Ok, I must confess, reading Security Analysis is a shade difficult, I feel sleepy after reading 5 pages at a stretch.

I’ve just been reading Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions), which I’d recommend to all. It’s updated with new commentary by great current value investors such as Seth Klarman, James Grant, Bruce Greenwald and others. I had an earlier copy of the book, however, I must say, the additional commentary by these great investors really helped me understand so much more. It’s a true gem which every value investor must have.

So I got around to reading and learning the book in a different way, using Concept Visuals(a technique invented by a friend of mine, Sanjay Vyas). I made a Concept Visual about Intrinsic Value as described by them in the book…(do let me know your feedback after viewing it.)

Intrinsic Value as defined by Benjamin Graham (using a Concept Visual)

At the rate I’m buying and how people are getting me Finance books for presents, I will soon have an enviable library of Finance reads soon. Valuation modelling, Buffett, Soros, Security Analysis (original version!)… these are few of the new additions.

*beams*

Books give me a pleasure which trumps clothes/shoes/bags; they provide a constant, reliable and unfailing comfort to me, even in my darkest hours.

I’ve started reading or re-reading(the last time I picked it up I just couldn’t finish it) Benjamin Graham and David Dodd’s Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions) , which I’d recommend to all. It’s updated with new commentary by great current value investors such as Seth Klarman, James Grant, Bruce Greenwald and others. I had an earlier copy of the book, however, I must say, the additional commentary by these great investors really helped me understand so much more. It’s a true gem which every value investor must have.

Columbia Business Schools, The Heilbrunn Center for Graham & Dodd Investing has some interesting videos delivered by value investing professionals who have contributed their time to share their insights with Columbia Business School students http://www4.gsb.columbia.edu/valueinvesting/schlossarchives/class_recordings

The next two links are basically interviews, and both very good…

While different investors arrive at intrinsic value using different methods, they are all searching for the same thing:  businesses selling well below their estimate of intrinsic value. You can read the Graham and Doddsville interview here. For more on Bruce Berkowitz, see his interview in the recent issue of Outstanding Investor Digest here. (This one is especially long and quite interesting).

The last one I read recently was Balance Sheet Analysis: Cash which is posted at the Distressed Debt Investing blog.

I hope you enjoy these as much as I did.

First off welcome to the site.

Invest in Value is a site that is meant to hold any opinions I may have on anything in investing. The purpose of the site has not been thought out to any great extent and as “owner” of the site I feel that it is okay since it is a not-for-profit operation.

I am currently studying the works of Benjamin Graham. I have been trudging through Security Analysis at a very slow pace. I also have in my possession a copy of The Intelligent Investor. Both books are partially read by yours truly and I have high hopes that I am on my way to replicating the results of those previously who have studied Graham (read: Warren Buffett).

On a more serious note, it should be emphasized here that I am in no way an authority or expert on anything written on the site. It is merely an opinion of an ordinary person. If any posts in the future mention specific stocks, they are in no way qualified recommendations to buy or sell these securities.

The frequency of posts are likely to be low. My initial aim is for one per month, however this may be ambitious. My logic is in that the fewer times I come here to write, the longer I have to think of something worthwhile to write about (hopefully, let me repeat that this is an ambitious projection).

I also hope that any post that happens to be read by anyone stumbling upon the site that the reader may leave comments and remarks. I would love feedback, further comment or a difference of opinion left on the site. My hope is to stimulate some sort of discussion with every post. The readership is expected to be next to none (we just don’t have the advertising budget to draw in the traffic) but that is okay, the true value of anything written here is likely to be small.

With all the above being said, I hope that I may write on topics that interest you and that you will enjoy the future posts to come.

Over the weekend, I was paging through Graham and Dodd’s Security Analysis (5th edition, authors Cottle, Murray, and Block), and thinking especially about discount rates and the margin of safety concept, particularly in light of recent macroeconomic events. It is not yet clear to me how much attention an investor should yield to macroeconomic changes and predictions. Investors often take solace in Warren Buffett’s seeming ambivalence to most macroeconomic data, recalling his many quips about being wholly uninterested in the federal funds rate policy for the upcoming year. Cottle, Murray, and Block touch on these issues in their ninth chapter, on “Qualitative and Quantitative Factors in Security Analysis and the Margin of Safety Concept.” Having laid out the sources of information that an analyst should use, the authors move to the more difficult question—how should the analyst use them?

The basic quandary is this: the analyst could gather nearly infinite information about a given investment, information which would presumably help her to better judge its value. Any constraints on time and attention seemingly hold the analyst back from giving her best judgment. Yet, such constraints are not undesirable, for not all information is essential for a reasonably full evaluation. The analyst must cultivate discernment and practical wisdom in order to know whether the information she has is essential and enough. As our authors observe, “the analyst must exercise a sense of proportion in deciding how deep to delve” (114).

But the specifics here are likely the most useful. An analyst may not need to assess patent protections, geographical advantages, or labor conditions, which may or may not endure. For a stable company, five year financial statements “will provide, if not a conclusive basis, at least a reasonably sound one for measuring the safety of the senior issues and the attractiveness of the common shares” (114).

The company’s “statistical exhibit” though is not enough. “Exceedingly important” are qualitative factors, which—while difficult to assess—require the analyst to examine the nature of the business, the character of management, and the trend of future earnings (115). Particularly pertinent is the business’ position in its industry, its industry’s relative prospects, litigation risk, potential regulatory changes, and social issues. Management represent the face of the business, and many even consider picking good management more important than picking a business in a promising industry. Yet, our authors warn, “little tangible information is available about management… [and] objective tests of managerial ability are few and rather unscientific” (121). Even more worrisome, “there is a strong tendency in the stock market to value the management factor twice,” for both the fact that earnings growth is so robust, and that this capable management produced it (121). Though qualitative factors may be overemphasized and lead to an undue emphasis on perceptions of quality (think of the “Nifty Fifty” and the slogan “Make sure of the quality and price will take care of itself”), researchers Clugh and Meador have concluded that the predictive process is based primarily on qualitative factors.

Thoughout their discussion here, our authors say little explicitly about macroeconomic concerns, in large part because of their emphasis on the presence of a margin of safety for any true investment. As they observe, “when the price is well below the indicated value of a secondary share, the investor has a margin of safety which can absorb unfavorable future developments and can permit a satisfactory ultimate result even though the company’s future performance may be far from brilliant” (504). Though the margin of safety may not guarantee favorable performance by itself, when coupled with sufficient diversification, the margin of safety concept can produce acceptable returns in a variety of macroeconomic environments.

Since an analyst’s time and attention are limited, Graham, Dodd, and Buffett concentrate their energies almost solely on understanding businesses, and in particular, on those aspects of the business which management can control—namely, costs, marketing, and pricing. This concentration, coupled with the margin of safety concept, should be sufficient to defend the investor from unforeseen changes in the broader economy and render detailed economic analysis less relevant to the analyst’s work.

Seth Klarman, clearly one of our favored sources of investing insight, recently took up the task of revising Benjamin Graham and David Dodd’s famous Security Analysis. In the introduction, Klarman observes some of the persistent difficulties in the stock market that enable some investors to generate outsized returns. One such difficulty is the lack of clarity about what makes a good business.

Klarman writes: “Another area where investors struggle is trying to define what constitutes a good business. Someone once defined the best possible business as a post office box to which people send money. That idea has certainly been eclipsed by the creation of subscription Web sites that accept credit cards. Today’s most profitable businesses are those in which you sell a fixed amount of work product–say, a piece of software or a hit recording–millions and millions of times at very low marginal cost. Good businesses are generally considered those with strong barriers to entry, limited capital requirements, reliable customers, low risk of technological obsolescence, abundant growth possibilities, and thus significant and growing free cash flow.” (xxxv)

All told, a very useful set of criteria.  The only thing I would want is some additional criterion about increasing margins.  In highly competitive industries, some businesses find it difficult to raise prices, since their market share quickly drops when they do.  A good business has customers who are relatively unconcerned about marginal price increases.  Businesses that have this privilege include Coca-Cola, Moody’s, Mastercard, and Visa.

Case in point, at the football games this past fall, a Coke was selling for $5 a cup.  And let me tell you, you still had to wait in line to get it.

“In the last three decades the prestige of security analysis in Wall Street has experienced both a brilliant rise and an ignominious fall—a history related but by no means parallel to the course of stock prices. The advance of security analysis proceeded uninterruptedly until about 1927, covering a long period in which increasing attention was paid on all sides to financial reports and statistical data. But the “new era” commencing in 1927 involved at bottom the abandonment of the analytical approach; and while emphasis was still seemingly placed on facts and figures, these were manipulated by a sort of pseudo-analysis to support the delusions of the period. The market collapse in October 1929 was no surprise to such analysts as had kept their heads, but the extent of the business collapse which later developed, with its devastating effects on established earning power, again threw their calculations out of gear. Hence the ultimate result was that serious analysis suffered a double discrediting: the first—prior to the crash—due to the persistence of imaginary values, and the second—after the crash—due to the disappearance of real values.”

Security Analysis, 1940

Diehard value investors will appreciate the transcripts of lectures featured in “The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend,” by Janet Lowe. Posted on John Wiley & Sons’ web site, the “lectures are from the series entitled Current Problems in Security Analysis that Mr. Graham presented at the New York Institute of Finance from September 1946 to February 1947.”

A special thanks to Todd Sullivan (find him at http://valueplays.blogspot.com) for posting these lectures and bringing them to our attention.

U P D A T E

On February 2, 2009, Meadow Valley completed its going private transaction at $11.25 per share. The approximate return to arbitrageurs is 65%, or 520% per annum.

http://finance.yahoo.com/news/Meadow-Valley-Completes-bw-14229823.html

T H E S I S

Meadow Valley’s construction services segment builds bridges, overpasses, channels, roadways and airport runways; the construction materials segment manufactures ready-mix concrete, sand and gravel products. In a 10-Q filed November 14, Meadow Valley comments on the status of its operations:

“As with each quarter this year, the third quarter was significantly buoyed up by the performance of our construction services segment. Entering fiscal 2008 with approximately $172.4 million in backlog provided a good deal of momentum for the construction services segment. Contract backlog as of the end of the third quarter was approximately $145.1 million, 63.4% more than a year ago, and should continue to provide near-term opportunity for solid performance from the construction services segment. The construction services segment is primarily engaged in public infrastructure construction and, so far, the public works sector of the construction industry has been less affected by the turmoil in our nation’s economy. As a result, we have had ample bidding opportunities, but what is apparent from the bidding is that competition is intensifying both in terms of the number of bidders as well as tightening profit margins. Our current bonding limits of approximately $250 million total bonding program and a single project limit of approximately $100 million allow us to bid on larger projects which typically see fewer bidders because of such high bonding requirements. Nonetheless, in today’s competitive environment we see an increased number of bidders on jobs of all sizes.

“The sharp decline of the housing sector has been the primary cause of the recent poor performance of our construction materials segment. Since demand for our product, ready-mix concrete, depends entirely on the amount and location of construction activity and because most of our facilities are located to best serve the residential or residential-related commercial construction projects, we have been dramatically affected by this downturn. A few quarters ago, what seemed to start as a slowdown in housing has now erupted into a full-blown global financial crisis. It appears highly likely that we will experience a much more pronounced and longer downturn than previously believed. Furthermore, commercial construction typically lags residential construction and we have only begun to see the slowdown in commercial construction activity. Accordingly, we have taken specific actions to reduce costs and preserve cash for our construction materials segment. These actions include, but are not limited to: (i) not filling the vacancy created by the promotion of our Vice President to President of RMI upon our President’s retirement, (ii) reducing construction materials segment administrative personnel, (iii) implementing a fuel surcharge, and (iv) reducing operational overtime for the construction materials segment. Subsequent to the third quarter ended September 30, 2008 we also imposed a 5% reduction in pay for all construction materials segment salaried employees. We will continue to analyze our operations for other opportunities to further reduce costs and preserve cash.”

Since service contracts account for the great majority of Meadow Valley’s revenue, the company should maintain a moderate level of earning power through the current recession. Indeed, third quarter performance has been satisfactory even after the exclusion of a particular non-recurring benefit. There are, however, two important risk factors for the construction services segment:

“Because much of the funding of transportation infrastructure comes from local sales and fuel taxes, any event that may impact the overall economy that would decrease consumer spending or diminish fuel consumption would result in lower receipts of tax dollars that, in turn, would diminish the availability of funding for transportation infrastructure.

“As public works constitute the majority of our CSS volume, and governmental entities are the primary source of funding for infrastructure work, it is, therefore, important that public funding be maintained. The national transportation legislation, SAFETEA-LU, was signed by President Bush on August 10, 2005 and should provide relatively stable funding for transportation infrastructure at least until its expiration in the fall of 2009.”

Government construction expenditures should increase under the Obama administration.

In July 2008, Insight Equity proposed to acquire Meadow Valley for $11.25 per share. Given the significant premium to current prices, I believe that stockholder approval is assured. However, Insight Equity now claims Meadow Valley may have experienced a material adverse effect, viz., fair market value has declined by more than $6 million. Fair market value is not clearly defined in the merger agreement, but the main issue appears to be poor operating results at Meadow Valley’s Ready-Mix subsidiary. According to management, Ready-Mix has not violated deal covenants.

There are three obvious outcomes to the Meadow Valley situation: first, stockholders can receive $11.25 per share; second, they may receive some reduced price; and third the merger may be terminated. I believe that each outcome is equally probable, and that even a termination will not be too onerous for stockholders. The mathematical expectation is positive.

Vigorish.wordpress.com is a private forum detailing arbitrage and hedging opportunities in equities, bonds, derivatives and convertible securities. I am not certain of how to proceed with the blog; however due both to technical matters and my desire to keep opportunities “close to the vest,” I do want to limit the audience to 35 individuals. Candidates will be selected based on the quality of their ideas (submitted to me via email).

Wild Card: Well forget about EMH, would you agree a lot more riskless opportunities exist now than say…back in 2006?
How highly efficient can this market really be right now?

Deep Throat: Riskless is very relative. The tricky part of a market like the one we have is figuring out which deals are fairly priced. Ok, that’s the tricky part of every market. But my point is that you might be more easily become overly excited in a market like this than in a much calmer market, when perhaps people with the tiny amount of capital that we have are more likely to blow their wad on stuff that’s not worth it.

In other words, look at those people on google finance who invested in Freddie and Fannie, thinking it was a riskless opportunities. Obviously, we’re not that dumb… but it’s all relative.

Cogitator: No, [REDACTED]. As I understand the English language, riskless means “without risk.” And the [REDACTED] arbitrage truly is without risk; you short sell 3.3682 shares per [REDACTED], and exercising the [REDACTED] gives you 3.3682 shares back. It’s like selling 10 apples at $1 each and getting those identical apples back for a price of only $0.93. It yielded a riskless 7% return today.

How could an investment in Fannie Mac riskless? Any directional bet is by its terms riskier than an arbitrage. Granted, the Volkswagen/Porsche incident demonstrates the risk of this technique, but that is a peculiar case. If you buy and short sell economically equivalent securities (of the same issuer) at a substantial spread (say, 30% or more), the risks should be nil.

The market is efficient most of the time for virtually all participants. However, Ackman makes a very good point: not everyone has permanent capital (capital not subject to redemption). A great deal of Buffett’s success is due to having steady access to capital at times when the rest of the world does not.

Deep Throat: “Well forget about EMH, would you agree a lot more riskless opportunities exist now than say…back in 2006?”

I was responding to the more general above statement from [REDACTED]. Not your particular case. And I didn’t believe he was *only* talking about arbitrage, though if he was, then I stand corrected.

As for the Fannie thing, I was using an exaggerated point (of stupidity) to show how recklessness even in a favorable market can get people into trouble. The point I was in particular discussing involved the discussion that [REDACTED] had linked on Google finance boards, where people were arguing, in essence, that Fannie was a riskless opportunity when at that point it was trading at 0.50$ and the government hadn’t stepped in. I was just using that to show how people were taking the idea that stuff was undervalued in the broader market and applying it to mean that investing in Fannie had no downside. And that we could make similar mistakes, so true riskless opportunities (again, outside arbitrage) did not exist.

Wild Card: I wasn’t talking only about arbitrage. I was just wondering how “highly efficient” this market really is and what makes it so highly efficient because Derek kept using that phrase.

Cogitator: Here’s what Ben Graham said about the subject:

“To the objective observer the failure of the funds to better the performance of a broad average is a pretty conclusive indication that such an achievement, instead of being easy, is in fact extremely difficult.

“Why should this be so? We can think of two different explanations, each of which may be partially applicable. The first is the possibility that the stock market does in fact reflect in the current prices not only all the important facts about the companies’ past and current performance, but also whatever expectations can be reasonably formed as to their future. If this is so then the diverse market movements which subsequently take place–and these are often extreme–must be the result of new developments and probabilities that could not be reliably foreseen. This would make the price movements essentially fortuitous and random. To the extent that the foregoing is true, the work of the security analyst–however intelligent and thorough–must be largely ineffective, because in essence he is trying to predict the unpredictable.

“The very multiplication of the number of security analysts may have played an important part in bringing about this result. With hundreds, even thousands, of experts studying the value factors behind an important stock, it would be natural to expect that its current price would reflect pretty well the consensus of informed opinion on its value. Those who would prefer it to other issues would do so for reasons of personal partiality or optimism that could just as well be wrong as right.”

These are extraordinary times particularly for active participants in the capital markets.  While I do not normally choose to write about macro and regulatory events, I thought it would be useful for you to understand how we think about recent events and their impact on our portfolio.

We are currently witnessing the greatest deleveraging event in history.  What began as a credit bubble bursting has now spread to the equity markets as banks, investment banks, hedge funds, structured products, mutual funds, pension funds, endowments and other leveraged and unleveraged market participants have been forced to liquidate assets by their counterparties, leverage providers, redeeming clients, and as a result of downgrades, other debts or other commitments that need to be funded.

These actions have led to forced and indiscriminate selling in security markets around the world, which in turn has caused other investors to panic or simply to sell, to get out of the way of other forced sellers.

As a fund which is generally substantially more long than short, we have also suffered large mark-to-market declines in our long investments.  Year to date, however, our performance has substantially exceeded that of the broader equity markets, which at this writing have seen a more than 34% decline.  Our outperformance is largely due to large gains on our investments in Longs Drugs and Wachovia Corporation as well as profits on our credit default swap and other short exposures.  Our market losses have been further mitigated because we operate unleveraged and have substantial cash balances.  Currently, we have cash and near-cash (Longs Drugs and Wachovia/Wells Fargo long/short) equal to approximately 39% of our capital.

When, you might ask, will the selling end?  While I don’t proclaim to be a market prognosticator, I will make a few observations.  Unlike the deleveraging that takes place when banks and other financial institutions sell assets to meet regulatory requirements, which is typically a longer term process, the forced deleveraging that is now taking place in the equity markets is being implemented largely by the prime brokerage firms and margin account managers at broker dealers around the world.  Prime brokers are not known to be laggardly in their approach to liquidating an account that no longer meets margin requirements.  This is likely to be even more true in the current environment.  As such, it may be reasonable to conclude that the forced liquidation that is now taking place may not be a prolonged process.

Security prices around the world have come down tremendously.  In the larger capitalization U.S. markets, which are the focus of our strategy, the reductions have been substantial.  As of the market close on October 31st, the S&P 500 is down 34.0%, year to date, and down by 37.5% from its high on October 31, 2007; and this is after last week’s rally in which the S&P 500 rose more than 12% from the lows.  Unlike the bear market of 1973 and 1974, in which stocks declined by 45% from the highs, this bear market was not preceded by the “Nifty 50” bubble in which large capitalization growth stocks traded at extraordinary valuations.  While valuations were not cheap one year ago, in a long-term historical context, the market as a whole (particularly if one were to exclude financials) was not particularly expensive either.

As such, in today’s market, we are finding extraordinary bargains, the kinds of opportunities that are normally associated with market bottoms.  While there are still weak and poorly capitalized businesses that are likely still overvalued, the high quality, well-capitalized, larger capitalization businesses which are the focus of our strategy look very cheap to us.

While this means that now is likely to be a much better time to be a buyer rather than a seller, it does not mean that the market will not continue to decline, even substantially, from current levels, particularly in the short term.  In fact, because of tax-loss selling over the next 60 or so days, there will likely be additional selling pressure.  At some point, however, the forced selling will come to an end.  Large amounts of cash are sitting on the sidelines waiting to be deployed when investors feel the coast is clear.  In the event the market were to start to rise again, it would not be a surprise to see institutional, retail, and hedge fund investors rapidly deploy capital so as not to miss a, perhaps, explosive market rally.

What does this all mean for Pershing Square?  Despite the fact that we occasionally have an opinion, we spend little time trying to outguess market prognosticators about the short-term future of the markets or the economy for the purpose of deciding whether or not to invest.  Since we believe that short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.

Our strategy is to seek to identify businesses and occasionally collections of assets which trade in the public markets for which we can predict with a high degree of confidence their future cash flows – not precisely, but within a reasonable band of outcomes.  We seek to identify companies which offer a high degree of predictability in their businesses and are relatively immune to extrinsic factors like fluctuations in commodity prices, interest rates, and the economic cycle.  Often, we are not capable of predicting a business’ earnings power over an extended period of time.  These investments typically end up in the “Don’t Know” pile.

Because we cannot predict the economic cycles with precision, we look for businesses which are capitalized to withstand difficult economic times or even the normal ups and downs of any business.  If we can find such a business and it trades at a deep discount to our estimate of fair value, we have found a potential investment for the portfolio.  Next we look for the factors that have led to the business’ undervaluation, and judge – based on our assessment of the company’s governance structure, management team, ownership, and other factors – whether we can effectuate change in order to unlock value.  When the price is right, the business is high quality, the management is excellent, and there are no changes to be made, we are willing to make a passive investment.

Our assessment of the short-term supply and demand for securities plays almost no role in our determining whether to invest capital, long or short.  If we believed that it was possible to accurately predict short-term market or individual stock price movements and we had the capability to do so ourselves, we might have a different approach.  Below I quote Warren Buffett in his 1994 Letter to shareholders where he perhaps says it best:

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.  Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles.  Nor did they render unsound the negotiated purchases of fine businesses at sensible prices.  Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital.  Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak.  Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years.  We will neither try to predict these nor to profit from them.  If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results…

Stock prices will continue to fluctuate – sometimes sharply – and the economy will have its ups and down.  Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.

I believe we will look at the current U.S. stock market valuations for high quality mid and large capitalization businesses as presenting perhaps the best investment opportunities of our lifetimes. 

Portfolio Update

The last quarter and, in particular, the last few weeks have been an extraordinarily busy and productive time for Pershing Square.  During this time, we have made considerably more buy and sell decisions than usual, taking advantage of the liquidity of our holdings, the enormous volatility of the market, and new opportunities that have presented themselves in recent weeks.

In the third quarter, we disposed of our investments Cadbury PLC, Canadian Tire, and Austrian Post at prices generally higher than current levels.  We also disposed of the substantial majority of our investment in Sears Holdings. We hold a residual interest in Sears (which represents approximately 1.5% of fund capital) as its price declined to a level at which it made no sense to continue to sell. We redeployed the capital from these sales into Wachovia Corporation, which I will discuss further below, as well as a new investment in which we are in the process of accumulating a position.

We sold these positions not because we thought they would be poor investments, but rather because we believed that we could redeploy the capital in investments that offered a more attractive risk-reward profile.  As we have often stated, we are always willing to sell an existing holding at a profit or a loss, if we can find a better use for the funds.  For our taxable investors, sales at a loss have the additional benefit of offsetting taxable gains.

Our sales were also motivated by the fact that three of the above companies – Sears, Canadian Tire, and Austrian Post – each have a controlling shareholder.  Because we believe that one of our important competitive advantages is our ability to effectuate change at companies in our portfolio, other than in special circumstances, we do not expect to make investments in controlled companies in the future.

As a result of recent changes in the portfolio and strategic developments with respect to Longs Drugs and Wachovia Corporation, our long portfolio is now comprised of higher quality, more economically resilient businesses, companies for which we can be a catalyst to create value, and a large amount of cash and soon-to-be cash that we can redeploy in new opportunities.

On the short side of the portfolio, we have been opportunistic in unwinding single-name credit default swaps in cases where spreads have increased significantly, and have covered certain short positions where stocks have declined substantially as a result of company-specific as well as market-related events.  We recently repurchased CDS on the investment grade credit index as certain technical factors have made this investment/hedge attractive once again.

Longs Drugs

In last quarter’s letter, I alluded to a new position on which we expected to file a Schedule 13D shortly.  That position was Longs Drugs, a West Coast based drugstore retailer.  While Longs’ was valued in the market as an underperforming drug store retailer, we valued the business based on its component parts which included:  (1) owned and long-term, below-market, leasehold real estate, (2) RxAmerica, a rapidly growing pharmacy benefit manager (“PBM”) which generated more than 20% of the company’s trailing operating income, and (3) an underperforming, low-margin drugstore retailer.  At our cost, we believed that Longs real estate value alone more than covered our purchase price and we were getting the PBM and the retailer for less than free.  We estimated the fair market value of the company to be $85 to $95 per share assuming each of the company’s assets was sold to the buyer who could pay the highest price.

Unlike many of our previous active investments, we concluded that Longs had reached the end of its strategic life and should be sold to one of its larger competitors, namely CVS or Walgreens.  While it has been rare for us to buy a stake in the company with a view that a strategic sale was the right exit opportunity, we have done so in the past.  For example, our original investment in Sears Roebuck & Company was predicated on a strategic outcome at the company which was ultimately achieved when it was acquired by Kmart.

In the current weak (to use a euphemism) credit environment, we are particularly wary of investments which are predicated on a sale.  However, in this case, we were comforted by the fact that Longs Drugs would be a must-have acquisition for CVS and Walgreens and that both companies, which are many times the size of Longs, could easily finance the acquisition.  Even in the event a sale did not go through, we had purchased Longs at an attractive price which offered a substantial margin of safety against a permanent loss of capital.

Within one week of our 13D filing, Longs announced that it had entered into a transaction to be sold to CVS for $71.50 per share in a cash tender offer, an approximately 44% premium to our average cost.  While we were happy with the deal, we were somewhat unhappy with the purchase price, particularly when we learned that the company had not run a competitive auction.  Thereafter, we hired the Blackstone Group with whom we have worked successfully in past transactions in an attempt to achieve a better outcome for all shareholders.

We and Blackstone were successful in attracting a bid of $75 per share from Walgreens; however, the greater regulatory risk and potential time delay in a transaction with Walgreens led Longs’ board to reject the transaction in favor of the CVS offer.  Walgreens subsequently withdrew its offer citing market conditions, and a day later, the CEO of Walgreens stepped down.  We anticipate that we will be fully cashed out of our investment in Longs’ by the close of trading today.

Wachovia Corporation

Wachovia is a good example of the types of opportunities that have emerged in the current highly volatile environment.  On Monday morning September 29th, Wachovia Corporation announced that it had entered into an agreement in principle to sell its banking subsidiaries to Citigroup.  The transaction was structured in an unusual manner.  In the deal, Citi was paying $2.1 billion of its own stock to Wachovia Corporation (the publicly traded holding company for the Wachovia banking subsidiaries) and assuming $53 billion of senior and subordinate holding company debt in addition to the debt and other liabilities of the Wachovia banking subsidiaries.  The description of the transaction was limited to a several paragraph press release and a conference call presentation by Citigroup that morning.  Wachovia stock opened later Monday afternoon at approximately $1.80 per share, down 82% from Friday’s close.

The market’s reaction to the Citi transaction was severe, particularly as the transaction was announced only four days after Washington Mutual’s subsidiary banks were seized by regulators and sold to J.P. Morgan.  In that transaction, WaMu’s holding company filed for bankruptcy, wiping out shareholders and materially impairing holding company creditors.

The Wachovia transaction, however, was structured in a materially different manner from the WaMu seizure.  It appears that the government, in order to protect bank holding company bondholders from losing their investment and perhaps to avoid triggering a CDS credit event, structured this deal so that Citi would assume the holding company debts.  Interestingly, as part of the Citi transaction the government provided an excess-of-loss guarantee on Wachovia mortgages to protect Citi, which the government could likely have avoided if it had not required Citi to assume $53 billion of holding company debt.  It appears that the government had concluded that additional bank holding company debt defaults would create systemic risk or reduce the ability for bank holding companies to access this important source of capital, and therefore chose to protect the Wachovia banking subsidiary and the holding company bondholders.

The unusual structure of the transaction created an interesting investment opportunity.  By removing the holding company debts, Wachovia Corporation, now orphaned from its bank subsidiaries was left with some very attractive assets.  Based on our reading of the public filings, conference call transcripts, and internet research over the course of Monday morning and afternoon, we estimated that Wachovia was left with the following assets:  approximately $2 billion or more of cash, $2.1 billion of Citigroup Stock, the Wachovia Securities wealth management operation, A.G. Edwards (which had been purchased one year ago for approximately $7 billion), Evergreen Asset Management (a mutual fund manager with $245 billion in assets under management), Wachovia Insurance Services, and other ancillary assets.

In light of the Citi debt assumption, the only material liability of Wachovia Corporation was $9.8 billion of non-cumulative, perpetual preferred stock.  Because this preferred is both non-cumulative and perpetual, Wachovia has no obligation to ever pay a dividend on these securities making these liabilities effectively a free form of equity financing.  These types of preferred securities are typically structured to qualify as an attractive form of bank holding company equity which gets favorable regulatory and rating agency treatment.  Now that they were orphaned by the transaction, at best these liabilities were worth less than 50 cents on the dollar.

We also determined that the structure of the transaction would create a large tax asset for the holding company.  By selling the bank subsidiaries for less than their net tangible asset value, we estimated that a $26 billion tax loss would be created.   This tax loss could by carried back two years enabling the holding company to recover approximately $7.5 billion of cash taxes that had previously been paid.

Our conservative estimate of value of New Wachovia was in excess of $8 per share even assuming that the preferred stock was redeemed or valued at par.  We began buying the stock shortly after it opened on Monday afternoon.  My instructions to our traders Ramy Saad and Erika Kreyssig were to buy every share we possibly could, including pre- and post-market trading.  They did a superb job. 

Between Monday afternoon and late Thursday we acquired 178 million shares, or approximately 8.3% of the company, at an average price of $3.15.  On Friday morning before the open, Wells Fargo announced a definitive agreement to acquire Wachovia for 0.1991 shares of Wells common stock, or more than $7.00 per share based on Friday’s trading price.  We began selling our Wachovia stock on Friday.  We could not, however, hedge the Wells Fargo stock price because the short selling ban was still in effect.

Citi, which thought it had an exclusive to complete the transaction with Wachovia, brought litigation later that Friday to enjoin the Wells Fargo deal.  By late the following week, Citi, likely as a result of pressure from the government, had agreed to allow the Wells transaction to go forward while retaining their lawsuit for damages against Wells Fargo.

As of this date, we have hedged 100% of our exposure to Wells Fargo shares, and have been opportunistic in unwinding a substantial portion of the position.  Assuming we waited until transaction closure and taking into consideration Wachovia shares already sold, we have locked in a 67% profit on this $560 million investment.

The government and all of the parties appear to be doing everything they can to consummate the transaction promptly.  The transaction received HSR approval in one day and the Treasury and banking authority approvals over the following weekend. Wells has been issued 39% of the voting stock of Wachovia and transaction closure is anticipated by year end.  The transaction requires the recently filed form S-4 to be approved by the SEC and the completion of the mechanics of the shareholder meeting in order to be consummated.  It is an excellent deal for Wells Fargo and for Pershing Square.

A Mistake

While most of our long investments are comprised of great businesses or assets at fair prices with a catalyst to create value, we occasionally are willing to invest a small amount of fund capital in situations which offer the potential for a many-fold profit at the risk of a large or near-total loss of capital invested.  I typically call these investments mispriced options.  Our CDS investments fit this profile.  While not all mispriced options will be profitable for the funds, I expect our collective experience in these commitments to be quite favorable over time.

We purchased stock in American International Group, Inc. (AIG) after the announcement of the government bailout.  In summary, we did so because at the price paid, we purchased AIG at a substantial discount to book value, and we believed that book value was a conservative estimation of the value of AIG’s underlying businesses net of derivative losses.  We also believed that there was the potential for a renegotiation of the government’s extremely harsh financing commitment to AIG which provided for 80% dilution, enormous commitment fees, and a high interest rate.

In particular, we believed that if AIG could pay back the government promptly through a combination of asset sales, termination of certain CDS contracts at potentially less than fair market value, and equity investments from existing and potentially other investors, that there was a chance to renegotiate the 80% zero-strike warrant package to the government.  If the warrant dilution could be mitigated, it would be possible for AIG shareholders to make a many-fold return on investment.  Initially, we believed that the potential for return outweighed the risk of loss.  Because of the inherent leverage of AIG, the risk of a permanent loss of capital on this investment was material.  As such, we limited the size of our investment to 2.5% of fund capital.

After acquiring our position, we met with other large holders, policymakers and contacted Berkshire Hathaway and other potential investors about a proposed recapitalization of AIG.  Unfortunately, the collection of shareholders that were attempting to restructure the government deal was exceedingly disorganized and some large holders were conflicted by a desire to buy certain assets from the company.

We ultimately concluded that the return on invested brain damage from this investment exceeded the probability-weighted opportunity for profit, and we decided to fold the tent.  We sold our stock and incurred a modest loss to the funds.

Our Business Model

In order to achieve long-term success, Pershing Square must make good investments and operate with a robust business model.  With much media attention focused on hedge fund failures, I thought it would be worthwhile reviewing the characteristics of our business model and explaining why we will withstand industry-specific and overall environmental threats to the investment and hedge fund businesses.  The principle factors which contribute to the robustness of our business model are as follows:

• Our portfolio management approach is inherently low risk (where risk is defined as the probability of a permanent loss of capital), particularly when compared with other hedge fund business models.  An important distinguishing factor about Pershing Square compared to most other hedge funds is that we do not generally use margin leverage in our investment strategy.  The lawyers prefer that I put in the word “generally” to give us the flexibility to use margin to manage short-term capital flows, but, to-date, we have not used any but an immaterial amount of margin, and only for a brief period of time, and we have no intention of changing this approach,
• We generally invest in higher quality businesses with dominant and defensive market positions that generate predictable free cash flow streams and that have modestly or negatively leveraged (cash in excess of debt) balance sheets.  We buy these businesses at deep discounts to our estimate of intrinsic value giving us a margin of safety against a permanent impairment of capital.  I say “generally” again here because we do make exceptions in certain limited circumstances; that is, we may buy a more leveraged or lower quality business if we believe the price paid sufficiently discounts the risk.
• We often seek investments where we can effectuate positive change to catalyze the realization of value.  This serves to accelerate the recognition of value, helps us avoid “dead money” situations, and protects us somewhat from managerial actions which can destroy value.
• We are diversified to an adequate but not excessive extent.  This has further benefits for risk and operational management which I will discuss below. 
• There is an inherent balance to our long/short investment approach.  Historically, when equity or credit markets weaken, our shorts become more valuable, and occasionally materially more valuable, offsetting somewhat the mark-to-market declines in our long portfolio.  If we choose to unwind these short positions during market downturns, we can generate capital to invest in a now less expensive market.  These short investments generally stand on their own in that they do not typically require a stock market or credit market decline to be successful.  That said, they have served as a useful hedging tool during periods of dramatic market declines.
• We have been paranoid about counterparty risk since the inception of the firm.  First, we trade with counterparties which we believe to be creditworthy.  Second, we have negotiated ISDA agreements which provide us with daily mark-to-market cash and U.S. Treasurys equal to the previous day’s market value of our derivative contracts.  In cases where we are required to post initial margin and therefore have some exposure beyond the market value of our derivative contracts, we have typically purchased CDS on our counterparties to further mitigate counterparty risk. While our approach to counterparty risk has protected us from any counterparty losses to date, please be forewarned there is no perfect approach to avoiding counterparty risk. 

Our simple approach to investing also allows us to avoid complicated approaches to risk management.  Our investment strategy does not require us to open offices all over the globe.  As such, we don’t need traders working around the clock.  We can go to sleep at night and sleep.  Our weekends are largely our own (Ok.  I admit it.  I am writing this letter in the office on Sunday.)  Our risk management approach is to:   (1) put our eggs in a few very sturdy baskets, (2) store those baskets in very safe places where they cannot be taken away from us and sold at precisely the wrong time due to margin calls, and (3) to know and track those baskets and their contents very carefully.   We call this approach the sleep-at-night approach to risk management.  If I can’t, we won’t.

I am extremely skeptical of more automated, algorithmic, Value at Risk, and other business school sanctioned approaches to risk management.  None of these approaches saved Lehman, Bear Stearns, Fannie, Freddie, AIG, WaMu, Wachovia or any of the other institutions that used these and other ostensibly more sophisticated risk management strategies.

Our investment strategy and approach to counterparty risk serves to limit the risks inherent in our individual investment selections, our counterparty risk, and the portfolio as a whole.  There are, however, other important risks to our business, principally operational, reputational, and regulatory risk.

Operational Risk

Our investment approach is largely straightforward and relatively simple.  This, coupled with the concentrated nature of the portfolio, allows us to run our business with a limited number of personnel.  We have five senior investment professionals including myself.  Shane Dinneen, still officially a junior investment professional, is fast earning his stripes as an eventual senior member of the team.

We could manage our portfolio with less human talent than we have.  For members of the investment team reading this letter, don’t be concerned because I have no intention of shrinking the team, but I make the point nonetheless.  Simplicity in our investment approach allows for a simpler back office and a smaller overall staff.  We have 31 people total at Pershing Square.  It could be fewer, but one of Tim Barefield’s (our COO) important risk management principles provides for back-up talent for every role in the firm.

Our Noah’s Ark approach to personnel duplication makes for a good analogy for the ship we have designed.  We have worked hard to build a business that can withstand the Great Deluge, and this goes beyond counterparty risk.  For example, it is not yet clear this year whether there will be any incentive allocation to be shared at the firm. That said, whether or not the funds’ finish the year in the black, it will be extremely unlikely that a member of our team leaves by choice, and I have no intentions of letting anyone go.  This is due to several factors:

• Pershing Square’s large amount of assets under management per investment principal and per overall employee are important ratios to consider when evaluating the sustainability of Pershing Square or any hedge fund for that matter.  The economics of a high Asset per Employee ratio attract and allow for the retention of top talent.  Our team can be compensated appropriately even in times of short-term underperformance.  Hedge funds which barely (or don’t even) cover their costs with management fees are inherently unstable enterprises because in an unprofitable year they cannot pay their people and are likely to lose their most talented professionals to other firms.
• Pershing Square is a nice place to work.  While this sounds like an obvious approach to retaining talent, many and perhaps most hedge funds don’t fit this description.  We are big believers in taking care of our team not just financially and with attractive benefits, and we have those in spades.  We consider every employee at the firm a member of our extended family, and we treat and care for them appropriately.  We do this not for business reasons, but it has important long-term business benefits.
• Pershing Square is an extremely exciting place to work.  We believe our work creates value beyond the profits we historically have generated for our investors.  Our approach to value creation at businesses has created enormous value for investors who happened to own companies to which we contributed to the creation of value.  Similarly, investors and counterparties who listened to our views on the bond insurers, Fannie Mae and Freddie Mac, etc. saved themselves from large losses or perhaps profited by short sales.  The fact that our work creates value for the markets as a whole provides additional motivation to the team.

Bottom line, we are built to last, and we will continue to work hard to deserve your continued support.

Reputational and Regulatory Risk

Reputational risk is one of the key risk factors for a business that is subject to a high degree of regulatory scrutiny in an industry that seems to generate considerable public scorn.  Our approach to assessing reputational risk is to apply the New York Times test.  We ask ourselves whether we would be comfortable having our family and friends read a front page New York Times story about actions taken by Pershing Square written by a knowledgeable and intelligent reporter who has access to all of the facts.  If we are comfortable with such an article being read by our close friends, our families, and the public at large, our action passes the test.  If not, we reconsider our potential action.

More recently, I have decided to participate in the public dialogue about hedge funds, agreeing to occasional appearances on television or otherwise talking to the press, speaking at industry events, meeting with Congressman, Senators, and other officials.  I do so not for any desire for public recognition, but rather because I believe that it is important for the hedge fund industry to come out of the shadows and defend the importance of our work.  If we and others (that includes hedge fund investors in addition to the managers) don’t do so, the industry, in my view, is at even greater risk of further regulatory, tax, and other legal changes that will materially harm our business models and industry.

One does not need to look further than the recent short selling ban which was an extremely ill-advised regulatory change that contributed to market turmoil and the recent market decline.  By imposing a ban on an investment approach that has been legal for generations with no warning or opportunity for public debate, the SEC caused a short squeeze and subsequent market disarray that wiped out large amounts of hedge fund capital, caused forced selling as long/short, market neutral, quantitative, and other managers had to sell long positions to rebalance their books.  More significantly, it cost the U.S. capital markets its highly respected position as an exemplar free marketplace where the rule of law prevailed.  It also contributed to hedge fund underperformance, thereby leading to investor redemptions, further reducing industry capital.

I believe the short selling ban also contributed to continued market declines since the ban was put into place.  In that hedge funds are among the most opportunistic investors in the world, destroying large amounts of hedge fund capital likely contributed to market declines because of a dearth of opportunistic hedge fund buyers who would normally step in and purchase the compelling values created by falling markets.

Even though the restriction on short selling has been eliminated, the longer-term consequences of populist regulatory actions will continue to be felt by the markets and its participants until such time as our securities regulator makes clear that the U.S. will never again change the rules of the game mid play.

Specifically, the short selling ban was harmful to Pershing Square because we lost the opportunity to lock in even greater gains on our Wachovia investment by not initially being able to hedge our Wells Fargo exposure.  I estimate this loss at approximately 3% to 4% of fund performance.  This loss was somewhat offset by our ability to sell certain investments into the short squeeze at higher than anticipated prices.  We were otherwise not materially affected because short selling equities has not been a material part of our investment program, although we did cover one large equity short at a loss which is now trading at a more than 40% lower price, another 4% to 5% potential loss of profit assuming we had not covered at higher prices.

Hedge fund investors – the pension funds, state plans, charitable, healthcare and other institutions and the individuals who invest in hedge funds – are a much more appealing constituency to defend the industry than the managers themselves.  I encourage you to consider becoming part of the public debate on the industry.  We collectively need one another’s support. 

Investor Risk

The stability of a hedge fund’s capital base is critical to its long-term success.  We have endeavored to attract high quality investors who have a deep understanding of our investment approach.  We do our best to continually inform you of the progress of our holdings and business, and remind you of the inherently volatile nature of our concentrated strategy.  Our investment strategy is also transparent.  The nature of our approach requires most of our holdings to eventually be disclosed publicly.  As such, it is easier for you to understand how we have made and lost money over the years, and to assess our ability to replicate our historic strategy and performance. 

Over the last nearly five years, we have delivered very little of the volatility that investors are concerned about, that is, downward volatility.  As such and with strong historical performance, we have not “tested” our investor base.  We hope never to “test” our investor base.

While we have considered a longer-term lock-up structure, we chose not to modify our existing liquidity terms because we did not want our terms to be overly burdensome to investors and to present a hurdle to the reinvestment of capital, particularly during a period of temporary underperformance.  Year to date, we have had minimal redemptions.  New commitments have exceeded our redemption requests by approximately 3 to 1.  We have a pipeline of new prospects that are in the process of completing their due diligence.  That said, the continuity of our investor base is a long-term success factor for the funds and for this we are relying on you.

Is Now a Good Time to Invest in Pershing Square?

I have never before suggested that one time or another would be a better time to invest in Pershing Square.  I am going to take the risk of doing so now.  At the risk of sounding promotional, I believe that now is perhaps the best time in our history to increase your investment in Pershing Square.  A few thoughts to consider:

When one invests in Pershing Square today, with respect to our current portfolio and potential opportunities in the market, the spread between price and value is the widest it has been since the inception of Pershing Square and likely over the last 30 or more years in our opinion.  Investments like Target Corporation which we purchased initially in the mid to high $50s per share now sell at approximately $40 per share and there has been no meaningful diminution in the per-share value of Target since our initial purchase 18 months ago.  In fact, the probability of Target and other Pershing Square holdings implementing a value-creating transaction are higher today than before because of management and shareholder frustration with current share price levels.  Consider that Target management options are nearly all out of the money, and a meaningful number of vested options will soon likely expire worthless if there is no change in the status quo. 

An additional investment in Pershing Square today also purchases a pro rata interest in our cash and near-cash investments.  While purchasing cash indirectly is not an inherently attractive proposition, we are currently analyzing a number of long and short investments that appear extremely interesting, and subject to completion of our due diligence, may become large new commitments.  While for the first nearly five years of our business, we found only a limited number of interesting opportunities, albeit a sufficient number to generate attractive returns, we are now presented with tens of intriguing situations that are worthy of careful review.  One could reasonably conclude that the greater spread between price and value and a wider selection of attractively priced opportunities will lead to higher rates of return on these commitments than during previous periods of greater market efficiency which characterized the first four years of the funds’ existence.

While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility.  We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital.  As market values have declined substantially, this risk has actually diminished rather than increased.  Risk is high now for the leveraged short-term investor, but actually much lower for the unleveraged, long-term investor in high quality, mid and large capitalization, modestly leveraged businesses.

Unlike levered hedge funds whose risk increases as NAV declines, Pershing Square’s risk has declined with the recent decline in the value of our portfolio.   Why? This is due to the fact that a leveraged manager’s probability of being sold out by its prime broker increases as its portfolio’s equity declines.  Many hedge fund strategies are confidence and credit sensitive because they require continued access to low-cost financing.  Recent declines may also require leveraged hedge funds to post additional collateral on trades which did not require an initial down payment.  Because our investment strategy does not require leverage to operate, recent increases in financing costs and reductions in leverage afforded to hedge funds have no impact on our current or future prospects.  In our case, the margin of safety of our investments actually increases, the greater the decline in our holdings’ share prices.  We, of course, also have no margin leverage creating the risk of a forced sale.  So yes, I believe now is a good time.

Pershing Square Advisory Board Addition 

Matt Paull joined the Pershing Square Advisory Board on September 1st.  For some of you, Matt’s name may be familiar for he was formerly the CFO of McDonald’s Corporation before his retirement earlier this year.  I have known Matt for about 10 years, and interacted with him intensively in mid to late 2005 and in early 2006 when Pershing was advocating for change at McDonald’s.

As CFO of McDonald’s, Matt was one of the most highly regarded public company CFOs in the country.  Shareholders were the beneficiaries of superb capital allocation and strong share price appreciation during his tenure as CFO.  I consider it one of Pershing Square’s greatest accomplishments that we were able to garner Matt’s respect and friendship even though there were occasionally contentious moments during our engagement with McDonald’s.

Matt has already proved enormously helpful in our interactions with Target Corporation.  As a former CFO, particularly one that has been on the other side of one of Pershing Square’s most significant engagements, Matt brings a uniquely valuable perspective to the firm and to the management teams of our portfolio companies.

In addition to his Pershing Square advisory role, Matt is currently serving on the business school faculty of University of San Diego. 

Organizational Update

We completed our move to the 42nd floor of 888 Seventh Avenue in August.  The second time round, we really got it right.  The space is beautiful, promotes communication, and is extraordinarily well organized and efficient.

After the move, we made several additions to the team.  Courtney Leonardo and David Robinson joined the IR team in administrative roles, roles which had previously been filled by temporary employees.  Alex Song joined us from Goldman Sachs as the newest junior member of the investment team. Amy Stern joined the Finance and Accounting team from Tiger Global, and will focus her efforts on management company accounting.  Amy is also attending the NYU Stern School of Business where she is working on a business school degree.  Jill Skousen replaced Whitney Stodtmeister as the administrative assistant for the investment team after Whitney moved to Santa Barbara.  Helena Tunner joined us to work with Dianna Baitinger at front desk reception.

On other news, Alex Kaufmann of our IR team will be attending Columbia University’s Executive MBA program on Fridays and weekends.  We are big believers in continuing education for our personnel.

As always, we are extremely appreciative of your support, particularly during uncertain times.  If there are any questions I have failed to answer above, please call Doreen, Alex, Ashley or myself.

Sincerely,
William A. Ackman

Deep Throat: I don’t really like Target, which Derek said to look into. Retail’s gonna be hit the hardest during the recession, and I don’t know that Target enjoys the same economic or brand advantages Walmart has.

Cogitator: The problem with your reasoning is that (1) recessionary effects may already be accounted for in the stock price and (2) Walmart has no smart activist investor to push the price toward intrinsic value. I have explained the first point many times. A company is worth the sum of its cash flows from now until the end of the world discounted to the present—thus value neither declines in a recession nor increases in a boom. The public’s constant exposure to the news (with all of its poor reasoning) assures that they will never understand this simple principle. [REDACTED], your employment with [REDACTED] may put you in an even worse position.

Target was recently selling close to its real estate value, let alone its earning power value. It is essentially in the same situation as Sears Holdings, except that the earning power is more predictable.

Ultimately the problem with your comments is that they are all qualitative. It is surprising to hear this from someone with a quantitative bent. You can take it as an axiom that the most salient thoughts (as most qualitative thoughts are) tend to be factored into the stock price.

http://www.valueinvestingcongress.com/landing/p09/pershing/target.php

Today I received our Risk Assessment and Security Analysis from Will Geddes of the ICP Group.

I worked with Will on The Race when he taught Lock Stock.. star Nick Moran & Atomic Kitten’s Jenny Frost evasive driving. He is a Security Specialist, and advises the rich and famous, governments and royal families on issues of counter terrorism (think Jack Bauer in 24), kidnap (Proof of Life), & close protection services (think The BodyGuard) . We need to seek advice on security issues, as we are ultimately responsible for the safety of all our children, staff and volunteers.

ICP are going to review and assess the site, work in partnership with Mark Williams-Thomas on staff vetting and verification, devise the compound security policies and procedures and emergency response procedures.

Security Report

I can now sleep safely.

The relative value arbitrage technique detailed in this paper has yielded 11% per annum. It requires no capital, since the cost of one security is offset by proceeds from short selling a related security. I believe it to be a sound technique, so long as the public does not act on it en masse. In fact the expected return of relative value arbitrage increases as its popularity diminishes.

“Many investors make the mistake of thinking about returns to asset classes as if they were permanent. Returns are not inherent to an asset class; they result from fundamentals of the underlying businesses and the price paid by investors for the related securities. Capital flowing into an asset class can, reflexively, impair the ability of those investing in that asset class to continue to generate the anticipated, historically attractive returns.”
-Seth Klarman
Security Analysis Sixth Edition 

The sixth edition of Security Analysis is a strange amalgamation of Graham’s original work (styled in British English) and new commentary from prominent value-oriented investors (in American English). I find it impossible to read fluidly. Nonetheless the contributors make a strong independent showing, especially Seth Klarman and his protégé, David Abrams. They argue—as I have done in numerous essays—that market inefficiencies are smaller in magnitude and frequency than before.

I am especially pleased that both men acknowledge the hedging opportunities present in derivative securities. This has become my favorite area of study and action—and one that appears unlikely to be outmoded soon. (Elsewhere, I have found much of the “value investing” philosophy to be comparatively inadequate.)

Excerpts:

While formulas such as the classic “net working capital” test are necessary to support an investment analysis, value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required. For one thing, not all elements affecting value are captured in a company’s financial statements—inventories can grow obsolete and receivables uncollectible; liabilities are sometimes unrecorded and property values over- or under-stated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes. Sometimes a stock becomes cheap for good reason: a broken business model, hidden liabilities, protracted litigation, or incompetent or corrupt management.

Nevertheless, 25 years of historically strong stock market performance have left the market far from bargain-priced. High valuations and intensified competition raise the specter of lower returns for value investors generally.

In addition, because growing numbers of competent buy-side and sell-side analysts are plying their trade with the assistance of sophisticated information technology, far fewer securities seem likely to fall through the cracks to become extremely undervalued.

Great innovations in technology have made vastly more information and analytical capability available to all investors. This democratization has not, however, made value investors any better off. With information more widely and inexpensively available, some of the greatest market inefficiencies have been corrected. Developing innovative sources of ideas and information, such as those available from business consultants and industry experts, has become increasingly important.

Even complex derivatives not imagined in an earlier era can be scrutinized with the value investor’s eye. While traders today typically price put and call options via the Black-Scholes model, one can instead use value-investing precepts—upside potential, downside risk, and the likelihood that each of various possible scenarios will occur—to analyze these instruments. An inexpensive option may, in effect, have the favorable risk-return characteristics of a value investment—regardless of what the Black-Scholes model dictates.

Ira pointed to a stock… and asked me this question: “What if you buy the $35 calls, sell the $40 calls, buy the $40 puts, and sell the $35 puts all at the same time?” After a few minutes with pencil and paper, I looked up, still a bit confused, and said, “It’s always worth $5.” “Right,” he said. But still the light did not flicker in my brain until Ira asked, “What if you could buy it for $4.50?” Bingo! I finally got it. Even though I was new to Wall Street, I had done enough arbitrage to understand what Ira was saying. Typically, the most liquid option contracts are those with expiration dates relatively close by; which means that if you could buy this “box,” as it is called, consisting of two pairs of options for $4.50, you would make a guaranteed 11% on your money in less than six months.

It was my turn to pose a question. “Can you really buy them for $4.50?” I asked. “Sometimes,” he said. And then I realized who had been the proverbial patsy at the poker game. It was me. By relying on Graham and Dodd’s overly simplistic approach to the options market and not fully understanding the mathematics of the instruments in which I was investing, I didn’t appreciate how the trade might look to the person on the other side.

Unlike the world in which Graham and Dodd lived and worked, today’s security analyst is at a disadvantage without a good understanding of how option pricing models work and what their limitations are. Not only are derivatives pervasive in the financial markets but many corporations and investment entities use them for purposes both prudent and reckless.

U P D A T E

It was confessedly speculative to infer that Lehman Brothers would be purchased simply because Bear Stearns had been. Preferred shareholders will likely become general creditors of the company. This demonstrates both the reflexivity of markets and the weaknesses of the valuation approach. (Incidentally, George Soros owns 10 million shares of LEH.)

T H E S I S

Lehman Brothers preferred shares are likely to trade at around par value of $25 if the company is purchased. (Bear Stearns preferred shares doubled after the announcement of its ignominious $2 acquisition.) The comparatively low coupon of the “G” issue corresponds with a low price and high appreciation potential.

This opportunity is possible at least in part to the treatment of Fannie Mae/Freddie Mac preferred shareholders who were wiped out last week; investors are generally afraid to own preferred shares of financial companies. At the time, Fannie’s assets exceeded shareholders’ equity by a multiple of 100. When Bear Stearns was acquired in March, its leverage ratio was about 40. Lehman’s balance sheet is far less leveraged than either of these companies, and it can continually borrow from the Federal Reserve by using mortgage securities as collateral. Moreover the value of Neuberger Berman is two times greater than the market value of the common equity, leaving some margin of safety for the preferred stockholders.

There is a conspicuous gap between the last Buffett Partnership letter, written in 1969, and the first Berkshire Hathaway letter posted on the company’s website, written in 1978. Recently I discovered several of the “missing” documents.

A consistent theme in Buffett’s early management of Berkshire is that capital from the textile operation was best redeployed in either marketable securities or business acquisitions. From 1969 to 1977 the textile operation averaged a return on capital of less than 3%, while the insurance and banking subsidiaries averaged well above 10%. Buffett’s refusal to shut down the Berkshire mills resulted in an immense opportunity cost compounded over nearly 20 years.

The moral seems to be that basing investment solely upon asset value (quite significant in Berkshire’s case) is not intelligent. This was a rewarding activity when security analysis was in its infancy, but a great deal has changed since then. One of the best criticisms of the “Graham approach”—which involves net working capital bargains, classic arbitrage, etc.—can be found in Victor Niederhoffer’s The Education of a Speculator:

“On the rare occasion when a true guru shares secrets of a recurring, well-defined systematic nature, the cycles are about to change. Better to go against. What looks good today is encapsulated in the market tomorrow and will change the expected profits, the probabilities, and the paths of least resistance in subsequent periods. A good bet is that all systems will stop working when you use them.”

This criticism extends to merger arbitrage, convertible arbitrage and liquidations, as well as to other approaches that are less systematic. Recent experience suggests that even value-oriented investors are unsafe.

1969

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Recently I studied the prospectus for Royal Dutch’s 2005 exchange offer. On page 47 it reads:

“The historical trading relationship between Royal Dutch ordinary shares (RDA) and Shell Transport ordinary shares (SHEL) has broadly matched the 60/40 interests set forth in 1907. When this relationship has deviated from parity, it appears to have done so for reasons external to the Royal Dutch/Shell Group, such as index inclusion, relative index performance and taxation changes.”

From 1986 to 2005, the market capitalization of RDA as a percentage of the Royal Dutch/Shell Group averaged 61.72.

This mispricing per se does not prove that security prices are inefficient. The short sale of RDA and simultaneous purchase of SHEL had been consistently profitable, with one exception: in 1998 it cost Long-Term Capital Management several hundred million dollars. In the case of closed-end fund arbitrage, which involves the purchase of fund shares below NAV and the short sale of underlying portfolio securities, the magnitude of mispricing is correlated with the difficulty of finding shares to short sell. These two cases vindicate efficient market hypothesis as I understand it. While mispricings exist, they are either too risky, too costly or too difficult to exploit.

Relative value strategies, however, do not need to be narrowly defined as the type practiced by LTCM, West End Capital (a Buffett investee) or Salomon Brothers. Early this year I effected a relative value hedge by purchasing Genesco and Finish Line simultaneously. My initial success has given me a strong interest in specialized operations of this kind—among other things, I have concluded that money can be made both conservatively and plentifully by buying two common stocks which analysis shows to be inconsistently discounting the chance of one major event. This is an unpopular strategy but one that seems to be entirely logical.

In the mid-1960s, Warren Buffett practiced a more common variant of relative value hedging:

“‘Generals – Relatively Undervalued’ – this category consists of securities selling at prices relatively cheap compared to securities of the same general quality. We demand substantial discrepancies from current valuation standards, but (usually because of large size) do not feel value to a private owner to be a meaningful concept. It is important in this category, of course, that apples be compared to apples – and not to oranges, and we work hard at achieving that end. In the great majority of cases we simply do not know enough about the industry or company to come to sensible judgments – in that situation we pass.

“As mentioned earlier, this new category has been growing and has produced very satisfactory results. We have recently begun to implement a technique which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g., we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sell at 10 times. This risk has always bothered us enormously because of the helpless position in which we could be left compared to the “Generals – Private Owner” or “Workouts” types. With this risk diminished, we think this category has a promising future.”

This technique was well suited to the “Nifty Fifty” era, when for instance GM sold at a large premium to Ford, despite nearly identical operating metrics. A great deal has changed since then. First, it is almost impossible to find two corporations similar enough in their operations to be comparable (even Coca-Cola and Pepsi are quite different); and second, the speculative component that caused divergent valuations in the 1960s is no longer present.

Nonetheless I believe that low-risk relative value opportunities will arise from time to time—perhaps once a year.

]]> http://stableboyselections.com/2008/07/11/indymac-bank-failure-deficiencies-of-the-valuation-approach/ Fri, 11 Jul 2008 23:30:20 +0000 Cogitator http://stableboyselections.com/2008/07/11/indymac-bank-failure-deficiencies-of-the-valuation-approach/

The basing of investment upon valuation will often lead to absurdities. Not only are some companies unsuited for appraisal due to the risk of technological disruption, inconsistent earnings, etc., they may also be subject to reflexivity (a.k.a. “self-fulfilling prophecy” or “Barnesian performativity”).

On July 11, 2008 the OTS took control of IndyMac Bancorp, marking the third largest bank failure in U.S. history. Depositors had withdrawn money at accelerated levels throughout the week after Senator Chuck Schumer warned that it might become insolvent. Fears of insolvency quickly led to insolvency.

There have been numerous cases of reflexivity during the past year: Bear Stearns’ takeunder, the mortgage and student loan securitization “freeze” and the financial strength rating downgrades of various monoline guarantors. The moral seems to be that valuation is not an adequate measure of investment attractiveness. Rather it is only one component of mathematical expectation, which I have consistently advocated as the superior model. This led me to the arbitrage of IMB and IMB LEAPS (detailed below) instead of a straight common stock investment.

U P D A T E

URI should cash out odd-lot holders by the end of July—resulting in a 160%+ annualized profit for arbitrageurs.

T H E S I S

On June 16, URI commenced a Dutch auction tender offer for 27 million of its common shares. Odd-lot holders will have priority to receive an amount between $22 and $25 per share. At the low end there is a 14%+ arbitrage opportunity (160%+ annualized, depending on the expediency of management, brokers, etc.).

Partial tenders are almost categorically bad investments. If the offer price exceeds the market price, everyone will tender shares and cash distributions become prorated. After the company returns shares not purchased, arbitrageurs rush to sell and market prices fall. The net return of this “Prisoner’s Dilemma” is usually around 0%.

In the case of URI, there is no after-deal risk because odd-lot holders will be cashed out in full. The primary risk is that management may cancel the tender offer if American equity indices fall by 10% during the offer period. Since URI’s intrinsic value appears to be significantly higher than its current price, this would likely result in only a temporary loss.