Thursday, January 3, 2008

Media hype

As investors we’re surrounded by media “noise”. Financial tabloids, television broadcasters and internet news services publish their daily opinions on their latest favourites and villains. Most of the time these opinions reflect a popular held belief that is the prevailing sentiment at the time whether it is factual or not. Share price movements in particular stocks can further reinforce these biases. Its easy to feel this pressure as an investor. When you see a stock you own being vilified in the press and trading down each day, its easy to start second guessing your own judgement and believing that you should join everyone else and dump the stock. After all it feels better and safer to do what everyone else is doing.

Lets explore three companies whose leaders and stocks have been subjected to a media storm, they include two insurance focused investment companies whose prospects and shares prices are now back on a favoured footing and one holding company with a retailing focus which is still down but certainly not out. In each case, the CEO or Chairman and Company has been the target of attacks by the press.

Prem Watsa and Fairfax Financial(FFH)

Smart people don’t suddenly become stupid, the story of Prem Watsa and Canadian insurer Fairfax Financial is a case in point. From 1986 to 2000, Fairfax Financial and Prem Watsa achieved phenomenal business results growing book value per share by 37% and Fairfax's share price by 33% (measuring from 1985 to 2006, compound book value grew a more moderate but still excellent 24% ) . Much of that success was attributable to Prem Watsa and his team achieving strong investment results using the float from the insurance businesses.

But by 2001, Fairfax Financial’s golden run was in trouble after making a series of takeovers , including TIG & Crum and Forster. Fairfax was forced to massively raise its reserves for these new subsidiaries and this substantially reduced its book value and placed pressure on its ratings and caused successive years of writedowns and losses. Things looked bleak , Fairfax Financial’s Canadian listed shares(FFH.TO) went from $600 in 1999 down to $85 in 2003 and were $175 as recently as January 2006.

Fairfax a one time darling of the financial community became a villain in the press . Fairfax’s record prior to 1999 was forgotten amid the media hail storm, in a Value Investor Insight article Jim Chanos a short seller of Fairfax described Fairfax as massively under-reserved and even implied it was a bankruptcy candidate or a “zero” . However, Prem’s closest friends and supporters all great investors themselves backed their man, they included Steve and Tony Markel at Markel Corporation, Mason Hawkins at Southeastern Management and John Templeton at Templeton Funds.

So the battle lines were drawn, a small collection of some of the smartest investors of our time backing Prem Watsa and Fairfax versus numerous short-sellers and many financial publications. Given the central argument of the media and short sellers that Fairfax was massively under-reserved to the tune of billions of dollars that would potentially destroy all of shareholder capital, their argument was simply that management were either careless in setting reserves or were not being forthcoming about their exposure (translated - not of good character). But what was interesting is that the Markels and Templeton, people who knew Prem on a personal level, had worked with him and who were experienced with the insurance business and were in a better position than anyone else (media and short sellers included) to judge Prem Watsa’s character continued to back Prem and Fairfax. If you are a betting man, it pays to back the people in the know!

In 2006 and 2007 the tables began to turn. The reserve writedowns started to end, Fairfax’s Canadian, US and Asian insurance subsidiaries began firing and huge bet by Hablim Watsa Investment Council (owned by Fairfax Financial) against the bubble in the US housing market and inadequate yield spreads in the corporate bond market began to pay off in a very big way. Fairfax sued a group of short sellers who they said were spreading malicious rumours about Prem Watsa and the Company in the press in order to manipulate their share price. And over the last 12months Fairfax’s shares have bounced to new highs, up 48% from $187 to $277 today (4 Jan-07 to 4 Jan-08)

All of a sudden Prem Watsa and Fairfax were back. From favourite to villain to favourite again.

Warren Buffett and Berkshire Hathaway (BRKA & BRKB)

Everyone knows the legendary story of Warren Buffett and Berkshire Hathaway. Yet Buffett has received his fair share of media attacks. What really struck me as downright ridiculous was a series of media articles in 2005 by Peter Eavis for After it was reported that General Re was caught doing finite reinsurance deals with AIG, Peter Eavis in a March 2005 article bluntly titled “Show Buffett the door” said that “There has been no indication so far that Buffett was personally involved in the deal… But it would be absolutely no surprise if Buffett had played a part in this transaction or others like it.” And then Peter Eavis gave his view on why Warren Buffett should depart from Berkshire “Even if Buffett never ends up getting specifically tied to any particular deal that comes under the regulators' scrutiny, it is time for the Oracle of Omaha to go. His handling of the 1998 General Re acquisition is reason enough.”

Anyone who has listed to Warren Buffett or read his annual reports or any “informed” press on Berkshire Hathaway would know how irresponsible and unfair these comments were.

In 1999 commentators suggested that Berkshire was out of touch and missing the internet stock bonanza. Well in hindsight they certainly didn’t miss much. Then in more recent times the media concern became that Berkshire was sitting on too much cash because Buffett wasn’t spending it quickly enough. In a Forbes piece, released in October 2004 titled “Berkshire weighed down by cash” it was reported “…the biggest uncertainty for Berkshire Hathaway (according to Morgan Stanley) remains allocating its cash balance”. Berkshire Hathaway made some acquisitions but did avoid much of the private equity frenzy and buyouts over the 2004-2006 period.

Well fast forward to 2007. Berkshire Hathaway is now riding high . Its conservative balance sheet and big cash reserves are now being viewed favourably, its share price has jumped and its excellent business performance has stood out amid the storm that has engulfed numerous financial concerns over the last year due to the subprime loan crisis and credit market freeze. Many private equity funds are seeking to undo deals made at the peak of cheap credit in 2006 and early 2007 meanwhile Berkshire is taking advantage of all the distress and has become the acquirer , adding Marmon holdings to its collection of outstanding businesses just recently.

Warren just like Prem was always smart and honest, even if he was portrayed in a different light in some areas of the news media.

Eddie Lampert and Sears Holdings (SHLD)

Eddie Lampert and Sears Holdings are the latest company to feel the wrath of the mainstream press.

A few years ago, after Eddie Lampert made a vulture like move on Kmart in bankruptcy and later merged it together with Sears , he became the poster guy for the hedge fund community. Eddie Lampert was described as the next Warren Buffett and there have been press reports comparing Sears Holdings to an early day Berkshire Hathaway.

But this year , Sears performance has been ugly and Lampert’s star has faded. Sears has suffered from the housing downturn and like its competitors has seen a big drop in profitability. Sears shares in 2007 hit over $190 a share , but are now down nearly 45% and trading at $105.

In a recent CNBC broadcast, Lampert was nominated as one of the worst 3 CEOs of 2007. After being called a modern day Warren Buffett , he’s suddenly become one of the worst CEOs , besides the fact he is actually Chairman and not CEO but lets not get technical.

First lets look at the facts and start with Lampert’s hedge fund, ESL investments. Eddie Lampert achieved 30% a year for his investors from 1988 to 2006. An accident, I don’t think so! Richard Rainwater, a former business colleague of Eddie’s, has described Eddie Lampert as “…the greatest investor of his generation,"(Fortune Feb 6 2006). Unlike the financial tabloids, that is the kind of recommendation that I take note of as an investor. Like Eddie, Richard Rainwater has a great track record and performance and ,having known Eddie on a personal level, he is in a sound position to judge Eddie’s character as well as his business acumen.

When Eddie Lampert started buying up Kmart’s senior bonds at 40 cents in the dollar, it was no accident that he saw enormous potential unlocked value in Kmart’s real estate. He was betting big time and could not afford to be wrong. As it turned out he was right. During liquidation all of Kmart’s real estate had been valued at just $800 million, yet soon after taking control Lampert sold a small portion of Kmart’s real estate for $900 million to Sears and Home Depot.

Lampert later merged Kmart with Sears knowing that there was enormous value in Sear’s real estate along with its retail operation and other assets. Currently Sears shares are suffering under the weight of criticism in the press and the housing downturn. Certainly things look bleak. But taking a longer term view, Sears Holdings looks cheap. Its market cap is $14 billion and sells for less than the value of its real estate,estimated at between $15-$20 billion. Throw in its brands, $2 billion in Sears Canada stock and other assets , and its net asset value works out between $24-$26 billion and that’s not including an option play on its retail operations that may or may not be turned around.

Eddie Lampert sees value in the shares at current price also. He has spent billions in cash buying back shares, and in the September 2007 quarter spent around $1 billion.

Investors backing Eddie Lampert have to be brave. And there are smart investors backing Eddie Lampert like Bruce Berkowitz and Michael Price. Certainly Sears Holdings could be a 2 to 3 year work out. The press will continue to argue Eddie Lampert is out of touch, doesn’t know how to run a retailer. But I believe Eddie Lampert’s record speaks for itself. Sure smart investors make mistakes and Sears retail turnaround may be too hard a task even for Eddie, but given that the shares of Sears trade for less than the value of its real estate and you’re getting one of the smartest investors around without paying a “hedge fund like” surcharge, its hard to see much downside on Sears Holdings.

Just a final note, Eddie’s decision to be patient in selling real estate and unlocking value has upset many investors in Sears. But I have two points to make on this. Eddie has not been selling real estate to upgrade Sears stores and in so doing I believe he’s protecting his downside or his “out” option if the retail turnaround does not work, I think that’s smart. My second comment is that Eddie knows the real estate potential better than anyone, his current strategy is to maximize its use for its retailing concerns, if this doesn’t work out I’m sure he knows the potential for this real estate to be used or developed for other uses. Either way I trust Eddie Lampert’s judgement more than the popular press.

Wrapping it up

Media negativity surrounding Sears and Lampert at the moment is a good example of media journalists pushing a popular but ill-informed opinion like they have with Fairfax Financial and Berkshire Hathaway. My own view is that Lampert is smart and that hasn't changed. I am not betting that Sear's retail business will succeed but simply that Sears will not trade substantially less than its net asset value indefinitely.

Disclaimer: The opinions expressed represent the authors own point of view and should not be regarded as investment advice or relied upon as such.

Disclosure: I own shares in Fairfax Financial (FFH), Berkshire Hathaway (BRK_B) and Sears Holdings (SHLD)

Note: This blog post was updated and re-edited 4th January 2008.

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