Investing Ideas

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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An amazing piece of research done by Whitney Tilson of T2 partners was released on March 7th. This is a must read for anyone who plans to buy Financial’s, Brokers, Asset Managers, Monolines, Insurers, Banks or Housing related companies.

The main things he covers

• Why we had a housing bubble
• How the Bubble formed
• The consequences and why he feels it has much lower to go.
• Details on Loan Origination volume
• Default rates
• Mortgage Loses for companies/industries.
• Securitization, Asset Backed Securities, CDOs.

The first chart on page 3 of the presentation tells a lot about the Bubble. It points out that from 1995 to 2005 the pretax income in the US went from $30,000 to $40,400 an increase of 35% while the borrowing power of the people went from 90,000 to 360,000 an increase of 300%. Simply put in 1995 homebuyers would be lent 3 times their annual income while in 2006 it had risen to 9 times their annual income.

You can read the presentation here. You will need to give your Email and Name.

Full Disclosure: I am not invested in or short of MBIA, Ambac, Moodys, McGrawHill(S&P) or Any of the companies listed on page 50 of the presentation. I used to own shares of Washington Mutual and D. R. Horton. I do own shares of USG. After reading this presentation I am considering a position in Whitney Tilson’s fund (TILFX).

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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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Berkshire Hathaway will release its Annual Report tomorrow after the close of trading. In my Opinion it is recommended reading for anyone that invests. The First 20-25 pages of the Annual Report are the Chairmans letter to Berkshire Hathaway shareholders. This is where you get a view into the mind of Warren Buffett, his views, opinions and take on the market. Here is a small excerpt which warned about the housing mess that unfolded a last year.

“The slowdown in residential real estate activity stems in part from the weakened lending practices
of recent years. The “optional” contracts and “teaser” rates that have been popular have allowed borrowers
to make payments in the early years of their mortgages that fall far short of covering normal interest costs.
Naturally, there are few defaults when virtually nothing is required of a borrower. As a cynic has said, “A
rolling loan gathers no loss.” But payments not made add to principal, and borrowers who can’t afford
normal monthly payments early on are hit later with above-normal monthly obligations. This is the Scarlett
O’Hara scenario: “I’ll think about that tomorrow.” For many home owners, “tomorrow” has now arrived.
Consequently there is a huge overhang of offerings in several of HomeServices’ markets.”

- Warren Buffett in the 2006 Charimans Letter to Berkshire Shareholders.

Berkshire is one of the most diverse companies in the US. It has operations in Insurance, Manufacturing, Housing, Retail, Utilities and more. Reading the financial details of each segment along with Buffets commentary usually provides valuable insight into the industries and the economy.

What should shareholders look for?
If you’re a shareholder of Berkshire Hathaway there is a lot to look for in the Annual Report. Here’s a small list

• Berkshire Hathaway Assurance Corp and Insuring Muni Bonds.
• The Marmon purchase.
• TXU Bonds.
• What Buffett likes about Kraft (KFT)?
• More details on last years teaser Burlington Northern (BNI).
• How the Insurance sector is performing?
• How last years 2 big acquisitions TTI and Equitas are performing?
• Is Buffett still invested in the Brazilian Real?
• and finally the most important thing to look for, how is the search going for investment managers to replace Warren Buffett?

I will be dissecting the Annual report in posts this weekend.

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Sounds like a dumb question doesn’t it? But take a moment and think about the long term effects of $100 Oil, not the short market gyrations. I know Jim Rogers thinks Oil may go to $150 or even $200, and it might, but what will be its effect on OPEC? With a high oil price all alternatives to oil become viable. Most of the national income comes from exporting oil. They are building massive State Funds that invest the Petro-dollars. These investments should provide returns long after the OPEC country stops exporting Oil. The OPEC countries have decades of oil production left. If oil was consistently above $100 businesses would spend a lot of time and effort researching alternatives. If any alternative is found it could seriously harm the economies of the OPEC countries.

Current major OPEC economies.

• Saudi Arabia - 75% of budget revenues, 45% of GDP, and 90% of export earnings.
• Iran - 55% of Budget revenues, 25% of GDP, and 80% of export Earnings
• Kuwait - 50% of GDP, 90% of Exports
• UAE - 30% of GDP, 50% of exports (This is after a massive economic diversification project)
• Venezuela - 50% of budget, 35% of GDP, 80% of Exports.

Note: Not all countries listed, numbers are to the best of my knowledge aka Wikipedia and might not be totally accurate

Alternative to Oil?
The single largest use of Oil is to drive vehicles. Nearly 53% of Petroleum is used to run cars/trucks. Car companies are developing everything from Electric Hybrids to a Semi-Trailer that runs on Natgas(CNG/LNG) and even Biogas. The reason behind this is the growing number of people around the world that want cheaper alternatives to Petroleum. The international association of Natural Gas Vehicles provides the following statistics on cars running on gas.

Its not a big step to convert these vehicles to run on biogas or Hydrogen. Yes, you can modify your existing car to run on LPG/UNG/Biomass/Hydrogen and the kits are selling in developing nations for about $1000. Does OPEC really want this catching on? The only way to avoid the widespread adoption of these alternatives is LOWER oil prices.

The second biggest use of Oil is for Plastics, Chemicals and Manmade fibres which is about 10%. With the high price of Oil the race to develop viable alternatives to is on here as well. An example of ingenuity, clear plastic cups made from corn that are CHEAPER than normal plastic cups I found on other online sites, and these are compostable. Personally i am not a big fan of converting food into plastics but you get the point.

Disclosure: I am not invested in any Oil companies, I do own Chesapeake (CHK), I used to own Canadian Natural Resources (CNQ).

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Last weeks big whale news was Warren Buffett bought 8.6 percent of Kraft.

Why now?
Buffett needs to make large purchases for the investment to move the needle at Berkshire Hathaway. Altria (Phillip Morris) used to own 89% of Kraft. To buy 8.6% of Kraft Buffett would have had to buy 78% of the shares that traded. There was no way Warren Buffett could have purchases such a substantial stake in Kraft without moving the price significantly higher. It is quite possible that he had his eye on Kraft for some time. Altria’s spinoff of Kraft in April last year gave him the opportunity to build a big stake as existing Altria shareholders who recieved Kraft shares probably sold them off.

Why Kraft?
I must admit I don’t see this as a value pick. I think its fairly priced between $30-$35. I guess Buffett sees an improved future for Kraft. Kraft is now an independent company, the new CEO Irene Rosenfeld seems very competent. Kraft has also been undergoing some positive changes. The letter from Irene Roselfeld in the Annual Report points to an interesting change in how Kraft now views its products. Read Page 18 of the Annual Report. Finally Irene mentions the following “However, we will still have ample capacity for acquisitions. Our focus will be on building scale in key international geographies and on gaining access around the world to new categories, new capabilities and new technologies.” Kraft has a collection of great brands including Oreo, Gevalia, Jell-O, to Milka and Toblerone, but it currently has very little exposure to emerging markets. Kraft has an opportunity to increase sales and profits dramatically IF it expands its international business. Currently only 13.5% of Kraft sales are outside US/EU, compare this to 40.1% for Nestle and you can see where the opportunity lies. Irene has already taken the first step by buying Group Danone’s Snack business which get 25% of its revenue from China, Russia, Poland, Indonesia and Malaysia. Kraft can use the manufacturing/sales/marketing/distribution of the Danone business to unleash its US brands into the emerging markets.

Are these reasons enough to buy Kraft? Not for me, but as I said I probably missed what Buffett sees.

Disclosure: I do not own shares of Kraft but I have owned them in the past.

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Click here for my initial analysis of the Yahoo buyout by Microsoft

With Yahoo rejecting Microsoft’s initial offer the ball is in Microsoft’s court. The letter from Ballmer seems to suggest that if the $31 bid is rejected that MSFT will go to Yahoo shareholders. I still think this deal can be done at a price between $35-$38. Microsoft could easily sell off the non-core assets of Yahoo to pay for the increase, Will it? As a Microsoft shareholder, I hope not. There are no other buyers for Yahoo and existing shareholders will push for a sale to get the 62% premium.

Should Microsoft Wait?
Some people have suggested that Microsoft can take the offer off the table. They can then buy Yahoo cheaper in a year’s time. The problem is with Google holding 56% market share and increasing market share every quarter there is very little time left. The proposed buyout will take 2-3 quarters just for Regulatory approval, add in another year to integrate Yahoo and MSN. If they wait for a year before they try to buyout Yahoo cheaper, then its almost 3 years that Google will have to improve and consolidate its lead. If Google reaches 70-75% market share the Search/Text Ads battle is over. The only thing that could break Google’s domination with 75% market share would be a revolutionary search engine that provides dramatically better results than Google.

Is Search the complete story?
While everyone focuses on search and text ad’s and Google’s lead in that market. There is something most overlook, the banner displays and rich content ads. Yahoo holds a big lead over Google in the Banner Ads. Microsoft could use Yahoo to build a big lead over Google in the banner Ad’s market. Microsoft may feel they can use the Aquantive platform to boost revenue from Yahoo sites faster than most people think. Microsoft may also be interested in the mobile platform Yahoo has developed. Their interest in the mobile ad platform seems obvious with todays purchase of Danger.

Disclosure: I own shares of Microsoft

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To read Microhoo - Round 2 the follow up to this article click here
The Offer
Microsoft has offered to buyout Yahoo for 44.6 Billion. The Yahoo shareholders can choose either cash or 0.9509 shares of Microsoft, a 62% premium to the closing price of Yahoo of 19.18 on Jan 31 2008.

Why Microsoft wants yahoo

• Microsoft gets a world class internet franchise. Yahoo is the biggest portal on the web and the site with the highest number of views, about 500 million per month.
• 16.7 Billion in cash and assets. Yahoo has a lot of hidden assets that no one considers in their valuation like Yahoo Japan, Alibaba, Gmarket. A recent motley fool article by Rick Aristotle Munarriz calculated the value of these assets at 14.3 Billion + cash equivalents of 2.4 Billion.
• 1.33 Billion in recent acquisitions In the last year it bought Zimbra for 350 Million, Blue Lithium for 300 Million, Right Media for 680 Million.
• Yahoo also owns del.icio.us, Flickr, Konfabulator, Overture aka Yahoo Search Marketing (Yahoo paid 1.6 Billion in 2003), Hotjobs. Pulling a number out of my hat I’d say these are worth at least 2 Billion.

The price Microsoft is paying is not as exorbitant as it seems. The total value of cash and assets Microsoft receives is about 20 Billion. So in effect Microsoft is buying out Yahoo’s core portal+mail+search+messenger business for 24.6 Billion.

Microsoft’s MSN and Yahoo have a lot of businesses in common. Their portals provide news, finance, entertainment, search and maps. Microsoft and Yahoo also overlap on webmail and messenger services. A merger will bring about significant savings by removing redundant infrastructure and operating costs. The combined entity would have enough market share so that it can compete with Google. The press release says that Microsoft expects to generate 1 Billion in synergies for the combined entity. Currently Yahoo’s profit is 660 Million, MSN’s loss is about 250 Million, and synergies are 1 Billion. Microsoft can earn 1.4 Billion per year on an investment of 24.6 Billion, the merged unit has an effective P/E of 17.5.

How it affects Yahoo
Yahoo is steadily losing market share not only to Google but also to Microsoft. It would be great if Yahoo could merge with Google. Yahoo would provide the content and Google would provide the technology for search and advertising. Unfortunately since Google has a 56% share of the search marketplace the chance that a merger will be approved is zero. It has been mentioned that Yahoo could outsource the search and advertising to Google for an instant increase in earnings but that would mean giving up of the search and advertising market. Any partnership with Google would mean that Microsoft will not go through with the buyout and the share price would collapse and bring on shareholder lawsuits. There are few companies big enough to buy Yahoo and no other company that has the synergies to make the a buyout offer above 45 billion.

Yahoo was trading at $34 per share recently but had dropped below $20 when the offer was made. The 62% premium is difficult to turn down. The most that Yahoo can do is to get a better price from Microsoft, say in the $35-$38 range.

How it affects Google
Google cant buy Yahoo because it already has a dominant position in search. What Google can do is to make it difficult for the buyout to go through. Yahoo and Microsoft are the leaders in Portals, Messenger and Webmail. A delay in the buyout and any problems in integrating the companies would give time for increase its lead in search. If Yahoo accepts the buyout, the best Google can do is use any confusion and uncertainty during the integration process to increase its lead. The approval for the buyout would take months and the integration of MSN and Yahoo would take longer. If Google manages to get to 75% of the market share before a successful MSN+Yahoo integration they win the search battle.

A new proposal
In my opinion a better option would have been to create another company “MicroHoo”. This company would be a merger of Yahoo and the Internet division of Microsoft including the recent acquisition of Aquantive. The Microsoft guys would run the administration/finance/sales/marketing/monetization and the Yahoo guys would be the creative side developing the content/sites. In this scenario, Microsoft doesn’t have to pay the 62% premium or dilute existing shareholders. It might put in additional cash into the merged company so that it has a controlling 51% stake.

As a Microsoft Shareholder I worry about the expected cost savings from synergies. I also worry if the approval and integration can be done in time to challenge Google.
I hope Microsoft thought about a merged company before they decided to just buyout Yahoo. Its possible that a merger was proposed but the idea was rejected by Yahoo. I guess Steve Ballmer sees a big opportunity and thinks that any futher delay in combining MSN and Yahoo would give Google an insurmountable lead. Only time if this buyout makes sense.
This article is just my opinion please do not base any investment decisions based on the article.

To read Microhoo - Round 2 the follow up to this article click here

Disclosure: I own shares of Microsoft.

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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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So i am back with my favourite company. On August 23rd 2006 I calculated that the value of Berkshire Hathaway shares should be at least $120,000. Fast forward to August 23, 2007 and BRK-A closed at $118,800. Not too bad

Market Cap of Berkshire Hathaway = 212 Billion
Value of Individual Berkshire Parts = 246 Billion (Based on the Interim 3nd quarter report. Numbers used are 9 Months Net Profits *(4/3) for full year estimate values)

Recently Buffett has been making a few deals after nearly 1 year of inactivity. The 2 Billion of TXU bonds earning 11.2% and 11.8%. Buying 60% of Marmon for 4.5 Billion. Starting a Muni Bond Insurer. Purcasing ING’s Reinsurance business. All this point to Buffet finding ways to invest Berkshire’s cash hoard. The credit turmoil will create good buying opportunities for Berkshire. Finally at the next Annual meeting Buffet should have a couple of Investment managers lined up to take care of Investments going forward. All of this will add significant value to the shares in 2008.

The A shares of Berkshire Hathaway should sell for $163,000+ and the B Shares for $5400+.
** Investment gains or losses are recognized upon the sales of investments or as otherwise required under GAAP. The timing of realized gains or losses from sales can have a material effect on periodic earnings. However, such gains or losses usually have little, if any, impact on total shareholders’ equity because most equity and fixed maturity investments are carried at fair value, with the unrealized gain or loss included as a component of accumulated other comprehensive income. - From the Report

Disclosure: I own Shares of Berkshire Hathaway

Note: I originally wrote this article late last year after the 3Q Earnings were released but i never published it. It’s a little late since Berkshire will be releasing FY07 earnings soon and Annual Report is due in a month.

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