Sears Hunts for Restoration

Last night, Sears Holdings (SHLD) disclosed a nearly 14% ownership stake in Restoration Hardware (RSTO). Restoration, a specialty retailer of hardware, bathware, furniture, lighting, textiles, accessories and gifts, has a few retail locations but focuses the mostly on its direct-to-consumer catalog/Internet business. RSTO shares were up significantly in after-hours trading following the disclosure. Sears acquired the shares at an average cost of $5.69, including commissions. RSTO shares closed at $6.33 yesterday prior to the announcement.

This is interesting news because Eddie Lampert, Sears’ Chairman and the person designated to invest Sears’ excess cash, has been relatively quiet lately. Sears Holding stock appears to be down in large part due to lack of activity; the disclosure last night may give the market some impetus to drive shares higher. In the 13D filing, Sears disclosed that it had engaged in discussions for a transaction at an initial price ($4/share when shares were at $2.87) that was much lower than RSTO’s current price. Chairman Lampert, the President of Land’s End, and a Sears director together visited with Restoration’s management regarding a merger, only to learn that RSTO’s management was considering a management-led buyout. Though initial talks went nowhere, Sears is currently seeking a confidentiality agreement and to engage in a due diligence process regarding a strategic alliance or merger.

Restoration appears to offer products complementary to Sears’ own and a partnership (or acquisition) with them could bring important synergies as Sears could drive those products through its retail locations. Lampert is very smart and I’m sure he would like to see more here than a minority ownership. Despite that, he is not someone who overpays for assets. Perhaps we’ll get a little more color on this when Sears Holdings releases its third quarter results on November 29th.

Full disclosure: Long shares of SHLD.

Where Is the Bottom?

"Many will be restored that now are fallen and many shall fall that are now in honor."

Where is the bottom? At this point, it doesn’t seem like there is one with banks and mortgage-related companies. Several very good companies’ stocks are down more than 50% year-to-date, yield in excess of 10%, and in many cases trade below book value. I’ve seen many of them trade down 5-10-15% in one day on no specific news. Fear is pervasive. Investment capital continues to shift to commodity-related companies – energy, materials, industrials – which continue to perform well, from bank and mortgage-related stocks – on concerns about bad loans – which are performing terribly. Yet the degree of stock price selloff in many cases is disproportionate to the actual levels of economic value that may be impaired by escalating loan losses. Eventually, stock prices will reflect the companies' true fundamentals.

While it is nearly certain that many banks and mortgage companies will experience lower levels of profitability over the next few years, that profitability is well below normal. Yet the stock market is valuing many as if declining loan losses will continue indefinitely, all dividends will be discontinued, and book value will erode far beyond its current levels. While these scenarios are inevitable with some specific names that are less prepared for a more difficult credit and economic environment, several will do very well as market sentiment shifts.

It is important to keep a clear head in this environment. Investors seek to earn a total return on their capital over time and historically dividends have been a big piece of that return. At their current quotations, some financial stocks offer (growing) yields of 10% or better. This happens to be the S&P 500’s approximate average annual return over 70+ years. At those yield levels some very good companies trade for in the market today, one need not see any price appreciation from here to earn satisfactory returns over long periods. But when most of the problems seem resolved, the market is not likely to leave yields at these levels for long.

For those looking for a diversified way to play this opportunity, take a look at the Financial Select Sector SPDR (XLF), which continues to (not surprisingly) hit 52-week lows. It yields 2.8% and trades at 1.6 times book value. For those unwilling or unable to handle the short-term volatility, buy a long-term call option on the XLF out to January 2010 at a strike price of $30 (roughly its current price). Buying the calls now cost $5.75 for a net cost basis of less than $36 if shares are worth more in a couple years. Also attractive (and probably more so) is the iShares Regional Banks ETF (IAT).

The quote at the beginning of the post sums the case up nicely, and for those willing to venture into individual names there are opportunities for significant upside potential with little risk of permanent capital loss.

Full disclosure: No positions in the securities mentioned.

"Good" Mortgage News

Countrywide Financial (CFC) reported a huge quarterly loss yesterday, amounting to $2.85 per share. Most of this was a noncash charge to write down asset values – both of performing loans that are simply now worth less in the marketplace today as well as securitization residuals, on which there is not likely to be a recovery of value. CFC also added meanginfully to its loan loss reserves as delinquencies rose during the quarter. With respect to residuals, there is still $900 million on the balance sheet. On the other hand, there are between $900 million and $2.7 billion of mortgage servicing rights not reflected on the balance sheet, according to management. The conservative thing to assume is that both are $900 million and thus offset each other, having no effect on book value.

After today’s write-down and the 32% stock price rally, the stock still trades below its diluted book value of over $20. Now, in the near-term, book value is tough to get the arms around. Is it too high? While you may not be able to liquidate the company for that, as long as CFC has the ability to hold the loans they can wait for more favorable pricing. In this case, the economic value of the loans on its balance sheet could be even higher. While GAAP encourages write-downs of assets deemed permanently impaired, it does now allow “write-ups.” So if asset values are significantly written down due to higher loss assumptions that do not materialize, the balance sheet values will actually understate the economic value. Despite this possibility, I assume things will get worse.

In a more normal environment, Countrywide can earn returns on equity of 15% or greater. In this case, the company should be worth in excess of $30 per share versus its current price of around $17. In my view, that is a big enough discount to offer a solid margin of safety. Management, while surprised by the depth with which the credit market disruptions affected their access to the capital markets, is now stronger. Loan underwriting standards have already improved. During their conference call Friday management offered a slide I would call their "oops" slide showing the past business they would underwrite now versus under their old underwriting guidelines. On $170 billion of business underwritten 2006 and before, only less than $60 billion would have been accepted under the new guidelines. That is an admission of how lax their standards became and explains why loans on 2005 and 2006 vintages are performing as poorly as they are currently. Loan performance from those years certainly would be a lot better now had the company (and most of its competitors) not been as aggressive in pursuing market share while ignoring prudent underwriting principles.

While the company is not out of the woods, it seems they are dealing well with the current market realities. Access to capital has improved and the company is working to virtually eliminate its reliance on the commercial paper market, formerly its largest source of short-term financing. Having migrated its primary financing to the bank, near-term growth will slow as the company either sells loans to GSEs or holds them on its balance sheet. Given its exit from certain lines of business and elimination of 10,000 to 12,000 employees, Countrywide from here will grow from a much smaller base. But the company is poised to take share in a smaller, more rational market and be a meaningfully more profitable company in future periods than it is today.

The credit market turmoil is not over. The housing market is far from recovery, having not yet bottomed. There is still substantial excess housing inventory that must be lapped up. In some areas, prices went up far too much for far too long to not have a longer “payback” period where the excesses are wringed out and prices move more into alignment with income levels. There are more shoes to drop, but this news from Countrywide is reassuring to investors who have watched the stock freefall amid panic selling the last few months. Yet for a value investor, the bigger the discount to underlying business value, the greater is the implied future return on the stock.

Full disclosure: Long CFC shares and call options.

Wisdom from Forbes' Second Wealthiest American

"...The scorecard on our investment decisions will be provided by business results over [many years] and not by [stock market] prices on any given day. Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near-term earnings or recent trends in earnings when purchasing small pieces of a company; i.e. marketable common stocks."

- Warren Buffett, March 1978

A Win-Win Deal?

Bank of America (BAC) scored itself a sweet deal, announcing yesterday that they’ve acquired $2 billion worth of 7.25% convertible non-voting preferred securities in Countrywide Financial (CFC). The securities are convertible at $18.00 per share, so they’re already in the money by over $4 per share. Assuming the preferreds trade at a price based only on the underlying common stock, at this point they're sitting on a capital gain of nearly $500 million. Both sides are touting it as win-win, though it gives some insight into the terms B of A can garner given its reputation and solid finances.

So why did Countrywide accept terms that appear to offer asymmetrical economic benefits? Put simply, the credit market continues to be tight and it’s difficult to discern how widespread or deep the problem could go. Credit was abundant for a long time as risk premiums declined to historic lows. Now, to paraphrase Warren Buffett, the hangover may be proportional to the binge. Countrywide’s primary funding sources, or “oxygen” as CEO Angelo Mozilo calls them, are commercial paper, the repo market, and medium-term notes. The markets for each of these has more or less seized up. The Fed’s discount window is available to them, but only to the Banking division. But the bank doesn’t have sufficient assets to borrow in amounts that will put much of a dent in the needs of the Home Loan division, where most of the assets are held. Over time, as the banking business becomes the primary funding source for home loans, the discount window would be a much more viable source of funds. But it isn’t at this point.

To make a long story short, Countrywide needs capital to continue funding new loans. The transaction gives Countrywide some additional capital along with the implicit backing of deep-pocketed Bank of America. Countrywide has traded some of its economic value (offering a conversion price that is half what the shares are worth) in exchange for a strong endorsement and (at least implied) reliable access to capital.

How does this affect Countrywide value to common shareholders? It dilutes shareholder value, but because it saves them from selling off assets at fire-sale prices to continue to finance operations, it looks to be more wealth preserving than wealth destroying. Start by assuming B of A waits to convert. In this case Countrywide is on the hook for $145 million in preferred dividends, which is around 5% of the company’s 2006 net income. The 7.25% interest rate is reasonable, but does not enjoy the tax break that interest receives (preferred dividends are paid from net income, not pretax income). But the additional expense is not unduly burdensome.

In calculating per-share value, I assume B of A will convert the shares, which adds an additional 111 million shares to Countrywide’s 562 million outstanding. So the share count goes up by nearly 20% and B of A owns 16-17% of the company. Book value (as of June 30th) now is a little over $20 (down from over $24) after considering the dilution. The widespread credit market problems have destroyed some shareholder value here, which is why a margin of safety in initial purchase price is so important. Though this is only a start, Countrywide is now on more solid footing. The media, which has been a part of the problem these past few weeks should now (hopefully) cast the company in a more positive light going forward, which should reinforce confidence in the company by its investors, depositors, and other stakeholders.

Full disclosure: Long CFC and BAC shares.

Panic Sellers Want Cash

The recent market selloff, led by financials and consumer discretionary stocks, looks very much like a panic. By mid-day Thursday, the S&P 500 was down 10% - an unofficial "correction" level. The last couple weeks have been one of the best times to invest new money in a very long time.

Over the past few weeks, we've seen indiscriminate selling across the board. For instance, one company I watch very closely was down as much as 50% since the end of June, a result not of its own operational problems but of being lumped into a broad category along with American Home Mortgage (AHM), a just-bankrupted mortgage REIT. Yet its business model and risk profile is very different than the typical “mortgage REIT.” It has now rebounded 50% from its lows and the indiscriminate selling offered a great opportunity to add to positions. This situation is not isolated only to this one stock; I've seen it with many others.

Countrywide Financial (CFC), a company I’ve mentioned here as a reasonable value at higher prices, is down 50% year-to-date on concerns the company doesn't have access to enough liquidity to continue funding its operations. I’ve read all the recent filings and press releases, but what has been reported in the media based on those communications has amounted to “spin.” In the most recent example, the widely reported news that “Countrywide is forced to max out its credit line” was an exaggeration. True, CFC did max out one of its credit lines, but has access to quite a bit of additional short-term liquidity that will allow it to continue making loans. And now, with the Fed cutting the discount rate Friday to 5.75% and the borrowing term now 30 days renewable, CFC now has access through its bank to highly-available, reasonably-priced capital.

As of June 30, CFC was paying its depositors a weighted-average rate of about 5.15% on deposits and is now offering 12-month CDs at 5.65%. Discount window loans won’t cost them much more. Countrywide is continuing to make loans and take market share. They bought five branches from HomeBanc a few days before it entered bankruptcy and are hiring workers from American Home, previously mentioned. Year-over-year through June 30, market share rose to near 19% from under 15% last year, and funding grew despite an overall mortgage market that was down 10%. I cannot summarize the entire investment case here, but I (still) believe CFC shares are an excellent value at current prices, but are not for the faint of heart because the road will be very bumpy until the dust settles.

As Ben Graham said, “In the short term, the market is a voting machine; in the long-term, it is a weighting machine.” And in the past few weeks people have “voted” by taking their capital out of the market, and especially certain sectors. During just the past week ended Thursday, $585 million was pulled from the Select Sector SPDRs Financial fund (XTF), which was nearly 20% of its assets. Money market funds reported net inflows of $41.484 billion, the largest year-to-date. The week prior to that, money markets had net cash inflows totaling $36.229 billion, the largest inflows since 12/7/05. Investors are selling stocks (and bonds) and going to short-term funds to “wait out” the storm. As a value investor, I am happy to turn over some of my cash for the undervalued assets they’re selling.

The best time to get in is when everyone else is getting out. Analyze well, consider worst-case scenarios and downside risk, and if your reasoning and analysis are good market prices will eventually reflect economic reality, regardless of the irrationality of Mr. Market.

Full disclosure: Long CFC.

Some Broad Market Perspective

In the midst of a stock market that continues its selloff today, I decided to put together a quick analysis looking at the current stock market valuation. So I’ve prepared some commentary regarding the stock market’s current level versus history, the market’s valuation given current long-term interest rates, and the relationship between stocks’ earnings yield (inverse of P/E ratio) and the 10-year yield. As of this writing, the S&P 500 stands at 17.5 times trailing earnings (earnings yield of 5.7%) and (assuming a trend growth rate of 6%) 16.5 times forward earnings.

The first chart is histogram of the quarterly, trailing 12-month (TTM) P/E ratios of the S&P 500 since 1950. It shows the frequency with which the market has traded around a given level relative to earnings. As is shown, the market has traded right around its current P/E ratio 30% of the time since 1950. The chart also shows that when the market trades at twenty or more times trailing earnings, it does not trade there for long. Relative to the past 50+ years, the valuation level does not seem to be excessive.

The next chart shows the trend of the S&P 500’s P/E ratio since 1950, along with its mean value over that time period. The P/E ratio has fluctuated wildly around the average, but it appears the S&P is currently near its average P/E of the past 57 years. This average is, of course, biased upward by the lofty multiples of 1999-2000.

The third chart shows the relationship between the S&P 500 earnings yield and the 10-year Treasury note, along with the average of each value over the period from 1953 through the second quarter of 2007. I am using the constant maturity 10-year Treasury as a proxy for long-term interest rates. I was able to get data from 1953, so this chart runs from that point to the end of 2Q 2007.

There is a clear relationship, as there should be, between the earnings yield on stocks and long-term interest rates. As the chart shows, the average spread between the earnings yield on stocks and the rate on Treasuries over this 54-year period is just 0.3%. Currently, that spread is 1.0%; stocks yield 5.7% on a trailing basis and the 10-year T-note is trading at 4.7%. What this basically means is that if the S&P 500 experienced zero growth over the next 10 years and paid out all earnings as dividends it would yield 1% more than Treasuries. Looking from this perspective, on a relative basis stocks appear to be less expensive than average. Yet 10-year T-notes have traded as high as 5.3% in the past couple months, which would bring the spread down to only 0.4%, about average. And just because stocks are relatively more attractive does not mean they couldn't get more attractive (read: continue to fall). As the chart reveals, the earnings yield on stocks was substantially higher than long-term rates for the better part of the 1970s. Such a situation would present an incredible buying opportunity.

I do not focus solely on the rear view mirror when I drive, and it is hazardous to do so when investing. But as Mark Twain said, “History doesn’t repeat itself, but it rhymes.” It helps to have a historical perspective, especially about the broad market. And on a broad market basis, I don’t think stocks are expensive. But I don’t know where they will trade next month or next year. Sure, they can go down (which is what they’re doing now) but over long periods the trend is up. In my view, the lower one can buy the market, the better, because the implied future rate of return rises as the market falls.

A couple caveats about these charts: the P/E ratio – and the earnings yield – is very dependent on the E(arnings). If recessionary conditions come back into the fore, corporate earnings will fall (the earnings yield will drop, absent stock price declines). This analysis is meant to provide some perspective on what the market looks like relative to low-risk alternatives such as long-term bonds (favorable). Also, the time period I chose (largely as a result of the data set that was available) could also have an impact on the averages I’ve calculated. They are merely illustrative and should not be construed as precise calculations. It is better to be approximately right than precisely wrong, as Warren Buffett says.

Open Up Your Wallets!

Perhaps to a fault, I enjoy seeing a screen full of red. That is, declining stock prices. And that is exactly what has been happening the past few days. The market is providing the opportunity to average down or initiate new positions in some good companies at attractive prices. I am usually early in buying as a stock goes down, but one cannot often buy right at the bottom. Rather, I buy when the price represents a significant discount from my conservative estimate of instrinsic value. And if the stock price continues to fall, I welcome the opportunity to average down the purchase price. As an investor focused on obtaining value, I believe these are some of the most exciting times to be investing – when fear is overtaking greed in the collective sentiment of stock market participants. Now is the time to be aggressive in taking new positions.

While the overall market is still not cheap, the recent pullback has provided some excellent opportunities to invest cash. Several excellent companies related to housing and consumers are now trading at very attractive valuations relative to their normalized earnings. Companies I’ve mentioned previously, such as American Eagle Outfitters (AEO) and Countrywide Financial (CFC), are now trading at new 52-week lows. Best Buy (BBY) is back near its lows for the year. As for S&P 500 sectors, financials in general have really taken a hit, down 6.4% (so far) this month alone. And looking at a list of stocks that are down significantly year-to-date exposes a myriad of regional banks down 20-30% on average. I think there could be several opportunities in this space.

Full disclosure: Long positions in all companies mentioned.

A Tough Call

Stable market share positions among the main players in an industry combined with high returns on capital typically are evidence of a long-term competitive advantage. I made a mistake by not weighting this heavily enough in my initial assessment of Motorola (MOT) several months ago. I also did not consider enough the unpredictability of mobile phone industry dynamics. While MOT benefits from scale in distribution, relationships, and the ability to spread fixed costs, including as R&D and advertising, over a larger revenue base than its smaller competitors, the short product cycles and the need to continually innovate products, combined with a smaller, more powerful group of buyers (mobile phone companies that have been consolidating) have made the company’s plight that much more difficult.

In late 2006, I made a buy decision on Motorola (prior to the disclosure that Icahn was involved) based primarily on a few facts: 20% of its market value was in cash, and this cash could be used, among other things, to wipe out its debt and buy back loads of shares. Over the past few years the company had generated copious amounts of free cash flow and that looked reasonably certain to continue. But I soon found that the stock price was down for a good reason. Management had turned to the dark side - managing for market share, not profitability. Profits quickly turned to losses and cash flow evaporated when pricing power faded and unit sales slumped. In March, I sold July call options on the stock. So after being called out a few days ago the investment netted at breakeven (loss on the stock, gain on the option). Over this same period, the S&P 500 was up over 5%, so I consider that the opportunity cost of the investment in Motorola.

The company will probably recover and thrive again. But I came to the conclusion that I am not smart enough to figure out when that will be or how it will occur. If they come out with another product line as revolutionary as the RZR, certainly profits will return in spades. But after that phone comes on the market they’ll need another one to follow it. And now that Apple (AAPL) has entered the mobile phone space, the competition for innovative products is even more fierce. Overall, the visibility of the industry is low to me. So if in a few years I see the stock at double its current price, it won’t faze me because it fell outside my circle of competence. The uncertainty of the commodity cell phone business no longer makes Motorola the no-brainer that I like to see in a stock before I pull the trigger.

Full disclosure: No positions in the companies mentioned.

Subprime Concerns Again!

The concern from the subprime market continues to spill over into the stock prices of companies such as Countrywide Financial (CFC) and others. Countrywide has been the subject of frequent posts and that mainly is because (1) I own the stock so I’m watching it and (2) subprime concerns have caused its price to bob around well under intrinsic value for some time now. And now its share price is back under $35 apiece amidst renewed subprime concerns (less than 10% of its business was subprime).

The latest news regarding subprime is that two Bear Stearns hedge funds that specialized in subprime mortgage-backed bonds have ended up virtually worthless. Much of the reason the funds went down so fast was likely due to the leverage employed, as the index that tracks subprime loans originated in the 2nd half of 2006, the ABX "BBB" 07-1 index, fell to nearly its lowest level ever over the last couple days.

This is a classic illustration of the market being irrational longer than one can remain solvent. Yet these funds were probably using “risk controls” that considered the probability of such an event as so miniscule that they ignored it (based on the dubitable "proof" of historical data or simulations heavily contingent on multiple assumptions). Turns out the risks were higher than the so-called models told them. Looks like they opted to be precisely wrong rather than approximately right.

Over the past few years, anyone could sell a mortgage. Just get in touch with GMAC, provide the documentation they want, and get paid a fee based on each mortgage obtained for them as a broker. GMAC (and many others) in turn would package the loans together and sell them to investors. So the accountability was really lost at each stage while the packaging, or securitization, process mysteriously turned a group of loans into investment grade despite the dubious characteristics of its individual constituents. Downgrades in these bonds over the past few weeks have called into question the quality of the underlying loans and hit these two funds very hard.

I think underwriting standards today are likely to have improved overall (yet, even though its only anecdotal, I still see advertisements touting “no down payment” loans available). But overall, going forward, the lax lending standards have likely subsided and overall loan quality has probably improved (that is, until the next boom period for housing). For originators whose loans are sold through securitization, the bigger players are the ones that will benefit long-term as smaller competitors are shaken out. This includes Countrywide, Wells Fargo (WFC), and other large banks such as Bank of America (BAC) and Washington Mutual (WM).

Full disclosure: Long shares of all companies mentioned.

A Quick Word on Sears Holdings

I want to post a quick commentary regarding Sears Holdings (SHLD), a company I have admired (from the sidelines) for quite a while because of its Chairman and owner of 42% of its stock, Eddie Lampert. The stock was down over 10% yesterday on the heels of a reduced earnings outlook, making the shares more attractive.

Sears is a company that throws off solid free cash flow and continues to buy in shares opportunistically. For any company, what matters should not be size or market share for their own sake but profitability in the markets in which it operates. Lampert is keenly aware of this and is managing for profitability. I would compare this to Warren Buffett not growing premium volume just for the sake of having a larger policy base. There have been 10-year periods for Berkshire where premium volume shrank in every single year, but profitability on those in-force policies remained solid. Lampert is a Buffett disciple, so there is ample reason to believe he looks at Sears in a similar way. I think he’s willing to shrink the total size of the “empire” as long as he, per-share, grows wealthier.

If the Sears (and Kmart) business as a whole shrinks, the stores that are still around will be more profitable in their individual markets. What remains of a smaller, more profitable company will have low reinvestment requirements (since it’s just maintaining what it already has). This will lead to even more robust free cash flow (and proceeds from real estate sales) to use for even more opportunistic buybacks. Using this procedure, Lampert can increase per share business value at a steady clip even while aggregate sales and net income decrease.

As an example of his influence on a company, look at what he’s helped orchestrate at AutoZone (AZO), of which he owns 31%. Since 1997, sales and profits at the company have risen 9.2% and 12.7% annually, but 18% and 22%, respectively, on a per-share basis. They’ve done this by focusing on profitability (net profit margin has gone from an average of around 7% to nearly 10% over that time period) and have used increasing free cash flow to buy back heaps of shares. And the stock has followed, up nearly 20% annually over that time.

Full disclosure: No positions

A Stock to Go with Those Jeans

A stock that has recently come onto my radar screen is that of American Eagle Outfitters (AEO). I must admit that I do not shop at their stores, but I do walk by them during my infrequent sojourns to the local mall. I find the stores to be clean, well put together, and the fashions to be relevant (as judged by the fact that the teens walking around the mall are wearing what I see in their store). I also know a few teens in the core AEO demographic who provide me with knowledge on what fashion trends are out there (I bought the stock for one of them). The company’s core target is 15-25 years olds, and its new concept store, Martin+OSA, targets 25-40 year olds.

Obviously the most important thing for a teen retailer is to have the knowledge of not just current fashions but what will be fashionable in the near future. Keeping “on-trend” is crucial. AEO management has consistently done this for the past ten years or so, by using focus groups and extensive market research to remain relevant. And its clothes are lower-priced than Abercrombie and Fitch (ANF), one of its main competitors, which bodes well for less heady times for retailers.

AEO shares are just 2% off a 52-week low, and are probably sitting there because of concerns about revised (downward) quarterly guidance. But it is the longer-term that I am concerned with, and there is much to like here. For one, I like the recently announced 23 million share buyback, representing 10%+ of outstanding shares. Its Chairman (and founder) owns about 14% of outstanding shares, so his interests are aligned with minority shareholders. The stock trades with roughly 15% of its market cap in cash and a free cash flow yield of nearly 10% based on its 2006 results. Even with growth slowing (which it inevitably will), the company can throw off lots of cash.

At first glance, it looks like the company has no long-term debt on the balance sheet, but it holds about $975 million (present value) worth of operating leases off-balance sheet. That makes its true debt-to-total capital ratio about 40%. So you’re really getting a 12% return on total capital (20%+ return on equity) at a P/E of 13.5. If the company can continue to grow at 5-10% over the next few years, this works out to a fairly cheap price, even if the growth is lumpy. And if its new Martin+OSA stores take off, the shares could look very cheap in retrospect 5 years from now. At current prices, the market seems to be offering a good price for the core business and what more or less amounts to a call option on the Martin+OSA brand for free. And if Abercrombie continues to fall (down over 4% today), its shares could start to look attractive.

Full disclosure: As mentioned, long AEO.

Best Buybacks

Best Buy (BBY) today announced a 30% boost to its quarterly dividend and a $5.5 billion buyback program (replacing its previous $1.5B program), $3.0 billion of which will be done immediately. This should reduce share count by over 13% at today’s prices, giving shareowners who hold on a bigger piece of the pie. Given the company’s cash-generating ability (a roughly 5% free cash flow yield after capital expenditures needed to maintain and expand the business are subtracted) and the currently undervalued state of its shares, I think this is a great use for the company’s cash and view this as a shareholder-friendly move as long as buybacks occur at sensible prices.

More good news was announced: management now targets 1,800 stores in the U.S. and Canada (up from 1,400), which represents a near doubling of its store base domestically. Assuming returns on invested capital can be maintained even with such a sizeable store base, Best Buy – the company and its stock – continues to look attractive at current levels (though I certainly wouldn't mind if they went lower in the short term).

Full disclosure: Long BBY shares.

Best Buy in the Crosshairs

I love a good growth company. Good growth businesses are even better when paired with long-tenured managers who own a significant amount of shares while presiding over a great track record of growing earnings and free cash flow and earning high returns on incremental capital. Furthermore, the situation is even better when the current stock quotation undervalues the business. These factors all may be characteristic of Best Buy (BBY) at its current price.

Best Buy announced quarterly earnings today that were 18% lower than the comparable period last year and shares are down nearly 6% on the day. Much of the decline in profits was due to a shift in revenue mix to lower-margin products such as flat-panel TVs, notebook computers, and gaming hardware. So is the selloff in the shares warranted? Are lower margins forever in Best Buy’s future? Those selling off shares today seem to think so.

The main concern swirling around Best Buy seems to be that of a sharp downturn in consumer spending. Though likely to slow a bit, betting against the consumer has not historically been a good gamble. In addition, Best Buy continues to take market share from competitors such as Circuit City (CC), which will help mitigate the pressure on its business in the event of a slowdown in consumer spending. But concerns about consumer spending represent short-term thinking. Investors in common stocks should typically think in longer time horizons. Are the company's competitive advantages intact? Can Best Buy grow while continuing to earn good returns on total capital? Over the longer-term, it seems highly probable that Best Buy can continue to grow and prosper both domestically and internationally. For instance, Best Buy holds a potentially valuable option in its Chinese operation, where it now has just one store.

There is a longer-term risk to profitability: Wal-Mart (WMT). I believe Wal-Mart will continue to be a fierce competitor but probably only on the lower end. Its main advantage is obviously price. Yet Best Buy offers more qualitative advantages: clean stores, great selection, a cool environment, and great service, and often consumers go there first if it’s electronics they crave. The wider selection and more knowledgeable staff (rather than someone who also works in fabrics or grocery) give Best Buy an edge over Wal-Mart in its core customer base for years to come.

As for profitability, for the past ten years returns on total capital have been around 20% on average (due to a modest debt load, returns on average equity have averaged a couple of percentage points higher). The lowest-return years of the past ten were 2001 and 2002 (recessionary conditions) and returns in those years were still quite satisfactory at 17.1% and 17.8%, respectively. Sales have risen 13.7% annually while store base has grown only 12% over this same period. Management stated in today’s press release that new store openings continue to produce 20% returns. These are great numbers and are evidence of a competitive advantage.

The stock currently trades at 15 times forward earnings based on the low end of management’s updated guidance for 2007. This compares with the stock’s average P/E in the 18-20 times range over the past 15+ years. Debt represents about 9% of capital. Management has been buying back shares and increasing the dividend payment steadily since initiating payments in 2003. Chairman Richard Schulze still owns 15% of the company. Even while steadily expanding its store base (the company has ample room to grow) and investing in existing stores, the stock’s free cash flow yield is roughly 5% at today’s price levels. And the company has $2.8B in cash and short-term investments (13% of market value) on the balance sheet. Back out the cash ($5.70/share) from today’s price and the stock trades at 13.5 times forward earnings. Hardly expensive for a business generating such high returns on capital if the returns are sustainable.

At today’s price level (roughly $45/share), taking a small position is likely to yield good long-term returns. Yet the stock doesn’t look cheap enough yet to load up. Unless something has fundamentally impaired the business, if the stock price continues to fall, I may be inclined to provide some liquidity to panic sellers.

Full disclosure: Long shares of Wal-Mart at time of writing.

Some More WB Wisdom

To paraphrase Warren Buffett:

"Be willing to look foolish as long as you don't feel you have acted foolishly."

Rumors Swirl Around Countrywide Again

Countrywide Financial (CFC) shares are up over 7% in today’s trading on no apparent news. Is this just speculation or another case of trading ahead of an impending deal announcement? Stories of the latter have been in the financial press in recent days regarding suspicious trading activity surrounding the take-private deal for TXU (TXU) and Rupert Murdoch’s recent buyout offer for Dow Jones (DJ). In fact, a complaint has been filed against a couple that allegedly bought Dow Jones shares just two weeks ahead of the offer announcement.

So is Countrywide a viable takeover target? I’ve argued shares looked cheap in the mid-30s but with the stock advancing nearly 20% since then, the margin of safety in purchase price does not appear to be as great. Yet in the hands of the right buyer Countrywide would be worth quite a bit more than its recent quotation of $41 and change. And if it doesn't get purchased, the company should continue to grow shareholder value - gaining market share in both origination and in servicing (both businesses with scale advantages), as the mortgage market “rationalizes.”

Countrywide is no stranger to buyout speculation. Shares ran up in a similar manner at the end of January on takeover rumors that never materialized. We’ll just have to wait and see if there is any substance to the move this time.

Full disclosure: Long CFC shares.

MSFT-YHOO?

Microsoft (MSFT) to buy Yahoo (YHOO)? I must confess that can’t see an acquisition happening, but I suppose it’s possible. The market seems to believe something will happen, given Yahoo shares are up over 15% today. With Google (GOOG) owning over half the market, and growing at more than double the rate of Yahoo’s and Microsoft’s respective online advertising efforts this past quarter, I believe each needs to take action to become more competitive in this arena.

Larger players (in terms of market share) benefit from the network effects inherent in this space, as Google has shown. The combined MSFT-YHOO entity would control 32% of the worldwide search market, compared with roughly 54% for Google, based on March numbers. So it gets them a little closer to Google’s market share, but still a distant second.

The ability to spread the operational infrastructure across a larger base of users is a powerful force; the broader the network, the more valuable that network becomes. As goes Metcalfe's Law, the value of a network is proportional to the square of the users in that system (i.e. n-squared). Google is the most popular search destination, but also boasts a huge network of third-party sites on which to place ads. Yahoo has the most popular online "portal," but has not been as successful at monetizing its position as has Google. There's not much to say about Microsoft.

That said, the result of combining Microsoft and Yahoo’s online advertising capabilities will be a more robust platform for advertisers, but likely won’t change much for users of their sites. I think an integration of some sort makes strategic sense for both parties. But what makes more sense to me here is a joint venture, not a merger. With a merger, the two companies would have a difficult time integrating the two cultures. Certainly that is one of the strengths of Google – a culture that encourages innovation in this space. Trying to put together two disparate cultures into one company would likely be to the effort's detriment.

This is a situation that certainly bears watching: (formerly?) sworn enemies taking the “lesser of two evils” path to gain some ground on Google. Even if today's speculation comes to fruition, I don't think Google needs to be shaking in its boots just yet.

Full disclosure: Long MSFT.

Another "Milestone" Approaches...

I posted comments when the Dow Jones Industrial Average (DJIA) was reaching new highs last year and so now feel compelled to comment on its recent rise to near 13,000.

The goal of active management is to, on a risk-adjusted basis, beat the return that could be earned by passively investing in a broad-market index fund or ETF. So long-term performance of indexes is relevant for comparison purposes. But over short-periods there is little relevance. Nevertheless, the financial press is hailing this is a “new bull run,” mostly based on an arbitrary number that has little real significance.

Let me start by saying the Dow will reach 13,000. The question is just a matter of when, and it looks like it could be soon. But what does Dow 13,000 mean? Not a whole lot. To me, it means the sum of 30 stock prices divided by 0.12482483 equal 13,000. It’s just a number whose absolute value is really meaningless to an individual’s portfolio, though technical analysts might say it is a “key psychological barrier” or a “technical breakthrough.” And of course CNBC is once again devoting some of its ticker real estate to a new graphic – “Dow is xx.xx points from 13,000 milestone.” I can’t blame them, CNBC is a financial news network and they have to report the financial news. But just because its being reported doesn’t mean it’s important. While we’re on the subject, the S&P 500 is still down 4.3% from its all-time high (1,553.11) set in March of 2000.

What is important is the individual makeup of each investor’s portfolio. Were the individual companies you own purchased at good prices? Are they currently trading at a cheap-to-fair price in relation to their normal earnings power? Do they have a competitive advantage that allows them to control their own destiny? Questions such as these are much more relevant than what an index or average value is doing. This is especially true if there is little overlap between your portfolio and “the Dow.” Day-to-day (even month-to-month) stock price fluctuations can have little to do with fundamentals and more to do with emotional reactions and to changing perceptions of those fundamentals. Over the long-term, as companies earn money and reinvest profitably in their businesses, their stock prices are going to follow. Finding good companies that can be purchased at reasonable prices should treat an investor well over longer time periods.

So what are some aggregate statistics of the broader market as of today? The S&P 500 Index is trading an earnings yield on a forward basis of just over 6.0%, versus a 10-year Treasury yield of 4.7%. Given these numbers, stocks seem relatively attractive to me, but I wouldn't say they're cheap. The S&P over the past year has generated returns on equity in the 18% range. Earnings have grown 15% year-over-year, and on a sustainable growth rate basis can probably grow 12% for the next year, assuming incremental reinvestment rates remain stable. However, analysts have predicted slowing growth – earnings are predicted to grow close to trend (~6%) for this quarter – a prediction that is being exceeded by several companies who have reported earnings thus far.

While buying “the market” at current levels is likely to result in reasonable but not spectacular returns, an investor’s best bet, as usual, is to find companies trading at more attractive valuations than the market as a whole. Pay attention to your “basket” of stocks, not those of “the market.” Find stocks with low debt and growing free cash flow that are returning cash to shareholders and generating solid returns on capital over a full economic cycle.

Where to look? The worst performing sector in the S&P 500 this year is “Financials,” up just 0.85% compared with the Index return of 5.21%, with an overall sector P/E of less than 15 and an above-market dividend yield of 2.5%. On an individual company basis, many stocks here are likely to be relatively more attractive, with a few yielding 4-5% along with solid growth prospects.

Another Warren Quote

“What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.”

- Warren Buffett

Importance of Good Business Economics

"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."

- Warren Buffett

Subprime Mortgage Fears Bring Select Opportunities

Yet another analyst downgraded Countrywide Financial (CFC) today. And the shares are down another 3% on top of being down almost 15% year-to-date. In my view, the decline on the news provides yet another great entry point for long-term investors. Don’t get me wrong, this will be a volatile sector to be exposed to in the near term, but an investment case here need not be predicated on a quick rebound in loan originations.

Despite market perceptions of CFC as a pure play on mortgages, less than half of Countrywide’s earnings are derived from originations. The company is the second-largest loan servicer in the country (after Wells Fargo), with a servicing portfolio of $1.33 trillion, up 17% year over year through February. The servicing fees and interest earned on no-cost escrow accounts in this business give it annuity-like characteristics that are not tied directly to originations. The company’s fast-growing banking division, with $84B in assets, has grown 12% since last year and now provides about one third of CFC's profits. The insurance and capital markets segments further diversify the business.

At $35, Countrywide trades at 8 times forward earnings, 1.4 times book value, and pays a 1.7% dividend. Management has an enviable track record of growing value for shareholders – over the past 15 years the stock has returned over 18% per annum including its recent poor performance. Based on conservative assumptions, I think the company is likely to have one or two years of flat revenues followed by continued growth as the industry recovers. Countrywide’s origination business will not suffer as greatly as the industry since it continues to take market share. And its financial strength and diversified revenue base give it many options as the industry shakes out the weakest players.

Is the market discounting overly pessimistic views disproportionate with their probability of occurrence? It sure looks that way. As an investor with a long-term perspective, I welcome the misvaluation as an opportunity to add to positions. The stock can still go lower, but the risk-reward balance seems tilted in favor of the patient investor. Outperformance over long periods requires being able to stomach bad news and volatility in the short-term. Once the mortgage industry dust settles, shares will make up for lost time.

I’m not oblivious to the near-term threats to the business. Countrywide has originated many option-ARMs, which are a relatively new product whose long-term viability has not been proven. Exposure to the nonprime market remains a concern, but Countrywide has not been a large player in this space. The company securitizes and sells nearly all of the loans it originates, so an investment in Countrywide carries low balance sheet risk. Though the company holds some residual tranches from CMOs it sells, these comprise only a small portion of company assets.

In aggregate, the potential rewards seem to outweigh the risks. While negative industry sentiment is justified with players such as New Century Financial (NEW), Countrywide’s year-to-date loss has just made its shares more attractive, in my view.

Full disclosure: Long CFC shares personally as well as for clients.

Buffett’s Successor Will Be A Lot Like Him

In his most recent shareholder letter, posted one week ago, Warren Buffett shed more light on Berkshire Hathaway's (BRK.A, BRK.B) CEO succession plan. It sounds like they’re in pretty good shape for the CEO role, but that they’re going to have more difficulty finding a chief investment officer who can take over. Buffett has long said the board will split his current position into two (CEO, CIO) upon his death.

So who will it be? My guess is that it will be someone very much like Buffett himself: A self-effacing, modest person who avoids the limelight, doesn’t go on the speaking circuit, and doesn’t attend black-tie events. It’s likely to be someone happy to be paid well, but not extravagantly, for doing what he or she loves (it's fair to say the person could be the highest paid in Omaha, however).

It'll be a family-oriented person who would not enjoy the fast-paced lifestyle of an East Coast hedge fund manager. This person will be more likely to be out coaching his or her kids’ sports teams rather than hobnobbing with other executives. It is this independence that likely has helped and will continue to help this person make superb investment judgments, I’m betting. Because of the trust Buffett will be placing in this person, his or her views and opinions will be deeply respected and closely watched.

The investment officer selection process at Berkshire is going to be fun to watch over the next several years.

Full disclosure: I own shares for clients as well as personally.

What Rate of Return Is the Market Implying?

Market pundits on CNBC continue to talk about the market being overbought at these levels and mentioning the likelihood that there could be a better entry point at which to put new cash to work. I tend to agree, as I look at market volatility at a nearly 20-year low (similar to this time last year) that is due to “revert to the mean.” So the market may be overbought and participants in general complacent about market risk, but is the stock market overvalued?

It’s hard to answer that question, of course, and I don’t know for certain. Various market participants use different methods to come up with the rate at which to discount the stock market’s future growth. And all have different returns they are willing to accept for the risk they take in equities. That's not finance theory, but it's the way I see it. I, for one, am always in a better mood when the markets are down and thus the implied future rate of return up.

Based on current S&P 500 Index levels, I calculate the implied future return on the market to be a little under 8.0% based on a long-term trend growth rate of 6%. This tells me that indexing from this level is likely to yield below-average future returns. So is the market overvalued? Well, are you willing to accept the added risk inherent in stocks for about 3% more than a 10-year Treasury? That's really the long-term Treasury rate plus inflation. I see that as being fairly valued to slightly overvalued.

Opportunities in Ethanol?

Over the past year, ethanol has become a buzzword that has attracted much media attention and debate. Environmentalists like it because it burns cleaner (I would counter that you get 20-30% less mileage from ethanol than ordinary gasoline). Politicians love it because it is “alternative energy,” a phrase that is sure to garner some good publicity and public support as they look for ways to curb our “addiction to oil.”

Producers love it, since domestic producers are generally protected from foreign producers (such as Brazil) by a $0.54 tariff on imported ethanol that has now been extended to January 2009. Largely because of a 51 cent-per-gallon tax break, ethanol has received about 50 cents more per gallon than gasoline at the wholesale level (right now it’s about $0.45 more).

Who also loves ethanol? Corn growers. That’s right, because corn prices were up over 80% last year and have stabilized at over $4 a bushel. This is a boon for farmers. Lots of them can do well at around $2/bushel…

Let’s do some quick math. A bushel of corn yields 2.8 gallons of ethanol. This amounts to $1.45 per gallon in the cost of corn alone! If this were the business’s only cost, it could still be pretty profitable, but ethanol production is very capital-intensive. They need get the corn to the plant, process the corn and separate byproducts, refine the corn into ethanol (using mostly natural gas), then ship it to the destination, which is done not by pipeline but by rail car. So the producers are captive to suppliers and at the mercy of shipping companies - trains - who are their only viable option.

And they have no control over the selling price of the finished product. Of course, they can use futures contracts and OTC swap transactions to lock in prices and smooth revenues. But the producer itself has no influence on prices. They can’t simply make a “better” ethanol than someone else, no matter what marketing says. As of today, the March ethanol contract on the CBOT was going for $2.00 per gallon. The so-called “crush spread” is about $1.25 at the moment (crush spread = ethanol price times 2.80 minus the price of corn per bushel). So the gross margin on corn is approximately 31%. Not bad. But that’s just the cost of goods sold. Consider all the SG&A and interest expenses these plants have to cover, that $1.25 per bushel can get used up rather quickly.

Anyone downstream of corn production does not so much like ethanol, because it has increased costs substantially. Ethanol demand currently accounts for about 20% of corn production. New plants are coming online soon and will boost that demand significantly – and production is looking to double by 2008 if planned construction takes place. This does not bode well for producers, as corn prices are likely to stay high. On the supply side, farmers can grow on additional acres and convert from existing crops to corn. But the supply of land is limited. Maybe they shouldn’t have sold so much land to developers – corn is now where the money is!

Several of these new plants are likely to be ill-conceived - a response to favorable market conditions this past summer. I recently reviewed a prospectus and projected financials for a new biodiesel plant that it proposed to go up here in Iowa. They’re projecting $2.35 per gallon on the top line for biodiesel to make this work! These projections were prepared in August, when gasoline prices at the pump were over $3.00! I question the assumption that with diesel pump prices to consumers right around $2.50 that they'll get wholesale rates that high. And the soy oil they're using as an input costs over $2.20 per gallon right now. Biodiesel is a bit different than ethanol in that there is the same amount of energy in 0.88 gallons of biodiesel compared to a gallon of gasoline and gets a higher tax break. So it actually trades at a slight premium. But making it work with soy oil alone priced above the wholesale price of diesel is a pipe dream.

I typically don’t like purely commodity industries where there are no bargaining powers with suppliers, and who have no pricing power whatsoever. If this were a business not protected by tariffs and tax breaks, it would not exist. But those tax breaks and tariffs are more likely than not to continue, because of the support of politicians from both sides of the aisle.

Given all the press about alternative energy, you might think ethanol companies would be doing quite well. Yet publicly traded ethanol pure-plays such as VeriSun (VSE) seem to reflect declining sentiments about industry prospects. The most difficult questions to answer are also those that are fundamental to an investment decision in this industry - (1) what will gasoline prices do and (2) where will corn prices be? Frankly, I can't answer either with conviction. But given increasing demand for corn, a crop that has little ability to expand significantly in supply, and increasing capacity coming on line for ethanol production, more likely than not the returns to this industry will fall and the most efficient producers will win out.

Watsco Continues to Expand

Watsco, Inc. (WSO) continued to roll on its growth path this past year, growing earning per share by 17% while expanding operating margins and gross profit margins year-over-year.

This is a boring business, but a profitable one. Watsco distributes air conditioning, heating, and refrigeration equipment and related parts and supplies. The company is still small and operates in an industry where demographic trends are favorable for continued growth as the industry consolidates. The market is highly fragmented, with over 1,300 companies in the space. The company’s goal is to build out a national network and broaden its product offerings. In this industry, larger players will benefit from economies of scale in purchasing from a concentrated group of manufacturers, and the ability to spread higher revenues over a large fixed cost base – in distribution and store location infrastructure. Watsco is the largest player in the industry, yet commanded only 7.4% of the $26 billion U.S. HVAC market at the end of 2006.

Watsco is controlled by its CEO, Al Nahmad, so while interests of existing shareholders are not aligned directly with shareholders, you can believe he’s looking out for the company’s interest given the amount of net worth he’s got tied up. From a management perspective, I like that they don’t need to worry about dissident shareholders trying to take this thing over. Private equity loves highly profitable companies operating in niche markets with very little debt. All things considered, I’d say the control issue is a good thing for outside shareholders at the moment, because this business is protected from takeovers that should allow it to continue on its growth path.

The risks here relate to the economic cycle. Its products are durables that will be effected by a downturn in economic activity. However, 75% of the company’s revenues are derived from the service and replacement market, which is less cyclical. People still want their homes cool when they don’t have a job.

At current prices, Watsco appears fairly priced, trading at about 17 times forward earnings with a 1.8% dividend yield. For a projected growth rate of around 20% for the next several years, this doesn’t seem overvalued, either. If the stock pulls back to the mid-40s, as it did this past summer and again in late December, I’d think seriously about adding to positions.

Full disclosure: Clients own shares in WSO.

Money Market Redemptions Hit 2 1/2 Year High

Let's take a look at recent fund flow data once again. According to AMG Data Services, for the week ended January 31st, "Money Market funds reported net cash outflows totaling -$35.720 billion, the largest outflow from the sector since 6/30/04 and fewer funds reported inflows (678) than any week since 6/29/05 as more funds reported net redemptions than any week since 4/27/05.”

To put these outflows into perspective, the last time the outflows were that large (6/30/04) the S&P 500 Index was down about 3% over the next 30 days.

Long Absence Quote

"By failing to prepare, you are preparing to fail."

- Benjamin Franklin