Thrift Conversion Results

Background paper here.

Before 1988 thrift conversions were done in a single step, leading to the earlier mentioned Lynch scenario of the free envelopes of money. Post 1988, two-step conversions were being performed. First steps would involve issuance of a minority stake of equity to the public, with the majority being held by the mutual holding company (MHC). In the second steps, additional offerings would distribute the remaining MHC shares to the public, raising additional cash and dissolving the MHC.

The published ratios for these firms are generally calculated on total shares outstanding, even though the MHC shares are not public and represent an overhang of untapped shareholder value. Also, when dividends are issued by these firms, MHC's generally waive their rights to the dividends which is an additional plus.

In attempting an extremely rough-cut valuation of these firms, I wanted to look at the post second-step offering scenario. One recently completed conversion was Abington Bancorp, Inc. (ABBC). As this press release states, 14.0M new shares were issued at approximately $10, and 10.5M shares were issued to existing shareholders. As of now, the bank trades at approximately 1.0 P/B ratio, which is cheap for a financial institution, but which we will use as our conservative estimate.

We assume a post second-step P/B ratio of 1.0 and fixed number of public and MHC shares to solve for the final share price.

1.0 P/B = (?? Price * Total Shares) / [ Shareholders Equity + (MHC Shares * ?? Price) ]

The numerator is the second-step market cap, assuming all shares are floated. The denominator is the current equity plus the proceeds raised from issuing the MHC shares. Rearranging for the ?? Price, we get the following equation.

?? Price = (1.0 P/B * Shareholders Equity) / [ Total Shares - (1.0 P/B * MHC Shares) ]

Using this rough guage for value, I analyzed 40+ current thrifts and published the results here: Thrifts Simplified. (BTW, Google Docs includes tools to automatically pull in information such as stock price) As you can see, 40-60% discounts can be found although the larger discounts are more prevalent in the nanocap space. If I had more capital under management, I might be tempted to make a Buffett control play. As a caveat, this is extremely rudimentary and there are no provisions made for earnings quality or growth, etc. I would, however, pay attention to those companies performing stock buybacks or issuing dividends. Given my inexperience with this strategy, I have diversified the allocation for a normal position into 8 separate positions.

Going Private Transaction: CNFL

UPDATE:

CNFL has received an SEC Notice for having an insufficient number of public shares. They have until Oct. 24 to submit a plan to regain compliance. The company "believes that the proposed Going-private Transaction represents "good cause" for which Nasdaq Staff may extend the October 24, 2007 cure period."

In my opinion, this is a slight complication, but does not violate the original thesis. Even in the case where CNFL shares are delisted, that does not preclude the GPT.

ORIGINAL:

CNFL

SEC Filings

10/04/2007
07/19/2007

The company will execute a 1-for-250 reverse stock split in order to go private. Shareholders who own fractional shares will receive $7.25 per share, effective Nov. 13. If you can pick up shares today for $6.75 (last trade, I picked up my shares weeks ago at better prices), that should give you a 7% return within a one-month turnaround, for a 137% annualized return.

Current Positions Updated

As you can see, it's been a busy few weeks. Despite my insistence on a focus portfolio, the number of ideas have proliferated. Lately I've realized that having a focused portfolio does not necessarily preclude a larger number of positions. Contrast the early Buffett focused portfolio of 20-30 positions, with single positions taking up to 30% of the entire portfolio, with Pabrai's 10 core positions or Greenblatt's 3-5 positions. Plus I suffer from rhinophobia, which I need to learn to control in order to improve my portfolio returns. I will do a brief synopsis on each later.

Thrift Conversions

This topic has lately caught my eye. This paper provides some good background material on the subject, although it first came to my attention through "Beating the Street" by Peter Lynch. I have about a dozen candidates to research and will post results as soon as I can. An excerpt:

Imagine buying a house and then discovering that the former owners have cashed your check for the down payment and left the money in an envelope in a kitchen drawer, along with a note that reads: "Keep this, it belonged to you in the first place." You've got the house and it hasn't cost you a thing.

Say your local thrift has $10 million in book value before it went public. Then it sold $10 million worth of stock in the offering - 1 million shares at $10 apiece. When this $10 million from the stock sale returns to the vault, the book value of this company has just doubled. A company with a $20 book value is now selling for $10 a share

Tender Offer: ISYS

http://biz.yahoo.com/ap/070814/integral_systems_stock_offer.html?.v=1

Shares are being purchased for $27, expiring midnight September 11th, includes odd lot preference. I purchased shares today for $24.30, for an approximately 11.1% spread.

Market Reaction and Portfolio Concentration

I was talking with my coworker the other day about the differences between arithmetic and geometric means. Arithmetic means are the averages that we are familiar with, whereas geometric means come into play in the compounding of returns. For example, let's say one of our stocks went up 2X in Year 1, and 4.5X in Year 2. The geometric return would be 3x ( square root [ 2 * 4.5 ] ). Equivalently, we could have had another stock with the same geometric returns and achieved the same results over two years (3 * 3 = 2 * 4.5).

With that being said, the differences between the two types of means differs greatly and changes with how we construct our portfolios. For the sake of simplification, let's assume that all financial assets consist of numerous fair independent coinflips that occur daily, with a 50% positive return for heads, and a 40% loss for tails. Although we can allocate our portfolio into any number of these assets, we must remain fully allocated and play everyday. What is the optimal strategy?

If we compute the two means, we see they differ greatly. The arithmetic mean is +5% ( [+50 - 40] / 2), whereas the geometric mean is -5.1% ( sqrt[ 1.5 * .6 ] ). To achieve the arithmetic mean, we would divide our bankroll into as many bets as possible, so that our sample means would converge to the population mean. This is the so-called "free lunch" of diversification. To achieve the geometric mean, we would place all of our bankroll on a single bet, and continually parlay the results of those coinflips into more coinflips, so that over a long enough series of days, our returns would approach the geometric mean. So is there ever a scenario where we would not want to diversify?

I got the idea that "it depends" from reading Bill Miller's Q4 2006 Letter to Investors. In it, he explains the reason why his streak of beating the S&P 500 was finally broken, and his mistakes of overly concentrating the portfolio at the wrong time.

If we go back to our earlier example, let us now assume that instead of numerous similar bets, there are different classes of coinflips we can make, and that they are limited in number. Class A coins offer +100% returns for heads, -60% returns for tails, and there are only 2 of them. Class B coins offer +20% returns for heads, -10% returns for tails, and there are 40 of them. Doing the math, we see that Class A has an arithmetic mean of +20% and a geometric mean of -10.6%. Class B has an arithmetic mean of +5% and a geometric mean of +3.9%. The arithmetic means of Class A clearly surpass those of Class B, but there aren't enough of them to properly achieve the population average.

So now the question of diversification / concentration is largely a function of opportunity diversity and becomes a conversation of tradeoffs between diversifying to achieve the geometric return, versus striving to achieve a higher arithmetic return through concentrating in rare "good bets". If your ideas are mostly similar and no ideas are clearly better than others, then diversify as much as possible.

The recent market events have introduced greater variability in the risk / returns profiles of my ideas, which has manifested in some positions being untouched whereas others have become hammered. Given an assumption of unchanged fundamental business value, I think now is the time to concentrate the portfolio, increasing positions in those ideas that seem 70+% undervalued (ie multi-bagger prospects) and exiting positions with only 30-40% undervaluations. Although this will almost necessarily introduce greater volatility in portfolio returns, I am confident that these actions will bear fruit 1-3 years hence.

Notable Quotes

"All life demands struggle. Those who have everything given to them become lazy, selfish, and insensitive to the real values of life. The very striving and hard work that we so constantly try to avoid is the major building block in the person we are today."
-- Ralph Ransom

"Restlessness and discontent are the first necessities of progress."
-- Thomas Edison

"All progress is based upon a universal, innate desire on the part of every organism to live beyond its income."
-- Samuel Butler

"Humanity has advanced, when it has advanced, not because it has been sober, responsible, and cautious, but because it has been playful, rebellious, and immature."
-- Tom Robbins

"Progress is made by lazy men looking for easier ways to do things."
-- Robert Heinlein

"Thinkin of a master plan, Cuz ain't nuthin but sweat inside my hand"
-- Rakim

"Ain't only three things to gambling: knowing the 60-40 end of the proposition, money management, and knowing yourself. Even a donkey knows that."
-- "Puggy" Pearson

"Things may come to those who wait, but only the things left by those who hustle."
-- Abraham Lincoln

"Go confidently in the direction of your dreams."
-- Henry David Thoreau

"Nothing focuses the mind better than the constant sight of a competitor who wants to wipe you off the map."
-- Wayne Calloway

"We are not here merely to make a living. We are here to enrich the world, and we impoverish ourselves if we forget this errand."
-- Woodrow Wilson

"The Longer I live, the more I realize the impact of attitude on life. Attitude, to me, is more important than facts. It is more important than the past, than education, than money, than circumstances, than failures, than successes, than what other people think or say or do. It is more important than appearance, giftedness or skill. It will make or break a company, a church, a home, or a chorus. The remarkable thing is we have a choice everyday regarding the attitude we will embrace for that day. We cannot change our past, we cannot change the fact that people will act in a certain way. We cannot change the inevitable. The only thing we can do is play on the one string we have, and that is our attitude. I am conviced that life is 10% what happens to me and 90% how I react to it. And so it is with you, we are in charge of our attitudes."
-- Charles Swindol

"Empty pockets never held anyone back.
Only empty heads and empty hearts can do that."
-- Norman Vincent Peale

"Our deepest fear is not that we are inadequate. Our deepest fear is that we are powerful beyond measure. It is our light, not our darkness that most frightens us. We ask ourselves, Who am I to be brilliant, gorgeous, talented, fabulous? Actually, who are you not to be? You are a child of God. Your playing small does not serve the world. There is nothing enlightened about shrinking so that other people won't feel insecure around you. We are all meant to shine, as children do. We were born to make manifest the glory of God that is within us. It is not just in some of us; it is in everyone. And as we let our own light shine,we unconsciously give other people permission to do the same. As we are liberated from our own fear, our presence automatically liberates others."
-- Marianne Williamson

"I've never been poor, only broke. Being poor is a frame of mind.
Being broke is only a temporary situation."
-- Mike Todd

"Wait for a miracle and it will never come. Take responsibility and you'll invite a miracle."
-- Laura Berman Fortgang

"The mind once stretched by a new idea, never returns to its original dimension."
-- Oliver Wendell Holmes

"Making mistakes simply means you are learning faster."
--Weston H. Agor

"If you really want to do something, you'll find a way; if you don't, you'll find an excuse."
-- Unknown

"A gem cannot be polished without friction, nor a person perfected without trials."
-- Chinese proverb

"Ignorance is the night of the mind, but a night without moon and star."
-- Confuscious

"Better a diamond with a flaw than a pebble without."
-- Confucius

"You can't lose what you don't put in the middle...But you can't win much either."
-- Mike McDermott (Rounders)

"Circumstance does not make the man, it reveals him to himself. Men do not attract that which they want, but that which they are. Man is manacled only by himself."
-- James Allen

"The stock market is filled with individuals who know the price of everything, but the value of nothing."
-- Philip Fisher

"Conversation enriches the understanding, but solitude is the school of genius."
-- Edward Gibbon

"It is your work in life that is the ultimate seduction."
-- Pablo Picasso

"In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time - none, zero."
-- Charlie Munger

"It had long since come to my attention that people of accomplishment rarely sat back and let things happen to them. They went out and happened to things."
--Elinor Smith

"High aims form high characters, and great objects bring out great minds."
--Tryon Edwards

"True happiness is not made in getting something. True happiness is becoming something. This can be done by being committed to lofty goals. We cannot become something without commitment."
--Marvin J. Ashton

"There is a close connection between getting up in the world and getting up in the morning."
--Anonymous

"The man who is born with a talent which he is meant to use finds his greatest happiness in using it."
--Johann von Goethe

"An individual who doesn't consciously select his goals is not really in control of his life. He is controlled. Without really knowing it, he is controlled by goals imposed by outside pressures (the expectation of other), or by habits (procrastination), or by desires (the longing to be honored and admired) and so on."
-- Anonymous

"Beaten paths are for beaten men."
--Eric Johnston

"The world turns aside to let any man pass who knows whither he is going."
--David Starr Jordan

"First, the only certainty is that there is no certainty. Second, every decision as a consequence is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly we need to judge decisions not only on the results, but how those decisions were made."
-- Robert Rubin

"We cannot promise to beat the market or even to match the market. But we can promise that nobody will care more about your money and work harder than the team that we have assembled."
-- Bill Miller

"When we think about the future of the world, we always have in mind its being where it would be if it continued to move as we see it moving now. We do not realize that it moves not in a straight line… and that its direction changes constantly."
-- Ludwig Wittgenstein

"The thoughts of others
Were light and fleeting,
Of lovers' meeting
Or luck or fame.
Mine were of trouble,
And mine were steady,
So I was ready
When trouble came."
-- A.E. Housman

"Entrepreneurship is not a civilized joust. It is streetfighting."
-- James Hong

"Pray not for lighter burdens but for stronger backs."
--Theodore Roosevelt.

Fish or Cut Bait

In light of recent events, this post seemed appropriate. I used to read the Motley Fool Message Boards (mostly Berkshire posts) everyday for a year or two, and it was instrumental in my education. They've reopened for free on an invitation-only basis. Let me know if you would like one by leaving a comment. There was mostly chatter on this board, but from time to time there were some really inspired posts. I've reposted it here for those without access. Special thanks to hartmanbirge, go here for the original post.

A lot has happened the last two months or so and at least to me the world is a far clearer, more exhilarating picture. I've had some time to do some thinking and I was struck by several themes. Bottom Line Up Front (or BLUF as we call it): An investor, an Army officer, a corporate CEO, a surgeon, a lawyer….you name the profession… if you're a professional then your purpose in life is not to manage – your purpose is to lead (people, change, emotions, whatever..). I've heard it said that a true professional is someone dedicated to their craft and someone who possesses a certain professional ethos. I think that should be taken one step further. Though professions vary greatly in what they represent I think it fair to say that all true professionals have a competitive drive (more with themselves than anything else) to prove themselves in great difficulty. They dedicate their lives to learning as much as they can about their circles of competence. And I also think it fair to say that the true professionals thrive best when chaos surrounds them… when “all others are losing their heads” as Buffett once said. I am convinced that there is a certain type who actually looks forward to chaos – it's where they're most comfortable. It's where they THRIVE. They've spent years and years studying and acquiring knowledge so that they can APPLY what they've learned and practiced upon a chaotic situation and get the exhilaration of a “win” - however “winning” is defined in their circle. They run with gusto to the sound of the guns. In order to do this there are several pre-conditions which must be met in order for our hero to do his or her thing:
1. They have to have a thirst to learn the craft and apply themselves to this quest voraciously – done during the “boring” times of status quo.
2. The above most likely requires an inner competitive drive – most likely with a high internalized set of standards
3. They need to have a “detached ego” which allows them to execute rationally rather than emotionally. (Recommend watching movie classic 12 O'Clock High with Gregory Peck)
4. They're beholden to none and have a personal center of gravity based on principles and values rather than external things
5. But ultimately they thirst for a set of external conditions that allow them to apply the above

In reading about George Marshall (the ultimate rational being) I note that he suffered in long obscure silence for decades (34 years) – plugging away…acting with integrity and honor…avoiding the limelight… doing the right thing. There was a time when he thought of leaving the Army. A Major at the time, his salary was just over the American average of $750. External opportunity arrived in the form of a job offer from a partner at JP Morgan – salary $30,000. Marshall was severely tempted. In the end of course he turned down the job offer that was pushing 40 times his pay. Why? I spent a few weeks mulling over that question. My only conclusion is that Marshall saw what was looming on the geo-political scene. He had already made a name for himself in WWI and had a wealth of knowledge and experience. He knew the craft so to speak. It is my conclusion that he thirsted for the chance to rationally apply it upon a chaotic scene and missing the chance would be the worst form of hell on earth. He had a deep sense of obligation and duty and due to his gifts to manage the chaos he had a duty. Because he had a grounding of values and principles, no amount of money or family riches could pry him from this. So he turned it down and waited patiently for opportunity – not financial – but the chance to apply his learned rationality upon chaos. Material possessions (to include money) as a central focus would have been a hollow outcome. Once given power as Army Chief of Staff he basically ripped the existing Army careerist culture to shreds and built a wartime Army full of mission oriented leaders who embraced extreme difficulty – (not at all unlike what's happening today I might add).

What's this have to do with investing? A lot I think. The above “rules” are the same no matter what the profession. Professionals are built for chaos, ambiguity, uncertainty, and extreme difficulty. Good times and relative “ease” though sometimes a welcome respite ultimately become the definition of a living HELL. Ask yourself if you ever felt any satisfaction getting an A on a test or a paper if the entire class did. No. Maximum satisfaction comes when you're the only one to get an A. There's a standard. There's a great difficulty that has been mastered and overcome. There is stratification. There are winners and losers. There is “justice” – those who took the easy way out and didn't study get “punished” by their poor grade. Grade inflation in a sophomore class or its stock market equivalent where all equities perform well (or fund managers) is the worst form of hell (Socialism might do well to learn this truth). To the master of the craft - There is a desperate NEED (and secret “want”) for external difficulty in order to apply the expertise acquired through internal drive. When Katrina hit New Orleans I noted two very distinct reactive differences. One type (with a need for external calm and status quo) was devastated (career bureaucrats). The second type I think saw the chaos as a challenge and call to perform (LTG Honore). The difference in response between the two was startling…

And what of now? I think that any professional money manager (or dedicated individual investor who gets turned on by the game) who gets a sense of “fear” or trepidation or worry on what is I think shaping up to be a chaotic situation in the not too distant future is in the wrong profession or passionate hobby. I think there should almost be a CRAVING for financial chaos, markets run amok, and a slew of distraught Wall Street hedge fund narcissists searching for answers that never materialize. Finally, at long last…. After two decades where the whole damn class got A's on their term papers (individual stock analysis) there looks to be coming a day where the true craft and sound tested principles of rationality can be applied. Where the rising tide can't lift all the boats anymore. Perhaps it sounds callous to be seen as “cheering” for chaos but that's not it at all. The chaos is going to come with or without anyone's cheering. Equilibrium theory tells us that good times will be followed by bad (the longer and greater the good times then the inverse) – it's going to come. The only difference is in how it's rationally dealt with on a very individualized level.

This is no different to the “competitive destruction” thread – where the thesis that chaos affords an environment of stratification with winners and losers. And much to my satisfaction take a look at what's happening in the reinsurance market where others are running for the hills – leaving Berkshire almost alone to take on the risk and get enormous premiums (what was it? Half the potential insured loss? Amazing)… That's what Berkshire Hathaway was built and designed for. It wasn't built for the whole damn class getting an A…. it was built for a real bitch of a final exam… Higher inflation? Higher interest rates? Rapidly falling dollar? Dollar's precarious position as world's reserve currency? Crashing emerging markets? Exploding ARM debt servicing? Falling housing market? Automatized sell orders on market ETFs which bring everything down? Tons of conflicting “activity” in options and futures markets? Confused messages from new Fed Chairman? Threats by Iran to strangle global oil supply? Exploding oil prices? Mass restated earnings at Fannie Mae? Corporate corruption in executive suite and on the passive boards? Narcissistic CEO at Home Depot? Predictions of huge hurricane seasons for at least next decade? Trade deficits? Rising protectionism? Nationalization of oil infrastructures in South America? Rise of socialist and populist impulses (windfall oil tax anyone?) in America? American manufacturing sector on brink of destruction? Pension calamities across American industrial base? The tapped out and hyper-indebted American consumer who essentially is pulling the rest of the world on his shoulders? Things that are supposed to be non-correlated are all moving down? Alas…Derivatives meltdown potential? Al Qaida and their threat to our way of life, social harmony and stability (who would have thought that peaceful Canada would be major target)? I think that about covers it for the questions posed on this final exam taught in this hypothetical yet very real 401 class of reality that the world is teaching us. To put ourselves in the right frame of mind perhaps the movie Cinderella Man is a good primer….

Either the above and where it might lead turns one on…. or perhaps fills one with 1) serious doubts bordering on panic or 2) apathy bordering on denial (the most prone to actually panic if and when the time comes). Not at all unlike New Orleans - (You bet those levees will hold! Up to a CAT 3 for sure). Not a darn thing any of us can do to change the reality. All we can do is to properly define it and prepare as best we can. Perhaps this brewing storm never materializes – certainly that's possible – but then we probably muddle along an eternity with stagflation which may just be a worse outcome. A booming stock market? Heck we just had that – not very likely to happen again anytime soon. One might ask oneself how might you feel if your portfolio drops 50% and your purchasing power drops another 30%? Not possible? Hmmmmm… I think if one can come to real grips with that possibility now, or something even more dire – with a serious dose of self honesty – then you're built for leading through the worst of the potential chaos and in fact may even be looking forward to the “test.”

Farmers Capital Bank Corporation Tender Offer

I was scanning some of the SEC feeds that I receive and this notice caught my eye.
[SEC Filing]
[Press Release]

"Farmers Capital Bank Corporation (Nasdaq: FFKT; "Farmers Capital") announced today the commencement of a modified "Dutch Auction" tender offer, approved by its Board of Directors, to repurchase up to 550,000 shares of its common stock (representing approximately 6.97% of its outstanding common stock) at a price not greater than $35.00 and not less than $31.00 per share. ... The tender offer is expected to commence on July 19, 2007 and to expire, unless extended, at 12:01 a.m. (Eastern Daylight Savings Time) on August 16, 2007."

With shares available for approximately $29.90, this deal offers a return of 3.7-17.1% for an approximately 3 week holding period. Since this offer includes an odd-lot preference I purchased 99 shares today and immediately tendered them. This kind of arb provides some stability in today's volatile markets, although I did leave some money on the table with the EXPE deal ($29 tender price, exited for $27.70).

Expedia Tender Offer

Expedia, Inc. (EXPE) has announced a tender offer for 25 M shares between $27.50 and $30.00. The offer expires August 8 and includes odd lot preference. Shareholders with less than 100 shares will be tendered first. For more details go here [SEC Filing]. With shares going for approximately $26.15 today, I made several orders for 99 shares in the separate accounts that I manage. This implies a 5-15% return, and I expect it to close within a month. One caveat is that brokers can charge steep fees ($40-50) to tender shares.

My first experience with odd lot tender offers was AutoNation, Inc. (AN) last spring and I was pleased with those results. This arbitrage is about as riskless as it gets.

Mid-Year Review

Reading the early Buffett Partnership letters has inspired me to do some introspection and writing on my portfolio performance. Year to date, my fund has returned 18.5% while the S&P500 has returned 10.6% including dividends. Working at the Fund-of-Funds has increased my sensitivity to benchmarking and performance attribution. With that said, the S&P 500 is not necessarily the most accurate candidate, but does enjoy the benefits of representativeness and notoriety.

Negligible margin has been used, although there is currently a large short position hedged by some options in order to arbitrage an unnaturally wide spread. From time to time, options are also utilized in order to magnify some short-term mispricings. There are 8 positions ranging in size from 5% up to 40%, focused in the microcap arena with an average-weighted cap of 144 M. As a result, trading in this arena is more similar to "fishing" for shares than rapid-fire trading. Gracefully entering and exiting positions takes time in order to minimize market impact as well as the cost of steep bid/ask spreads. The chart shows large spikes and swings in my performance (red), artifacts of both a concentrated and illiquid portfolio. This means that any one position has the power to significantly affect the portfolio, and in addition, any sizable investor changing their minds about one of my stocks has the power to upset the market price.

Despite these structural disadvantages, I feel confident that they are more detrimental to others than they are to myself, due to the small amount of capital under management. This also explains the reason why I look for 100% minimum gain (i.e. 50% margin of safety) when looking at prospective investments. 20% prospective gains remain within the range of noise and can easily be lost coming and going. Approximately one third of my positions have done extremely well, while the rest have languished. I am comfortable with the portfolio makeup, however I have been having trouble with idea flow to replace the one third as they approach fair value.

Idea flow has mostly been distracted by numerous career-related activities and ventures. Once I finish with the Buffett trip and post-graduation plans, I expect mental focus to return to normal levels. On the other hand, continual exposure to the portfolio this summer has increased my temptation for activity and the possibility of doing something stupid. This temptation has been quieted mostly through online poker, simultaneously forcing patience and satisfying the animal instincts to gamble. I am proud to say that I have won a handful of 300+ person tournaments.

If returns continue at a similar absolute and relative pace, I will be quite pleased with 2007 results. I am mindful of the incredibly small number of samples on which to base this judgment (position-wise and temporally) and hope to continue to submit similar results. I would like to close with classic quotes by Jerry Yang, this year's winner of the World Series of Poker and "Puggy" Pearson, one of poker's greats.

"I've seen the miracles of God with my own eyes. I also did a lot of bluffing."

-- Jerry Yang

"Ain't only three things to gambling: knowing the 60-40 end of the proposition, money management, and knowing yourself. Even a donkey knows that."

-- "Puggy" Pearson

Footsteps of the Master

One of a my planned summer projects has been to chronologically retrace Buffett's ideas and development by going through his partnership letters and Berkshire annual reports. Not only will this serve as a great primer for the upcoming trip, but it is a classic rite of passage performed by other investment greats such as Eddie Lampert and Mohnish Pabrai. As I go through each year, I will try to summarize the philosophies and examples in each. Enjoy!

Premier Exhibition Joins the Big Leagues

Premier Exhibitions To Join Russell 3000 Index & Russell Microcap Index

The information has been available since June 15, but the news release was today. PRXI has steadily marched upward since the end of May, which coincides with the Russell evaluation period. Russell prides itself on the objective measures for index membership. Also, membership is evaluated annually so stocks get to hang around for a while. To view other changes go here: Russell Reconstitution Central

In some ways this is positive reinforcement and validation of PRXI's prospects as a company. But more importantly, I look forward to all those index funds forced to buyin. The buying should be pretty violent too (if it hasn't been already), as most of them want to reduce tracking error. Makes me curious if any hedgies or traders would make plays around index changes as this creates a forced structural change in valuation, as opposed to a fundamental change.

CNBC "Fast Money"

Hey gang

In case you are interested, I will be on CNBC this Friday at 8 PM during the show "Fast Money". I will be part of a segment called "Grade the Trade" where students from various b-schools explain how they would respond to hypothetical situations. Check out the link for a clip of a previous episode:

http://www.youtube.com/watch?v=8D2xK694MN8

A Moment of Calm

I just finished taking the Level 1 CFA exam this weekend. I wasn't as prepared as I would like, but we'll see what 3 weeks of study can accomplish. I'm hoping to take the next week off and slowly decompress a bit from the continual run of activity from GMO in January, throughout this entire semester, and concluding with CFA prep. There are a lot of things on my to-do list, but mostly I want to just absorb new information, digest and do some independant thinking. I was restless the other night, thinking about some possible tweaks to financial theory dealing with asset leverage versus personal leverage. I hadn't done much synthesis or creation in a while, and the past year has been heavy on memorization and recall. Things I want to explore:

1. Finish "The Focus Investor"
2. "More Than You Know" as well as other writings by Mauboussin. I absolutely love his mind.
   
3. Finish "Of Permanent Value" as well as all of the original source Berkshire annual letters. I need to dissect and completely understand Buffett's thinking and motivations behind past acquisitions for the upcoming trip.
   
4. Catchup on Value Investor Insight reading. I think I'm behind on 4-5 issues already.
5. Finish Damodoran's valuation webcasts.

Sometime, it might also be helpful to figure out what I want to do after graduation in a year. I could try to aim for some large corporation, mentor for a smaller shop, or even go a more entrepreneurial route. I was talking to someone from my school's Career Management Center, and she told me I was one of the most promising people she had ever met. It was encouraging, but I need to remain vigilant that I live up to those expectations, as well as avoid any self-destructive hubris.

Another thing you have to do, of course, is to have a lot of assiduity.
I like that word because it means: sit down on your ass until you do it.
-- Charlie Munger

Buffett Trip

Every year Warren Buffett invites a dozen business schools to visit with him in Omaha. Students each get to ask him one question during the 3-4 hour Q&A session, followed by lunch at Gorat's steakhouse. In addition, the students get to pitch a company (public or private) for him to purchase. If they are successful, each student gets 2 Berkshire-B shares and the professor will get 1 Berkshire-A share. Only one class has been successful (University of TN - Knoxville and Clayton Mobile Homes) so far.

After over a year of "persistence" I called his secretary and Emory University's Goizueta Business School will be visiting with him during the '07-'08 school year. A tad bit of irony, considering Roberto Goizueta was one of the key drivers for Buffett's large purchase of Coke stock. We will have to make sure to bring Mr. Buffett a fresh case of Cherry Coke from Atlanta.

This experience will be highly valuable for all the students. How valuable, might you ask? If we look at public comps, we see a recent transaction of a $600K Lunch With Buffett paid for by a successful Chinese entrepreneur. If we consider that we will have between 40-100 students, the trip could be worth between $24 - 60 MM. Thats definitely a great value in my book.

The Dhandho Investor

I'd heard a lot about this author through various online interviews and discussions with other high-profile value investors, so I decided to check out his book. This book is a very quick read, but contains some pretty powerful ideas. Whitney Tilson said that he read it in one sitting, it was that good.

Some of the major ideas in the book include the following:

• "Few Bets, Big Bets, Infrequent Bets"
• "Heads, I win; tails, I don't lose much"
• Entrepreneurs as Arbitrageurs

This book is one of the first books I have seen to use the Kelly Criterion as a basis for position sizing. As highlighted by the first two bullets, it's advantageous to look for asymmetrical bets where the downside is limited, and the distribution of outcomes is very favorable. I would count my recent FTAR investment in that camp. In such a situation, with such a large edge and confidence, it does make sense to make significant commitments of capital. The approach is not to be riskier by betting on a few positions, but having incredibly stringent investment criteria, and only investing in those names that meet all those requirements.

The first chapter of the book details the rise of the Patel motel empire. He discusses all the competitive advantages and even does a basic DCF for a budding entrepreneur. Given the alternatives, there are situations such as these where it would make sense for someone to put their entire net worth on the line.

This book is also unique in that it is one of the the first books I have read that discusses a selling framework. Most investment tomes focus 90%+ on the selection and buying process and gloss over the details of exiting a position. One analogy he makes is to the Chakravyuh, an spiral-shaped Indian battle formation. One enterprising young warrior figured out a way to pierce the Chakravyuh. Once he entered however, he had no other option than to continue traversing deeper into the spiral. Once he arrived at the center, he had no way to exit and was eventually overcome. The main point is that investors should not purchase a security if they do not have a clear exit strategy or valuation planned out.

"Margin of Safety"

I finally got my hands on a copy of this book. It's a out-of-print book that is highly in demand. The cheapest version available is $1700 at Amazon. The author is Seth Klarman, head of the Baupost Group. You can read more here:

"The $700 Used Book"
"Notes on Margin of Safety"

After I take care of this whole internship process, I will spend most of my time devouring the book. I'm mulling two offers, but still looking at a few things in the pipeline. One opportunity is with a fund of funds type structure, and another opportunity is with retail equity research.

Back From Boston

GMO Investment Strategy Competition

I flew up to present to GMO on spinoffs, a very Greenblatt-inspired idea. I'll try to find a way to post a copy of my presentation slides, but the meat of my strategy is as follows:

1. Spinoffs / parent companies tend to improve operation metrics.
   
2. This causes spinoffs to outperform the market in the 1-3 year time window.
   
3. Mass institutional selling in the short-term can create attractive entry prices.

I was a little intimidated that my strategy wasn't as quant-driven or financially sophisticated as some of the others. However, at Goizueta we are taught the power of stories, a sentiment often echoed by Bill Miller of Legg Mason fame. With the help of classmates and professors, I was able to form a cohesive and logical argument that the judges liked.

We were also treated to lunch with Jeremy Grantham. I was incredibly impressed by the breadth of his macroscopic thought, in contrast to my bottom-up stock picker's perspective. He quizzed us on a variety of topics I had never even thought of considering, such as the reasons why timber outperformed other commodities, and which discount rates would be appropriate in cost/benefit analysis of environmental action.

Unfortunately, I wasn't able to secure an internship through this process. But hopefully this success can serve as a positive signal to other prospective firms. Several classmates were confused that I was still quibbling over $100 price differences in airline tickets, and that I had no plans to spend my prize money. What can I say, I'm a value guy through and through.

Quick update

I've trimmed a decent portion of my FootStar position. 60% in less than a year is pretty nice. I've started building a position in Aldila (ALDA). This piqued my interest after it showed up on the Magic Formula search for microcaps. I was able to purchase in the low 16's, with a sizable discount to my IV calculation of $30. Will elaborate some more soon.

I've been on short hiatus in preparation for my trip to Boston tomorrow. I have been preparing for this for the past few weeks, at the expense of everything else in my life. I will be giving a presentation on spinoffs as part of an investment strategy competition hosted by a large firm there ($140 B under management). If this works out, then I'll be set for the summer. Otherwise, I'll have to keep looking. Does anyone out there want to give me an internship?

Premier Exhibitions, Inc.

Premier Exhibitions, Inc. (PRXI) has been on quite a tear lately, surging close to 70% since the beginning of 2007. Their Q3 conference call (1/10/07) announced another great quarter, and I especially appreciated the fact that written transcripts were available. Key takeaways:

• Revenues of $7.9M
  
• Titanic exhibits are fully booked.
• Considering three options for monetization of Titanic assets.
  
• Two Bodies exhibits to be added late spring.
  
• Scrims (fabric walls) should save $1M annually, (5 exhibits * $100K / exhbit * 2 setups / year)
• Growing cash of $10.2M and no debt.
• $3.3 M revenues during the week of 12/26/06 to 1/2/07, which promises an excellent Q4.

Just a week ago, they announced plans to open new Bodies Exhibits in Pittsburgh, and Sao Paulo, the 5th most populous city in the world.

As a side note, value investors generally don't try to time the market. I've held this stock for under a year, with little substantial movement until the past few weeks. It's hard enough to be right about a stock. I doubt there's any way I could've predicted the timing of this action. When time permits, will post my updated writeup.

FootStar, Inc.

Footstar, Inc. (FTAR) is a holding company and operates a retail business through Meldisco, which sells family footwear through licensed footwear departments and wholesale arrangements. Meldisco has operated licensed footwear departments since 1961 and is the operator of licensed footwear departments in the United States. FootStar was forced into bankruptcy by a problematic athletic shoe division which was later sold off. In February, they emerged from Chapter 11, with no debt.

Valuation of FootStar must take into account two separate scenarios. Under the current Kmart Settlement, FootStar is set to be liquidated at the end of 2008. The liquidation would be the worst case scenario, however, it still represents an attractive proposition. In the two quarters out of bankruptcy, FootStar has reported $20 MM and $6 MM in earnings. Assuming a conservative run-rate of $40 MM per year and $5 MM adjustment for D&A, FootStar will have accumulated an additional $90 MM in cash through 2008. On the balance sheet, FootStar has $68 MM in cash, $110 MM in inventory, a $20 MM headquarters building with an additional $135 MM in liabilities. FootStar could be worth approximately $153 MM at liquidation with some additional upside for their NOL's.

If FootStar is allowed to continue as ongoing concern past 2008, then we assume $40 MM annual earnings, or $60 MM of EBITDA and look at peer comparisons. With an industry P/E multiple average of 14 and EV/EBITDA average of 8 and the existing $68MM cash, this implies FootStar is worth between $548-628 MM.

Given 21 MM shares outstanding, we have approximately $7.28 per share in liquidation value and approximately $26-30 per share if FootStar continues to operate. I was lucky enough to purchase shares in February at $4.20 and October at $4.93 which represented a large enough discount to the worst case scenario. The shares have moved up substantially since then to the current price of $6.60. This currently only represents a small discount to liquidation, and I am not sure if I would recommend a purchase. However, I continue to hold as a free call on the possibility that they are an ongoing concern, either through renegotiation of KMart Agreement or pursuit of a different business model.

Additional Opinions:

• George Schultze
• Whitney Tilson
  

Valuation

I recently sharpened my valuation skills with these excellent programs provided by the school.

Wall Street Program
Training The Street

As of now, I feel most comfortable with using public comps, historical comps, and DCF. Some of the other valuation methods seemed a bit too speculative (especially LBO). These models can be highly sensitive to the inputs, so there is an art of choosing which model to use as well as using that model correctly. But it is important to have an investment thesis be so compelling that you are less sensitive to any biases. I hope to post up within a day or two writeups of some of my investments.

"Based on my own personal experience - both as an investor in recent years and an expert witness in years past - rarely do more than three or four variables really count. Everything else is noise."

-- Marty Whitman

"Usually, the success of an investment is highly dependent on only a few key variables ... and I can’t think of a single case in which one of those variables was the discount rate we used - whether 8, 9 or 10 per cent."

-- Whitney Tilson

Recommended Reading

"In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time - none, zero."

-- Charlie Munger

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