Arohan’s investing life

This next article in the series has been a long time coming, so first of all, accept my apologies.

Let’s dive straight in. The first business I am going to discuss looks eerily similar to Berkshire Hathaway on the surface, with some temperamental differences. This company also has a smaller but equally devoted following with many investors entrusting the core of their portfolio to this company stock.

Markel (MKL)

It is an insurance company dealing in speciality lines which very few other insurance companies will touch. You know, like marine, catastrophe exposed property, product liability, etc. This business is a collection of small insurance niches and not surprisingly, Markel, the company has itself evolved over time with acquisitions of many smaller firms. Its niches are more or less protected from cut-rate competition due to hard to place risks inherent in these lines. Additionally, the Markel underwriting team is very disciplined, at times choosing not to play when the market does not allow them reasonable margins

Markel has another line of business and that is investments. Like Berkshire Hathaway, Markel invests its excess float for superior returns. Markel’s investment philosophy is similar to Berkshire Hathaway; they look for great companies that are selling at attractive valuations and they are happy to wait a long time for the value to be unlocked in their investments.  Their goal is to increase their book value by atleast 18% per year. Tom Gayner, Markel’s Chief Investment Officer, is a well respected value investor and many have speculated that he may be the chosen one to run Berkshire Hathaway’s investments after Buffett is gone.

Markel shares other characteristics of Berkshire Hathaway. They do not believe in splitting the stock. They do not compensate their employees with options grants (employee stock ownership is encouraged with the company providing low interest loans to help employees purchase stock. How quaint!). No dividends are issued. They are shareholder friendly and call their shareholders partners in business. They have expressed the sentiment many times that they want to attract long term oriented investors in their stock.

In my view though, there are some basic temperamental differences. Warren Buffett is willing to take more risks in his investments (albeit the risks that he understands) than Tom Gayner would. I can’t visualize Tom Gayner effecting a Salomon Bros style bail out, nor do I see him betting most of the assets on one stock as Buffett has done in the past. Nor have we seen Markel invest much outside of North America or show much interest in buying out private businesses. It appears to me that even though Markel has and will continue to perform well against any performance benchmarks it does so with a little less oomph in its investments. The upside risk of outsized returns in its investments is less compared to Berkshire Hathaway’s portfolio

However, one should keep in mind that Markel is still a young stock compared to Berkshire with smaller capitalization and over time it is very likely that more room could be made for riskier opportunities in its portfolio

Traditionally Markel trades at around 2x its book value. Currently it is trading at a good discount to this and is likely going to be an excellent purchase if one has patience to wait for many years. I am not going to go into details of Markel’s investments or their financial ratios. These are somethings my dear readers can easily look up and delve through. In investments like these, my main concern is to ensure that the manager has a superior track record, is shareholder oriented, has a skin in the game and a investing philosophy similar to mine and then I look to invest new monies in the stock when prices are attractive.

My recommendation is to buy Markel now and forget about it for 10 or more years.

A quick note regarding several investments that were recommended (and the author took a personal stake at the time of recommendation).

WSCI: WSI Industries was recommended as a growing metal working company with excellent prospects. I took a position in the company in the $4-$5 range several months ago. In the last one month, I have liquidated my entire position in the company in the $9-$10 range for close to a double. Very satisfying return for a few months work. The stock today is trading close to $14. If I had held for another month, I could be looking at a triple instead of a double. But I have no regrets. The company is approaching 40 PE and is getting quite frothy at these levels even if you take into account their projected growth for the next few years.

CFC:I am still holding Countrywide. If you recall, the play here was to buy Countrywide as a cheaper way of getting into Bank of America. The risk is that the Bank of America acquisition of Countrywide may not close. I am still comfortable in my position and will continue to hold

WM: I am still holding Washington Mutual and am currently underwater. However I am willing to wait out the current crisis of confidence as I think the company is taking the right steps to ensure that it survives
C: I have since my last writing on Citigroup increased my position in the company. The company is very quiet on what they are doing to improve their capital structure. However, they recently entered in an agreement to liquidate a part of their debt portfolio (to private equity) for about 10% discount. I think the company will correct course and come out stronger than many expect and in 3-5 years time should reward a patient investor handsomely

Additional notes: I have also increased my stake in BAM (Brookfield Asset Management), MKL (Markel), ACAS (American Capital Strategies), LUK (Leucadia), SLT (Sterlite Industries) and added positions in BRKB (Berkshire Hathaway B shares) and EPI (Wisdomtree India ETF)

Please note that if you choose to act on any of the recommendations/ideas outlined above, make sure that you conduct your own due diligence and understand the risks you are taking. I am not a financial advisor

Can the gloom surrounding Citigroup be any darker?

The stock as of this writing is trading at a 9 year low. Goldman and Merrill Lynch have reduced their profit forecasts for 2008 for Citi and Merrill also believes that there is additional 18B in asset writedowns looming.

Then there is news that Dubai International Capital professing a belief that Citi needs another capital infusion to survive. This is after Abu Dhabi Investment Authority, Kuwait Investment Authority and Prince Alwaleed of Saudi Arabia bought or raised their stakes in Citigroup recently

And Vikram Pandit, the new Citi CEO, has not yet offered any clues to the plan he may be considering to right the Citi ship

One good news for any investor eyeing Citi as a potential investment is that the stock is now trading close to its proforma book value AFTER adjusting for another projected writedown in Q1

The decline in the stock price today brought Citi to my attention. Question as always, is whether the shares are cheap enough to purchase given that so much risk and uncertainity remains in the business? Citi stock today is trading at levels it has not traded since the LTCM debacle

I think the stock is now finally getting in the cheap territory. There is lot of risk and possibly no level of due diligence today can offer any insight into the current state of Citi business (apparently the company itself is trying to figure out what the current state is) and by the time the fog clears, the stock price would have moved (either up or down, I am sure of it! If I were playing options, I would have likely bought straddles). So buying the stock today is as close to a gamble that one can find.

I took the gamble and bought a small stake today. A lot of it is guts but Citi is also one financial company that has built a strong franchise over the years and is a globally recognized brand that any investor would love to own. I expect more capital infusion to come in to stabilize Citi and eventually turn it around.

I will let the time be the judge whether this was a good decision or a rotten one …

What do you think?

This of course is not a new revelation. However, many readers and investors do not grasp the amount of risk that may be present in smaller companies. A big part of this risk may be just volatility due to illiquid nature of stock, but there are some other more basic risks that an investor needs to be cognizant of when investing in this asset class

To illustrate the points that I am making in this article, I will take an example of two stocks that the readers of this blog are already familiar with. Both these stocks have been discussed here in the past

Syntax-Brillian (BRLC)

This is a major egg on the blog author’s face. However, the case study on this company is worth reviewing to learn where we went wrong.

The rationale for investing in this company was many fold. Syntax-Brillian makes excellent quality HD LCD tvs (brand name Olevia) and sells it at a value price while maintaining great margins due to its optimized supply chain. The market for LCD TVs is growing and the future of the sector looks bright due to a potential for substantial increase in demand in the US due to forced HD conversion in 2009 as well as increased demand in China due to the upcoming olympics. Both markets where Syntax-Brillian is a significant player. The stock was trading at 10-11 PE when it was purchased and had just finished the year with triple digit revenue increases (YOY) and was on the verge of announcing two large big box retailers in US. So what could go wrong???

Well, plenty did go wrong. I would not dwell on BRLC’s history of missing projections to the street (after all if the stock is undervalued and still showing extremely high growth in business, why worry if the analysts estimates are missed. The stock price has to catch up to the potential, right!). No, the problem with the company was (is) really basic. It is in the execution and financial controls

Anyone who has owned a small, fast growing business, or for that matter worked in such business understands that growth requires working capital. If a company plans to grow (as an example) by 50% next year and sports 3-5% net profit margins, not enough cash is generated today to finance the growth for tomorrow. The shortfall needs to be made up by external financing (working capital)

Syntax-Brillian was constantly in need for financing to support its growth. The situation was made worse by the significant amount of business it did in China, where apparently the payment terms of 120 days is common place. This means that the product sold in China did not actually result in cash inflow until 120 days later. Meanwhile the company still has to pay its employees, its vendors (who are typically on a shorter payment term), etc.

And as the sales grew, the cash flow gap became wider and wider and recently it became so acute that one of the institution (Silverpoint)  funding Syntax-Brillian started the process to rein the company in by tightening the controls and increasing the cost of financing. The company, now it appear, has to review its finances on a weekly basis with its lenders and a lot of business planning discretion now no longer rests with the company executives

Ah, the pitfalls of debt financing!

It is not as if Syntax-Brillian did not try equity financing. Over the last 2 years, the equity holders were diluted numerous times to a total of greater than 50% dilution. A part of the stock price decline IS due to the dilutive effect of incremental equity sales.

In short, the company and the stock has been killed by extreme growth (I say killed, but the company is still solvent, although the future looks difficult)!

Generally a growing company picks a growth rate that is sustainable and can be funded either organically or even externally if the company is able to manage its fundamental ratios. But a steady and manageable growth rate did  not appear to be what the company was after as it raced to gain market share as the olympics and the forced HD conversion in US draw closer

There are only two outcomes that can be positive for a company in this situation. Slow the growth down and steady the ship, or, become a thorn in an incumbents boots so much that one of them choses to acquire the company. Sadly, enough shareholder value has already been destroyed before any of these possibilities can come to fruition

Growth at a reasonable price (GARP) is not enough. What we need is Sustainable Growth at a Reasonable Price (S-GARP)

I have exited this name with substantial losses

WSI Industries (WSCI)

This is a company in the metal service industry that we have discussed a few times in the past on this blog. As was reported earlier, the company had announced a significant increase in future business due to new customer acquisition. Subsequent to that, the company reported its quarterly earnings that bettered the estimates and more importantly, showed that the new customer has already started to become accretive to its earnings. The stock responded appropriately, jumping as high as $11s and finally settling down in the $8 range. This stock was purchased in $4-$5 range so there is a good capital appreciation already on my books. I am holding on to the investment for the time being

The important lesson from this is, when investing in micro/small cap companies, one needs to keep a close eye on the investments. The best rewards come to those who hold long term but it is also necessary to monitor the company’s business performance for signs of weakness and act accordingly

PS: Sorry for the brief unintended hiatus from posting! Sometimes life interrupts without warning! 

There is a brewing opposition to Bank of America’s proposed acquisition of Countrywide

First there was a news that the hedge fund SRM Global Fund with its 5.2% stake in Countrywide is opposing the BAC deal . The feeling in the market at that time was SRM may not be able to find any allies in other shareholders

Then comes the new yesterday that Capital World has acquired a 6.1% stake in Countrywide recently. Although Capital World appears to be a passive investor who may or may not side with SRM, they clearly think that the current price is a good value

Today it is revealed that Legg Mason as requested and received approval to raise its stake in Countrywide upto 25%, and its stake has already been increased upto 15% of the company. Additionally, Bill Miller of Legg Mason in a note to investors indicates that he is not in favor of Countrywide sale at the current prices

With many investors now gearing up to oppose the CFC sale to BAC, expect more buying in the stock and gradual appreciation of the stock price. A likely scenario that eventually plays out may include BAC sweetening its offer for Countrywide by possibly offering more BAC stock in exchange for CFC stock. This is getting interesting and even if buying CFC may not work out as a way of getting BAC cheap as suggested in an earlier article (that is if the sale does not go through. If the sale goes through at the current or higher prices than the strategy works beautifully), all the institutional support that is coming back to Countrywide bodes well for a good return on investment on CFC stock itself

If you are invested in CFC I would recommend to stay put. (Of course, there is always a risk of bankruptcy and that is something that you need to weigh)