Some Posts Worth Reading

Value Discipline: Recurring Revenues and Industrials
Bill Rempel: Fundamental Portfolio Struggling YTD
Cheap Stocks: Premier Exhibitions (PRXI) – Value Not Without Controversy
Cheap Stocks: Net/Net Index In Positive Territory

Some Books Worth Reading

Investing The Templeton Way
The Little Book That Builds Wealth

I don’t usually write on macro topics; however, I do get lots of emails asking me about the economy, markets, etc. I try to respond to these emails. Here are some excerpts from an email response I sent out tonight (some of the following has been edited):

The Fed is in a very tough position. This is a credit problem. It's serious. It's hard to say what the result will be - but it could potentially be very bad. You can have some pretty catastrophic things happen when people start to panic - as far as what happens with money and how all sorts of things can seize up at once. It's really a psychological problem - a spiral of negativity and panic that feeds on itself. People start to do irrational things and then others respond in irrational ways to their irrational actions and so on and so forth.

The possibility of terrible outsized effects from the kinds of problems we're seeing with Bear Stearns etc. is real. The housing problem is real. The economy can deal with a lot of things clogging up the system, but credit is probably the toughest.

This is the most serious threat the economy has faced in a long, long time - much more serious (to the economy) than the September 11th attacks. People always want to see just one catastrophic event - point to that - and explain away horrible problems. It doesn't happen that way. You have a whole climate of negativity, fear, panic, etc. that feeds on itself and causes real problems. It really does come down to psychology. And it's amazing how fast it can happen.

It's something that either achieves a sort of critical mass or it doesn't. It's like a riot. Either it never really gets out of control and we all forget about it, or it builds on itself and it gets bigger and uglier faster than anyone could imagine.

I don't worry about single issues. The price of oil alone means next to nothing. Housing alone means something, but it's really how housing indirectly influences everybody's behavior where you get problems. A stock market crash means next to nothing to the economy. But the totality of some combination of these things - the climate created - that means everything.

We are on the brink. We haven't seen such potentially perilous economic times in a long, long time. But if the peril passes no one remembers it. People remember 1929 because the peril didn't pass - because that climate of depression fed on itself in so many horrible ways that things got worse and worse not better. It seems almost inevitable in the past - but there was a point (no one knows when at the time) where you were on the brink, where terrible things lasting a long, long time could have happened (and eventually did) where you could have broken a downward spiral.

People always want to look at just one "black" day and say that was the day when "it" happened. It doesn’t work that way. What you really have is a series of unfortunate events; if people made different decisions at a lot of different points, things could have been better. But – like in a riot – everything around you is encouraging stupid, irrational behavior. The climate starts to drive the bad decisions that create the climate that drive the bad decisions that create the climate.

Has the Fed been too slow? Yes. It should have cut to below where we are now months ago. People would have said that was drastic. And it would have been drastic prevention.

I know you can prevent an economic disease. I'm not sure you can cure one.

Eventually the ravages of the disease create the right environment for a cure - actors start to act rationally and positively because it's so obviously profitable to do so – their greed overcomes their fear.

I'm someone who really believes the Fed and anyone else who thinks they can/should influence the economy has to "shock" the system before the spiral takes hold. There's always talk of "order", "prudence", and "measured" action. Psychologically, that stuff doesn't work. Only shocking action prevents true catastrophe.

I've always been skeptical of the Fed's ability to manage the economy. But, if and when it does something drastically unexpected and unexpectedly drastic it can potentially prevent a fearful spiral.

Is it too late for that now?

Maybe.

But that's the one thing I think the Fed can do - the one place where it can really make a difference. In a perfect world we would have rates well below where they are now months ago. In the fall, you could have cut a lot deeper. That would have been a good bet to make, because the one thing - above all else - the Fed must do is try to prevent the truly catastrophic from happening.

All the rest - the careful managing of unemployment, inflation, growth - and expectations is basically BS. You either get luckier with the climate you have or you don't. But avoiding the super spirals - the truly catastrophic events - you can do something about that in the embryonic stages and you can still try to do that now.

They'll probably be too prudent though. Even a full percentage point cut now won't be shocking.

We might manage to get out of this fine. I don't know. But it's the riskiest position we've been in for decades. While the probabilities may not be tilted toward catastrophe, it's a possibility, and the right bet is to throw everything against that possibility, because the cost of failing to do so is too high.

I think it's still probable we'll have problems that are relatively short-lived (in history's eyes, not ours) and can be overcome. But we are currently in a high risk situation. Although the odds of catastrophe may be small, they are real.

Regardless, the principles of value investing remain the same.

The best thing to do when you can't understand the world is to try to better understand yourself.

Invest in yourself during times like these. It'll pay off at some point.

In finance, liquidity is not a physical state it is a psychological state. Liquidity is a state of mind. Worse yet, liquidity is in the eye of the beholder. That is not merely to say that liquidity is subjective. Liquidity is subjective, but it’s also more than subjective – it exists in the minds of others – others who can and do transact business with you. So liquidity is – to a great extent – uncontrollable.

Good assets may not necessarily be liquid assets. As a result, good decisions do not necessarily lead to good outcomes when an actor is dependent upon liquidity. An actor is dependent upon liquidity whenever liabilities are great relative to assets. However, an actor can avoid insolvency and make good decisions that will almost certainly lead to good outcomes if the actor can studiously avoid disbursing cash or other assets to meet obligations in the near-term. An actor who can finance an asset by selling a thirty-year zero-coupon bond does not have to worry much about liquidity. Any actor so financed weds its destiny almost entirely to the intrinsic value of the asset – and only the intrinsic value of the asset. All other worldly concerns seem to melt away. This sort of financial nirvana is rarely achieved by any actor who has tasted of the sweet, sweet nectar known as debt.

Actors – like addicts – can develop a dependence through regular use. There is no such thing as non-habit forming debt. Debt is so addictive precisely because it is so useful.

Wonderful businesses have been brought down by a lack of common sense and an abundance of debt. Great businesses – even some simple, great businesses – have been brought down by debt.

What their competitors could never do to them, these great businesses did to themselves.

Berkshire Hathaway (BRK.B) bought Fruit of the Loom out of bankruptcy. It’s hard to bankrupt an entrenched underwear business. Only debt could kill a business like Fruit of the Loom or Hanes (HBI).

So how can investors evaluate a debt-laden liquidity whore? For the most part they can’t.

Investors never like to hear that. But it’s true.

Hanes may have debt; but at least its business isn’t directly dependent on liquidity. Like Fruit of the Loom, Hanes can go bankrupt, but Hanes can also be evaluated without reference to all sorts of variables beyond the company’s control. An investor can decide if the company has too much debt without giving much thought to capital markets, interest rates, commodity prices, and all the other much discussed macro variables. The further an investor ventures from the specifics of the business he is evaluating the more unstable all of his assumptions become. As he stacks unstable assumption upon unstable assumption, he builds a teetering tower crowned with an intrinsic value estimate that could prove perilous.

If you can make successful macro bets, make them. If that’s your strong suit, stick with it. But don’t confuse the business of evaluating businesses and picking stocks with the business of guessing which way the macro winds will blow.

You don’t need to have an opinion on every stock out there. It’s no mark of shame to admit you can’t come to actionable conclusions within whole industries. If you knew Bear Stearns (BSC) was a short – good for you. If you could admit Bear Stearns was beyond your comprehension – even better.

Investors have a hard time roping off the areas they can work within from those they can’t. Too many of us venture too far afield. A few good decisions can make a fortune. A few bad decisions can lose one.

You’re going to make mistakes. But there’s no need to make them in unfamiliar territory.

The temptation to take a stand, either with the market or against it – with the bulls or with the bears – is always great. Too great for most investors.

In the days and weeks ahead, most people will be focusing on Bear Stearns. However, most investors would do better to focus on themselves.

Now is a good time to examine how honest you are with yourself. Admitting when you’re wrong is good. Admitting when you don’t know is better.

What lesson will you learn from all this? How will you become a better investor?

Alive – definitely alive.

This question – more than any other – dogs every discussion of Berkshire Hathaway (BRK.B). It isn’t immediately visible to those arguing on either side (“Berkshire is overvalued”, “No! Berkshire is undervalued”) but it underlies their arguments all the same.

What do I mean when I say Berkshire Hathaway is worth more alive than dead? I mean that Berkshire as a continuing whole is more valuable than a Berkshire that is dismembered into its constituent parts this very day – a Berkshire that is cut up and dished out like a Christmas ham.

Why?

A lot of people value Berkshire as a closed-end investment fund. Peter Lynch wouldn’t make that mistake. He’d see that Berkshire fits the bill as one of his stalwarts:

“Stalwarts are companies such as Coca-Cola, Bristol-Myers, Procter and Gamble…and Colgate-Palmolive. These multibillion-dollar hulks are not exactly agile climbers, but they’re faster than slow growers…When you traffic in stalwarts, you’re more or less in the foothills: 10 to 12 percent annual growth in earnings”.

(From Lynch's One Up On Wall Street)

That’s what Berkshire is – not a lifeless closed-end investment fund, but a living, breathing stalwart – a mega-cap company that needs to be compared to (and valued like) other mega-caps.

I tried to make this point in the comments section of an earlier post, when I wrote:

“So, now the question isn’t whether Berkshire can compete with its past (it can’t). But, whether Berkshire can compete with similarly sized public companies such as Nestle, Unilever, Google, Microsoft, General Electric, Johnson & Johnson, HSBC, AT&T, Wal-Mart, Bank of America, and the big oil companies. Can it? I think it can. So, relative to its peers (in terms of size) Berkshire isn’t overpriced. Is it overpriced compared to the Berkshire of twenty or thirty years ago? Yes. But, so is just about every asset on planet earth. So, that’s not the right yardstick to use. You have to compare Berkshire (the stock) to other stocks you can buy today – and Berkshire the company to other companies with similar size constraints. On both counts, I think a valuation of about $140,000 a share is appropriate and fair.”

Berkshire’s value is every bit as dependent on growth as the value of those other corporate behemoths – more so, in fact, because Berkshire doesn’t pay out dividends. You need to value Berkshire based on its likely intrinsic value growth rate, because that rate will determine what the stock is worth in 3, 5, and 10 years’ time – just as it will at Microsoft and Bank of America and Wal-Mart and Google.

Berkshire is a growth stock. And how fast is it growing? Since 1995, I estimate intrinsic value has grown a little more than 15% a year. Of course, when I assign a value to Berkshire shares, I don’t assume it can keep up that kind of intrinsic value growth. Rather, I assume it could grow at a still stalwart like 10-12% annual rate with Buffett at the helm, and 8% a year without Buffett.

I may be (very) wrong about Berkshire’s growth prospects. But, I’m not wrong to see it as a living, growing integrated whole rather than a lifeless closed-end investment fund that needs to be parceled out soon and thus valued today as if it were already in liquidation.

That’s a pig-headed approach that runs contrary to everything we know about what Berkshire was in the past, is now, and likely will be in the future. It’s a compounding machine that will keep chugging along (at some pace) for many years to come.

How can I explain this simple truth in a way any investor can understand? How can I make people realize that Berkshire isn’t just the sum of its parts – but, rather an integrated whole that adds value that is not derived from the value of any particular part on its own, but rather comes from making those parts work in harmony towards a single goal?

I don’t know. So, I’ll try a simile.

The Berkshire model works. To some extent, it works with or without Buffett. It works a whole lot better with Buffett than without Buffett. But, a capital allocation conglomerate makes some sense even where Buffett isn’t at the helm.

Why?

Because businesses face capital allocation constraints very early – a lot earlier than we like to think.

An example of a good business in a smaller, narrower industry may help illustrate my point.

The following is total fiction – a complete hypothetical – however, I think it is oddly illustrative of the way the capital allocation conglomerate model can work (and does work at Berkshire).

There’s no doubt Berkshire benefits from Buffett’s “magic”; but there’s also some value adding alchemy in the capital allocation conglomerate model.

Berkshire is a combination of man and model.

The Strattec Simile

Strattec (STRT) is a small company with a market cap of just over $150 million and an enterprise value of much less.

Strattec is flush with cash and always has been. For background on Strattec’s spin-off, see Joel Greenblatt’s You Can Be a Stock Market Genius which includes a chapter outlining the case for buying Strattec when it was spun-off from Briggs & Stratton.

Strattec has been a good business; but, it’s also been a small business. Today, it carries about $60 million of cash on its balance sheet – which is just over 40% of total assets and just under 60% of total equity. That’s way too much cash for a public company to carry.

Strattec has been both blessed and cursed. It’s been blessed with a good, narrow business that produces plenty of free cash flow and it’s been cursed with a good, narrow business that produces plenty of free cash flow.

The cash kept coming; the growth never did. Over the last ten years, Strattec has tried to sop up some of that cash – and has succeeded to the tune of about $95 million in 10 years, or nearly $10 million a year in share buybacks.

Strattec is part operating business and part investment company. The market treats the operating business as the more valuable component, but there’s no denying capital allocation (or misallocation) has been a key determinant of the company’s stock price performance.

Strattec has $60 million in cash today, and has (indirectly) plowed $95 million back into the lock business through stock buybacks made over the last ten years.

Strattec could have really used a Buffett like capital allocator over the past decade.

Or, it could have just paid a nice, fat dividend. Either way would have worked.

You can see the conundrum. It’s natural for businesses (even publicly traded businesses) to find themselves producing more cash than they ought to reinvest in their established field of expertise.

Now, I’m not really saying that Strattec has too much cash today (though it very well might) and needs to do something about this problem. That’s a much narrower argument that only matters if you’re looking at Strattec as an investment.

I’m not doing that here. Rather, I’m saying that Strattec has had too much cash for a decade – and a decade is a very long time in investing – so, Strattec doesn’t just have a sub-optimal operating model today; it’s had one for ten years and its owners have suffered for that (“suffer” is a relative term; the stock has done fine versus the S&P – but, it hasn’t done fine versus the actual business).

The math is simple. Over the past ten years, Strattec had $155 million in cash ($95 million in buybacks + $60 million in cash now held) fall to the ultimate bottom line, the balance sheet.

Last I checked, the company had a market cap of – drum roll please….$155 million!

Investors who held the stock for ten years saw the business they owned generate $155 million in completely free cash flow – and yet the business they own is now worth merely the sum of that $155 million. Had all $155 million been paid out in annual dividends, the future value of the business as of today would not now be valued by the market at $0/share; so, it seems we’ve had some sub-optimal capital allocation over the past 10 years at Strattec.

The stock may be cheap too. I’m not ruling that out. But, even if it is very, very cheap today, if some investor had taken over Strattec ten years ago and set out to emulate Buffett’s capital allocation adventures at Berkshire Hathaway, shareholders of Strattec would be better off today.

Why?

For the past ten years, Strattec was a cash flow machine. To create value at a cash flow machine you can do one of three things 1) turn it into a compounding machine (like Buffett did at Berkshire) 2) turn it into a dividend paying machine, or 3) turn it into a EPS growth machine, either by growing the business, or buying back shares at low prices (relative to earnings).

Growing the business was out of the question at Strattec. It’s a big player in a small industry, and it was dependent on its key customers (GM, Ford, and Chrysler) growing their business. They didn’t. As a result, Strattec was starved for growth. It was (through no fault of its own) a cash rich, growth poor – highly profitable but hopelessly stagnant company.

Creating an EPS growth machine through stock buybacks was also a difficult proposition as Strattec had an average P/E of over 13 during the last ten years. While a P/E of 13 isn’t especially rich; it isn’t an especially low multiple for a no-growth business either.

Therefore, buyback fueled EPS growth would have been costly.

If an investor took control of Strattec ten years ago with Buffett’s mindset (but not necessarily his skills), he would have richly rewarded shareholders over that ten year period.

How would this work? And why would it work?

Intelligent capital allocation provides some value in this kind of situation even if capital isn’t allocated to investments that produce above-market returns, because something is being done with the cash.

If Strattec hadn’t bought back its own stock, and had instead created a stock portfolio into which it put all its free cash flow, that portfolio would now be worth over $150 million even if it achieved nothing in the way of returns. This would have resulted in Strattec being worth much more today, because Strattec would be valued as a $150 million closed-end investment fund with an automotive lock business thrown in.

Instead, the company has a higher EPS than it otherwise would as a result of spending $95 million buying back shares; it also has about $60 million in cash sitting on the balance sheet – unfortunately, the market tends to value that $60 million less optimistically than it would if it believed the cash would be invested (at the holding company level) in a basket of stocks that would be held for many, many years.

Capital reallocation would not have weakened Strattec’s financial condition in the least. In fact, it would have strengthened the company’s financial condition, because by now the holding company would have close to $100 million more that the lock business could tap in times of trouble. Strattec would be even more ridiculously overcapitalized than it is today – since, the $95 million in cash spent on share buybacks would still be on the balance sheet (rather than in the pockets of former shareholders).

This is a very conservative picture of what would have happened if an investor took over the capital allocation job at Strattec ten years ago and left the management of the lock business in place.

Why?

One, because Strattec really did produce $155 million in completely free cash flow – so, even if a stock portfolio at the holding company level did absolutely nothing over that time period, it would still have approximately that much in cash (invested outside the lock business). Returns in excess of zero over that time period would have grown the value of the company’s investments.

Two – and this point is of tremendous importance – the capital allocator at Strattec would have been ideally situated to make extremely intelligent investments (just as Buffett was at Berkshire).

Why?

Because the capital allocator at Strattec would have been in the same position as a mutual fund manager – except he’d have no fear of redemptions, no need to produce market beating returns within any single year or quarter, and fresh cash coming in each and every year.

What did Buffett do under similar circumstances? A lot of things. But, one of the most important things he did was buy big chunks of businesses he believed in at deep discounts to intrinsic value. Could a capital allocator at Strattec have done this?

The lock business would have been producing both earnings and free cash flow each and every year. Let’s assume the amount of free cash flow produced by the lock business was $15 million per year.

If the capital allocator had $15 million a year in cash to invest, he would have needed to find one good opportunity a year in public companies with market caps in the $100 - $150 million range. This would have given Strattec Berkshire like 10-15% stakes in public companies.

The capital allocator at Strattec could have lessened his work load even further if he limited himself to bigger companies – say those trading in the $200 - $300 million range.

Then, he’d need only one good idea every two years. As you move up the market cap ladder, great ideas tend to become scarcer. On the other hand, you can certainly wait for a perfect pitch if you only need to swing once every two years.

Why does this capital allocation conglomerate model work?

It provides several benefits. Among the most important are:

1) A way to put cash to work
2) A rock-solid financial position
3) Extreme focus at every level – especially the top

The first point is obvious. The second point is easier to overlook. Berkshire can achieve good returns while overcapitalized, because it’s a capital allocation conglomerate.

Financial strength isn’t a trait peculiar to Berkshire. Any holding company modeled on Berkshire would naturally tend towards a rock-solid financial position, because that’s the nature of the beast.

Management could intentionally undermine this rock-solid financial position by using leverage, but unless they did, such a holding company would tend towards financial strength as a result of the holding company’s capital reallocation activities.

Think about it.

How do slow growth, cash flow machines create value for shareholders?

Two ways: dividends or share buybacks. Both ways weaken a company’s financial position by returning cash to shareholders. Share buybacks can increase earnings per share, but they still take cash from the company.

Now, how does a compounding machine create value for shareholders?

It buys stocks or businesses. Both of these actions strengthen a company’s financial condition. The company’s assets are not distributed, they are invested. Diversification increases in either case. Stocks are highly liquid, but they are also solid long-term investments that offer capital appreciation and some inflation protection. Operating businesses can also offer capital appreciation and inflation protection – but more importantly they offer additional free cash flow from a different source.

The process of building a compounding machine naturally leads toward extreme financial strength– not because the capital allocator seeks to maximize the conglomerate’s financial condition, but rather because he seeks to maximize shareholder wealth without buying back shares or paying out dividends (which are normally the only options available to a high free cash flow, low growth business).

This is exactly what would have happened at Strattec if a capital allocator with a Buffett like mindset had taken control of the company ten years ago.

Look at the company’s results for those ten years and try to imagine what the company would look like today. Even if the capital allocator wasn’t especially skilled, shares of Strattec would almost certainly have a higher market value today than they do now – and the company would have an even stronger financial position.

That’s the natural progression for a capital allocation conglomerate built on a high free cash flow, low growth business. Businesses like Strattec become more valuable when they are part of a capital allocation conglomerate than they are on their own.

Likewise, the private businesses Berkshire buys become more valuable when they are part of Berkshire than they were on their own.

As separate businesses, they can harvest their profits – but they can’t plant new acreage.

As a result, next year’s yield will look a lot like this year’s yield. But, at Berkshire, Buffett can plant new fields using harvests from prior years.

This allows Berkshire to grow faster than the sum of its parts. Buffett harvests the old fields and plants new fields.

Of course, at Berkshire, there’s also the small matter of insurance (and the float it provides). But, that’s not worth talking about, because no one will argue that an insurance company isn’t worth more when it can invest its float than when it can’t. That’s already a generally recognized truth.

When you combine both elements – cash flow from operating businesses and float from insurance businesses – you have the fuel that propels Berkshire’s growth.

Visit Gannon On Investing Book Store

Books are an important part of value investing and an important part of this site. They were an important part of value investing right from the beginning – when Benjamin Graham and David Dodd published Security Analysis in 1934 and they were an important part of this site right from the beginning when I reviewed that august title and others on my podcast back in early 2006. Since then, Steven Rosales of Value Blog Review has helped fill the void on this site by supplying reviews for this site’s book reviews section.

Finally, I’ve gotten around to improving the lack of good reading resources on this site.

I’ve created a Gannon On Investing Book Store.

It’s very simple. But, I think you’ll find it useful. I’ve included and categorized value investing titles in the way I thought would be most helpful. The best part of the store is probably the Gurus Section where you can find book written by Benjamin Graham, Phil Fisher, Peter Lynch, Joel Greenblatt, David Dreman, Mohnish Pabrai, Marty Whitman, John Neff, and Phil Carret.

I’ve also included a general Value Investing Section.

Then, there’s the Buffett Books Section and the Buffett Quotes Section.

I rounded out the collection with investor profiles, books that broaden your horizons, and business books – all three selected with the investor in mind. Every book in the store is investor centric.

Finally, I added a section for all the books reviewed on this site – mostly by other people.

Let me know what additional categories you’d like to see added.

As for personal picks, there will be plenty of time for that later, but for now the one book I’d recommend for anyone and everyone is Roger Lowenstein’s excellent but outdated biography Buffett: The Making of an American Capitalist.

For the true Buffett buff, the hands-down favorite is “Of Permanent Value: The Story of Warren Buffett ”. It’s basically an entire Warren Buffett museum crammed into two hardcover books – at $50 it’s an absolute steal and a beautiful book. I’m surprised Amazon still has copies.

If you have any questions about my favorite editions of certain titles, which editions of Security Analysis are canonical and which are apocryphal, and how you can find titles that can no longer be purchased new – please send me an email.

Regarding the store – comments, suggestions, and complaints are welcome.

Browse Gannon On Investing Book Store

Visit Value Blog Review

Steven Rosales of Value Blog Review writes most of the book reviews that appear on this site. Steven is relatively new to investing. He posted his year-end results for 2007.

Envious bloggers are hoping it’s a simple case of beginner’s luck.

See Value Blog Review Year End Results

Visit Value Blog Review

Heeelys (HLYS), which was included in Cheap Stocks list of Potential Bargains in Profitable, Cash-Rich Double Net/Nets Part II on December 8th, 2007 (last trade: $6.82/share; NCAV: $4.48/share), filed this resignation letter written by a member of the board and addressed to the company’s CEO (emphasis added):

December 17, 2007

Mike Staffaroni, President and CEO
Heelys, Inc.
3200 Belmeade Drive
Suite 100
Carrollton, TX 75006

Dear Mike:

Effective immediately, I am resigning from the board of directors of Heelys, Inc.

As you know, I strongly support your vision for the company and your strategy for realizing it. Regrettably, a majority of the directors voted at the November meeting for an ultimatum expressing dissatisfaction with your performance, an action I openly opposed (that is not reflected in the minutes) and one that I feel signals an unjustified lack of confidence in you and your strategy. I am unable and unwilling to support the majority’s alternatives and directives.

You have put together a first rate management team and led Heelys to extraordinary success. I have greatly enjoyed my association with you and wish you well.

Sincerely,

Jim Kindley

Nautilus (NLS) issued the following press release yesterday:

Nautilus…and Sherborne Investors LP said today that the voting results from the December 18, 2007 special meeting of shareholders confirmed that all four Sherborne Investors nominees have been elected to the Company's Board of Directors. The final voting results, which were certified by IVS Associates, also showed that all of Sherborne Investors' other proposals were passed.

Effective immediately, Edward Bramson, Gerard Eastman, Michael Stein and Richard Horn will join incumbent directors Robert Falcone, Ronald Badie and Marvin Siegert on the Company's Board. Mr. Bramson was elected as Chairman at a meeting of the Board today and Mr. Falcone will remain as President and Chief Executive Officer. Mr. Siegert will remain as Audit Committee Chairman, Mr. Stein will be Chairman of the Compensation Committee and Mr. Horn will be Chairman of the Nominating and Governance Committee. Mr. Badie will remain as Lead Independent Director.

Edward Bramson said, "We appreciate the support of our fellow shareholders and look forward to working with the new Board and management to implement an effective strategy at Nautilus to return it to profitability and establish a platform for future growth."

"I look forward to working with our newly reconstituted Board of Directors," said Bob Falcone. "I believe very strongly in the future of this Company and am committed to implementing the necessary actions to restore it to sustainable growth."

Shares of Nautilus closed up $0.07 (1.44%) at $4.92. At their highest point today, shares reached $5.50.

Value Investing News completed its first full calendar year in 2007 – and my post entitled “Gannon to Barron’s: Berkshire Fairly Valued…As a Buffettless Empire!” won the title of best value investing article and link submission for 2007.

It’s no surprise that a Berkshire (BRK.B) article received the most votes (the folks over at Value Investing News aren’t exactly Buffett haters).

However, it is surprising that the article managed to rise to the top of the 2007 heap in just two weeks of voting (it was submitted on December 16th). As George points out, this was made possible by the tremendous growth over at Value Investing News. The number of users skyrocketed over the past year.

Also, as articles were submitted at a more feverish pace, they were either voted up or lost in the shuffle a lot quicker. So, the difference between a top story and a neglected story is now determined pretty fast on Value Investing News, because the community there is so much larger and more vibrant than ever.

Apparently, I’ll be getting a trophy badge to display on my site – once George designs it. I’ll also be getting a copy of Vitaliy Katsenelson's Active Value Investing – a book I reviewed favorably back in October.

This contest reminds me that I still have duplicate copies of some excellent value investing books and I ought to be holding some contests of my own to share the wealth. Expect them some time in early 2008.

I’d like to say the obligatory “I never expected this”, etc., etc. – but, really I can’t. I didn’t expect a free book. But, as I was writing the post, I knew it was perfect for Value Investing News. My post got circulated much more widely as a result of its exposure at Value Investing News; evidence of this fact can be seen by entering the title of the post into Google. The actual blog post on my site is far from the top result. Normally, my posts don’t get much mention in sites with higher page ranks.

So, thanks to Value Investing News for the award – and more importantly, for spreading the word. For those who frequent either Value Investing News or my blog, this post was definitely one of the highlights of 2007.

By the way, I actually enjoyed the Barron’s article – I’m glad they ran it. Barron’s is an excellent publication and my favorite weekly by far. They haven’t always been bearish on Berkshire. However, their valuation process in the article was fundamentally flawed as Berkshire has partially transformed itself from an asset based entity to an earnings based entity.

Berkshire still holds a lot of marketable securities; but, it’s as much a conglomerate as a closed-end fund these days. If you apply either a price-to-book ratio to the whole company or a price-to-earnings ratio to the whole company you’re going to end up with a very whacky intrinsic value estimate.

You have to recognize the parts for what they are and value them accordingly – marketable securities can be valued at market prices but operating businesses have to be valued on their earnings.

Berkshire’s purchases of Iscar and Marmon made it clear that Berkshire isn’t just a basket of stocks anymore. What matters to Buffett (and Berkshire shareholders) is what each dollar spent by Buffett adds to Berkshire’s market value. How much does each dollar spent buying minority stakes in public companies like Bank of America (BAC) or Burlington Northern (BNI) add to Berkshire’s market value? How much does each dollar spent by Berkshire buying majority stakes in Iscar or Marmon add to Berkshire’s market value?

If you don’t have a valuation process that can make sense of Buffett’s actions and look at a dollar spent buying part of a public company versus a dollar spent buying all of a private company – you don’t have any way of evaluating Berkshire as a whole or Buffett as Chairman. You just have a way of saying this amalgam called Berkshire once traded at a price-to-book ratio of “x”; now it trades at a price to book ratio of “y”.

That proves the relationship between Berkshire’s market price and its book value has changed. But, has the relationship between Berkshire’s intrinsic value and its book value changed as well?

If Apple (AAPL) once traded at a low P/E ratio and now trades at a high P/E ratio, wouldn’t you ask whether there had been changes in the business that justified that change in valuation? Are earnings likely to grow in the future? Has the business fundamentally changed? Is the company’s value now derived from the same products and industries, or different ones?

People see this when they write about businesses where they can add an earnings growth rate estimate to their model, but somehow they miss this when a company is undergoing a fundamental change from a marketable security heavy holding company to an operating earnings heavy holding company. I wanted to call attention to that error. That’s why I wrote the post.

Read “Gannon to Barron’s: Berkshire Fairly Valued…As a Buffettless Empire!”

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On April 1st, 2007 Clyde Milton of Cheap Stocks answered 20 questions. Today, he answers seven more.

Read 20 Questions for Clyde Milton of Cheap Stocks

Clyde Milton became enamored with deep value, off the beaten path investment ideas through years of fundamental research, and ultimately, as a writer/editor for a now defunct personal finance magazine.

He strives to research stocks that few others will, using valuation techniques based on Ben Graham's ideas (such as stocks trading below their net current asset value) as well as some ideas he has developed himself.

Milton freely admits that his site is written under a pseudonym; Clyde and Milton being the first names of his beloved grandfathers, to whom the site is dedicated. While Cheap Stocks was originally launched primarily to keep Milton's research and writing skills sharp (and not as a public site) it has developed a following.

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Which do you tend to invest in - high quality businesses or cheap stocks? Why?

Well, in a perfect world you'd want a hybrid: high quality businesses at cheap prices. In practice though, I tend to invest in stocks that are cheap, and honestly, they are not always high quality businesses. There is huge risk, however, if you don't do your homework. You've heard it before: Stocks are often cheap for good reasons, and the art is to not fall into the value trap that you can easily become prone to.

What have your experiences with each been? What have you learned?

I've learned not to jump in too quickly, not to fall in love with an idea, to limit initial position sizes, to stagger purchases, and that it's prudent to throw in the towel on a bad idea before it fails. As investors, we are all prone to behavioral biases. Some are hard to shake, others you can learn to deal with through experience...usually a bad experience.

How focused a portfolio do you tend to keep?

My current portfolio is about 20 names, and there's definitely an asset focus toward water, land or other assets that I believe are not properly valued.

What are your views on diversification and concentration?

Diversification is a great word: it tends to disappear from investor's vocabularies during a great bull run, then re-appears when the market tanks. But the truth is, it is imperative to be well diversified. While my stock portfolio is somewhat concentrated, and not well diversified, it is just one piece of the puzzle: My portfolio’s beta exposure comes from other sources.

Diversification is the word you did not hear in the late 90's, and it's made a huge comeback! I say that in jest, but it's amazing what a bear market will do to investors. I am a huge believer in diversification, especially in the context of building a portfolio designed to meet an investor's goals. It's not a one size fits all proposition.

How do you deal with general market risk and specific business risks?

I'm not all that concerned with market risk in terms of my stock portfolio; most names have fairly low correlations with the overall market. In terms of business risk, I limit initial position sizes, and will occasionally use trailing stops. Keep in mind, though, a portion of my portfolio is in thinly traded issues, where trading is rare--a trailing stop is of little use here.

Do your very best investment ideas tend to greatly outperform your inferior investment ideas?

Any self respecting portfolio manager might say that all of his ideas are the very best, but it certainly is not true in my case.

There are times when I am taking additional risk, perhaps the business is not great, and is selling for $5, but I believe it is worth $10, regardless of whether the business improves. Those situations usually take longer to pan out, if they pan out at all. I am less inclined these days to take a position in such a situation — that’s from experience, and learning lessons about value traps, and poor assumptions.

Can you normally identify which ideas you are most confident in – in other words, do you often have "higher conviction" ideas and "lower conviction" ideas?

Definitely. Part of that comes through analysis, but you also develop a gut for it as well. You learn to separate truly good ideas from those where the risks are much greater.

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Read 20 Questions for Clyde Milton of Cheap Stocks

Previous Interviews

20 Questions for Clyde Milton of Cheap Stocks

20 Questions for Bill Rempel (a.k.a. No DooDahs)

20 Questions for MarketWizWannabe of RVB's Market Musings

20 Questions for George of Fat Pitch Financials

20 Questions for John Bethel of Controlled Greed

20 Questions for Robert Freedland of Stock Picks Bob's Advice

20 Questions for Joe Citarrella of Joe Cit – Intelligent Investing

20 Questions for Jay Walker of The Confused Capitalist

20 Questions for Richard Beddard of The Interactive Investor Blog

20 Questions for Todd Sullivan of ValuePlays

Lincoln Minor of Reflections on Value Investing links to an excellent talk given by Steven Crist of the Daily Racing Form at the Legg Mason Capital Thought Forum.

This is a great talk. Anyone interested in investing should read the whole thing at least once.

Read Steven Crist’s Talk at Legg Mason Forum

I am here to talk about why most of what you have heard about horse racing is wrong, and why horse racing is much more similar to what you do than other forms of gambling. The general public probably thinks that for the most part, horse racing is just like the state lottery or playing craps or roulette in a casino, except that you have horses running around in circles rather than ping pong balls or a spinning wheel… The reason that you can win at poker and horse racing is the same - you are not betting against the house; you are betting against the other players. This is such a crucial and fundamental difference, and it is lost on the general public…. When the other players are setting the prices, it is an entirely different story because somewhere between frequently, occasionally and rarely, the public makes the wrong price. That is the beginning of the successful equation in horse racing…. In ten minutes I can teach anyone in this room how to pick the most likely winner of a horse race. There are data about past performance that we publish in the Daily Racing Form that correlate very strongly with the most likely winner in the race. Most horse players spend their lives thinking that if they just studied a little bit harder or got a little bit smarter, they could pick the winner of the race enough to make some money. There is no such thing. Picking the most likely winner is no great feat…. What you really want to do is determine which most-likely winners are good prices and which most-likely winners are bad prices. It is a very simple equation:

Price X Probability = Value

The entire world of investing is that simple too.

Asif Suria of SINLetter.com is running a stock picking contest where Top Financial Bloggers Face-Off. He invited me to join the contest, so I thought I would post my entry on this blog. The contest length is Q1 of 2008. It requires that you pick three stocks (either long or short) and a prediction for the S&P 500 at the end of Q1 2008 (to be used only as a tiebreaker). I didn’t want to worry about the S&P 500 prediction – so I just entered 1470 as my prediction (last: 1468.36).

All three of my picks for the contest are long. They are Bank of Ireland (IRE), NutriSystem (NTRI) and YRC Worldwide (YRCW).

Bank of Ireland (IRE) - $60.44
Irish stocks are cheap. Irish banks are even cheaper. IRE has very strong position in attractive banking market. More conservative than most large banks trading at higher price-to-earnings, price-to-book, and price-to-dividend. A competitive dividend yield should help encourage buying even if dividends don't count toward the contest.

NutriSystem (NTRI) - $26.98
Stock shorted like a fad last year – but company isn’t a fad. Beaten down to extremely cheap levels. Should be buying back own stock at these levels. Wonderful business model with plenty of revenue from customers once acquired. Can afford to pay a lot in advertising to acquire a new customer. Program works; people actually lose weight without any unpleasant side effects. Hit hard by new diet drug. Launching a new, improved program (now) in Q1 2008. Management has shown they know how to design, market diet programs better than anyone else. But, most of all, the market has set the bar very, very low on this one.

YRC Worldwide (YRCW) - $17.09
Big, cheap trucking company. Cheap on just about every measure. Not expensive on trailing earnings; even cheaper on any sort of average, normalized earnings. High operating leverage causes extreme sensitivity to small changes in the U.S. economy – so those betting for a recession will bet against YRCW; but, in time, the price of YRCW has to move back to something approaching normalcy over a full cycle. No reason to think YRCW shares won’t improve before the industry does. Good stock at best; untimely at worst.

For the contest, the picks won’t actually be priced until after the first day of trading of 2008. So, the prices shown above are just year-end quotes on the three stocks. Contest rankings will be based on percentage changes in stock price over the course of the first quarter of 2008 – regular dividends don’t count for or against you whether long or short.

See Contest Rankings

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Here are some of this blog’s most popular posts from 2007:

Gannon to Barron’s: Berkshire Fairly Valued…As a Buffettless Empire!
Pompous Prognostication: Irish Banks
Book Review: Active Value Investing
The Eight Best Investing Blogs
20 Questions for Clyde Milton of Cheap Stocks
The Normalized P/E Ratio Series
On Posco, Berkshire, and Buffett

Predictions

It’s something of a tradition in all financial media to do predictions at this time of year. The more predictions you make the fewer predictions people tend to remember – this can be a good or bad thing depending on your prophetic powers.

Anyway, I’ll stick to just one country and one stock. The country is Ireland and the stock is Bank of Ireland (IRE).

We’ll see how that pick does for 2008 – hopefully, I won’t look too stupid on January 1st, 2009.

Feedback

I’m planning some changes for the site. I’d appreciate any feedback about what you love or hate about this site. It should help me plan for the future. If you’ve been reading this blog for a long time – or if you remember the podcast – I’d appreciate any comments you have. Please email them to me.

Forget about the upcoming presidential primaries; it’s already election night at Nautilus (NLS) – and the early exit polls favor the challenger.

Shareholders met Tuesday to settle a proxy fight between an activist hedge fund and the fitness equipment company’s incumbent board.

Late Tuesday, Sherborne Investors, LP (which owns 25% of the shares outstanding) declared victory in its proxy fight at Nautilus. The hedge fund claims it won four of seven board seats (which will effectively grant control of the company).

Nautilus Chairman & CEO Robert Falcone has yet to concede defeat.

Early reports provided subtle hints of a Sherborne victory with Falcone being quoted as saying, “Our proxy service says it's close, but we just don’t know at this time” – and even more ominously, “It’s a dead heat.” Meanwhile, Sherborne’s representative was “optimistic” and claimed shareholders were “fairly supportive”.

News reports indicated the shareholders in attendance were dissatisfied with both parties’ presentations, with one shareholder saying, “Nothing was said here that hasn’t been said before.” In a series of press releases leading up to the meeting, Nautilus had been particularly expansive in its criticism of Sherborne which has been successful in several proxy fights, but hasn’t always had success in creating long-term shareholder value (in one case, that’s putting it very mildly).

Most shareholders I talked with in the lead up to the election had a low opinion of Sherborne and an even lower opinion of the board.

If the preliminary results hold, the greatest casualty of the fight will be Robert Falcone who was made interim CEO in August and (non-interim) CEO in October. His predecessor Greg Hammann stepped down in August. Falcone was then the company’s lead independent director.

Sherborne has already stated that Falcone will be removed as CEO. Technically, Falcone will retain his board seat. However, everyone’s expectation is for a quick and unceremonious resignation if the early results hold.

Falcone can’t be accused of inaction during his four month tenure, as this article makes clear:

Falcone has made several significant moves in his short tenure, including laying off 9 percent of the company's work force and cutting expenses by more than $10 million annually. He's also implemented an inventory reduction plan that should pump $20 million into the company's coffers. Falcone also continues to look for a buyer for the company's Pearl Izumi fitness apparel business.

Shares of Nautilus have traded between $18.63 and $4.31 this year. During today’s trading session (before Sherborne claimed victory), shares of NLS were up $0.97 or 17.32% to close at $6.57.

It will be interesting to see how the votes were distributed, as a couple shareholder advisory services had recommended electing some (but not all) of Sherborne’s nominees.

Note: No one at Nautilus has conceded defeat and it will be a couple weeks before any actual votes have been counted and verified. However, because most shareholders vote their proxies in advance, Sherborne’s proxy solicitation firm should know whether the proposals passed. As late as tonight, a Nautilus spokesman was still calling Sherborne’s declaration of victory, “highly speculative.”

Regardless, it’s a rare example of shareholder democracy – a close, contested election between two parties with opposing views. Of course, in corporate politics as in presidential politics, a good process doesn’t guarantee good results.

Barron’s “Sell Warren” cover story is now available to non-subscribers. Read it here.

A few other blogs have commented on the story, some recent examples include a post from the Peridot Capitalist and a post from 24/7 Wall St.

If you haven’t already, you can read my response to Barron’s cover story.

Finally, visit Value Investing News for all the latest posts on this and other Warren Buffett / Berkshire Hathaway stories.

Right now, the Barron’s article and the responses to it are among the top stories at Value Investing News.

Read Barron’s: "Sorry, Warren, Your Stock’s Too Pricey”

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