Arohan’s investing life

Two interesting articles/stories caught my eye today

The first one talks about the mind boggling 2007 total compensation (earnings + stock) to Blackstone Group’s co-founder Stephen Schwarzman. According to this AP story, his compensation in 2007 was $350.7 million and along with stock grants valued at $4.77 B during Blackstone’s IPO, his total takeaway was $5.13 Billion in 2007 alone

With earnings like this, it is no surprise that many hedge fund managers are now counted among the Forbes Global Richest list.

This brings us to the second article that examines what would have happened if Warren Buffett had followed the hedge fund model of compensation instead of just staying with his equity position in Berkshire Hathaway and let the investment compound. To quote from the FT article,

At “2 and 20″, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent.

It is basically saying that if Buffett had followed the Hedge Fund model of compensation, his accumulated wealth would have been just 10% of what it is today

The difference is in the business models. A hedge fund manager primarily derives his income from fees. The assets of the hedge fund are owned by investors in the fund and only a part of the growth in the value of this asset works towards increasing the net worth of the hedge fund manager. For Mr Buffett, and indeed many entrepreneurs, net worth is primarily determined by the equity stake in the business that they own. Equity ownership lets the business income continue to compound in the business. As the business grows, the net worth of the owner grows correspondingly (the story would have had a different ending if Buffett had kept diluting his stake in Berkshire Hathaway by continually bringing in new investors like a hedge fund does)

Also to note (and a point unaddressed by the FT article) is the effect of taxation. While a hedge fund manager pays taxes each year (capital gains or income, a matter of controversy for sure but not relevant to this analysis), Mr Buffett will only pay taxes if he sells his equity (again, the fact that his charitable actions have helped him avoid taxes altogether is besides the point)

If you are a superlative investor (like Mr Buffett or like many of the better hedge fund managers), business ownership model of Berkshire Hathaway will generate greater wealth over a long period of time. Sure, running a hedge fund will get you to great riches quickly (adding lot of investors quickly, in the years where the fund does very well, etc), but it is not a superior wealth creation machine over long term

Maybe that is why Warren Buffett long ago discarded the investment partnership model. Or maybe another reason why Blackstone, Fortress et al. are now choosing to go public bestowing large equity stakes on their founders

Buffet is buying 60% stake in the Marmon group, currently a Pritzker family holding, with the remaining 40% to be acquired over the next few years at future business valuations. Also a point to note is the before this acquisition is completed, the Marmon group will make significant cash distributions to the selling shareholders. The 60% stake was valued at 4.5 Billion

Buffet is doing what Buffet does best. Buying business that deals in the nuts and bolts of the global economy. Easy to understand (despite Marmon being made up of about 125 different operating businesses), generating significant cashflows, with tremendous tangible assets.

Much has been said about the futility of operating as a conglomerate. Focus on the core competency has become a buzz word within the academia. However, there are companies that do this right, Berkshire Hathaway being one of them, Marmon being the other. It is not surprising to see the allure Buffet found in Marmon

I own businesses in the metal working sector and I believe that this sector is overdue for some structural changes. Metal working (I include machining, fabrication, sales and brokerage and scrap recyclers as part of metal working sector) is a fragmented industry in North America with many small players sprinkled all across the map. It is interesting to take a look at one example: The Purchasing.com top 100 Metal services companies. The list includes the top ranked company Ryerson with about $6 B in annual sales, to the 100th ranked company with about $26 million in annual sales. There is a wide gulf between the largest and the smallest companies with very few companies with sales > $1B. There are maybe another few thousand small companies that are not represented on this list. The basic themes that run across this industry are:

1. Small shops with customers concentrated in one or two industries
2. Limited geographic reach
3. Heavy reliance on repeat business from existing customers
4. Metal working businesses serving some sectors, such as automotive clients, have generally seen their margins thin over the years due to relentless cost cutting pressures
5. Most of the businesses are privately held

The larger and mid-sized companies in this sector have a different problem: most of them manage several thousand customer accounts. This fragmentation in customer accounts becomes difficult to manage

An ideal and efficient company in this sector would be one that has several hundred large customer accounts that are diversified across different industries with multiple locations (so they can optimize inventory, capacity utilization, shipping and logistics across the network).

The industry is ripe for consolidation but most of all it also needs to restructure its customer base and geographic profile

From an economic perspective, a lot of value is currently being created on the raw material side (mining and mills). There is a large and increasing demand at the finished product side due to the growth in the emerging markets (as well as future domestic demand as the US infrastructure starts its upgrade cycle). The metal working/service industry sits right in the middle and will see a lot of value being created here in the next decade or so if the right restructuring and consolidation takes place

And the valuation of the companies in this industry is shockingly low. Most private companies can be purchased for a valuation of about 3 times EBITDA or about 0.2 to 0.4 times sales. Even some of the public companies like Reliance Steel and Aluminum (which has a metal service business) can be had for about 0.5 times sales. Of course, like any other industry, you do have some companies that are richly valued and we tend to stay away from them.

Finding good solid companies in this industry and taking a position in them should produce excellent returns over the next 10 years

In the next few posts, I will highlight a few of these companies that I am finding worthy of investment today. So stay tuned …