrowed from his broker. The net value (share - loan) is $200. The broker wants a minimum margin requirement of $100. If the shares fall to $8, the net value is now zero, and John will either have to sell the shares or repay part of the loan (so that the net value of his position is again above $100).

So whats happening in the markets?
Margin is used by companies, private equity and hedge funds the same way that it is used by individuals, but on a much larger scale. There are companies which have taken on leverage to buy large amount of mortgage debt. They borrowed money from Citigroup, JP Morgan, Goldman Sachs and other such companies. They bought mortgage debt that paid a higher percentage of interest than what they would pay to the companies they borrowed from.  As housing prices have declined so has the value of the mortgages held by these entities. The companies that lent them the money are now issuing margin calls to increase the net value or they will sell off the assets. The problem is that mortgage debt is considered toxic by the street and no one wants to buy it unless they can buy it at a huge discount.  If the motgage sells at a discount (which is the only way it would sell in this market), the lower sale decreases the market value of debt held by other institutions which in turn get a margin call and might in turn get liquidated and it continues. A deleveraging domino effect.

Fallout
In my opinion the the dominoes effect can cause closure/redemptions at a lot of funds that hold mortgage debt. It can also affect entities that hold mortgage debt along with other securities. These entities may try to stay afloat by selling stocks and bonds they hold instead of selling their mortgage debt at depressed prices. This will result in  spillover into other markets.

So whats the opportunity?
The only opportuniy for individuals with cash will be to buy stocks/bonds at lower prices if there is a fallout into other markets. The big opportunity exists for companies that are sitting on tons of cash and can buy this debt at very cheap rates. Companies like Berkshire Hathaway which has 40Billion in cash and a ton more in bonds could get very good deals. In a recent Q&A session on CNBC Warren Buffett mentioned that he had made a bid on a 3.5 Billion Municipal Bonds portfolio and had offered 75cents on the dollar. I’m sure he would pay a lot less for mortgage debt. Cash rich companies like this could make a lot of money buying mortgage debt at depressed prices, and investors could make good money buying the companies which get great deals on the mortgage debt.

Full Disclosure: I own shares of Berkshire Hathaway, I am not invested or short  Citigroup, JP Morgan, Goldman Sachs.

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Background
Municipal Bonds also known as Munis’ are Bonds issued by State and Local Governments who use the money to finance projects. The payments for these Munis are made from the taxes they collect. It is extremely unlikely (but not totally unheard of) for a Municipality/City/State to go Bankrupt and stop making payments on their Bonds. Most municipalities have credit rating that are relatively low. If they had a higher credit rating they would have to pay lower interest rates on the money they borrow. To get a higher credit rating for their bonds the government entity issuing the bonds can insure them with a AAA credit insurer aka a Monoline insurer. Once insured with a AAA credit insurer the bonds receive a AAA credit rating and have to pay much lower interest rates.

How the subprime mess has affected Muni’s
Most of the companies that provided insurance of Munis also started insuring CDO’s (Collateralized Debt Obligations). The companies have to pay the mortgage companies if the homeowner fails to pay and the house sells for less than the cost of the loan. As everyone has read/heard, there are an unprecedented number of people who are unable to make payments on their house. House prices are down and the mortgage companies are losing money. This in turn means that when they cant recover the original loan the Monoline insurers have to make payments. The market feels that the amount of payments that some of these companies need to make to cover the CDO obligations will leave little capital left to cover the obligations of the Insured Munis. Since the feel that the Monolines wont have money left to pay for insured Munis they are treating the Munis as if they are uninsured.

Whats the opportunity
As I mentioned earlier it is very rare for a government entity issuing Munis to go bankrupt. Another thing is that the interest from Munis is not taxable at the Federal level. If you buy Munis that are issued by entities in the state you live in the income is exempt from state taxes as well. Because the income is not taxed at Federal level and sometimes not taxed at state level, Munis usually have lower yields than US Treasury’s. The reason being that after tax a Muni yield of 6% is similar to a 8% yield that gets taxed at 25% income tax rate.

Here are some examples based on data when i wrote this

US Treasury Yields - 6 Month - 1.56%; 2 Year - 1.55%; 5 year - 2.49%; 10 year - 3.6%
Pimco California Municipal Income Fund - PCQ: 6%
Pimco New York Municipal Income Fund - PNF: 5.4%
Pimco Municipal income Fund - PMF: 6.4%
Individual California Muni Bonds with maturity in the next 5 years

Note : With Managed Funds or Closed End Funds the value of the Fund can go down. Some funds are only allowed to hold bonds with a specific rating eg: A or higher. If the monoline insurers have their credit rating downgraded the rating of some of the bonds the mutual funds hold will also be downgraded and the fund manager may have to sell the Munis at a loss. It may be safer to buy individual Muni Bonds because you can decide to Hold till Maturity. This is not an option when you buy a fund since the fund manager makes the decisions to buy or sell.

Disclosure: I do not hold any Munis but I am considering buying PCQ or individual California Bonds.

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First lets get a few things out of the way.

1. Sears Holdings is a Holding Company and not a Retailer. The current holdings just happen to be 3 retailers.

2. Same store sales. There is no point in increasing sales if it leads to decreasing profits. Would you rather sell 10 items of clothing with $10 profit per item or would you sell 15 items of clothing with $6 profit per item? The fewer sales give a $100 profit v/s $90 profit from the higher sales. An increase in sales does not mean increase in profits and what counts is PROFITS.

Now that we have that out of the way lets value Sears Holdings

Sears Valuation

Sears Canada - Sears owns 70% of Sears Canada which is worth $2 Billion
Brands - DieHard, Kenmore,Craftsman could be sold in a Bond valued at $1.8 billion.
Lands End - Sears paid $1.9 Billion for Lands End in 2002
Home services
Real Estate - Sears is a 115 year old company. Some of its real estate was purchased before Walmart even existed. The real estate is carried on their books at the price they paid for it 10, 20 and possibly in some cases 50 or more years ago. It currently owns about 110 Million square feet of real estate. A lot of this real estate is in prime locations around the US.

• Sears Mall stores 518 with Avg Sqft of 134,000
• Sears Essentials/Grand 20 with Avg Sqft of 113,000
• Kmart Discount 139 with Avg Sqft of 93,000
• Kmart Supercentres 34 with Avg Sqft of 165,000
• Sears HQ - 2 Million Sqft + 200 Acres of land
• Warehouse and Distribution Centres - 15 Million Sqft

Total = 107.2 Million Sqft * 160 (S&P/GRA Commercial Real Estate Indices) = 17.1 Billion

This gives Sears Holdings a minimum Valuation of 22.8 Billion the company is selling for 14 Billion.
Liquidation Value of SHLD in my opinion is $164+/share.

Additional value that could not be calculated due to lack of sufficient data

• Sears Speciality - Unknown size of stores so counted as zero
• Sears also has extremely favorable leases on a lot of its other stores. They control about 150Million sqft of leased properties usually at below market rates. It could sell its leases or sublease these stores. But detailed data on the lease agreements is unavailable so this has also been counted as zero.
• Valuation for HomeServices and the actual Sears business is also counted as zero

Who else is investing in Sears?
Eddie Lampert - ESL investments
Bruce Berkowitz - Fairholme
Bill Ackman - Pershing Square
Bill Miller - Legg Mason Value

Full Disclosure : I own shares of Sears Holdings and am planning to buy more.

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