Saturday, January 26, 2008

Investment Lessons Learned From a Bully


Charlie was the consumate bully. One of the older kids in the neighborhood, and also the paperboy, he had a bad reputation and it was well earned. The event that occurred on one snowy day in our small quiet town in central NJ some 30 years ago can today be used as a metaphor for an important investment lesson.

We'd spent much of the day building a huge snow fort--my brother and I, Jimmy and Jon, brothers who lived across from us, and a few other assorted neighborhood kids. We could all fit inside this circular structure, but the walls were so high that we could not see out, save for a "window" or two built into the wall. Definitely the best snow fort we'd ever built.

But we soon realized that our snow structure's hours of existence were limited. Not because of the sun, but because of something much more menacing: Charlie. We realized that he was due to make his afternoon newspaper deliveries, and as soon as he saw our fort, he would very likely destroy it. At 15 or 16, Charlie was a big kid, and could severely damage our fort with one flying leap.

We thought quickly. If Charlie was going to take down our fort, he was going to do so at his own peril. We quickly loaded that snow fort with everything we could find--rakes, shovels, other garden implements standing upright, even a full size garden tractor. He might take down the fort that we spent all day building, but that bully was not going to walk away unscathed.

We hid in the bushes, and along came Charlie. He saw our snow fort, but could not see what was contained within. He stopped, he sprinted, he jumped, and landed, destroying our fort. How proud he must have been as he hit that wall of snow--until a split second later when he landed on a tractor, several garden implements, and half the contents of Jimmy and Jon's garage. Charlie got a big, painful surprise that snowy afternoon. What appeared to be a harmless, ultra white snow fort, was actually much more. It's contents could not be seen from the outside; hidden within it's walls were dangerous, unseen risks.

That day, Charlie the bully cried like a baby. I don't remember seeing him all that much after that. He didn't suffer any permanent damage, and in hindsight, I'm glad he was not injured. We all (I hope) learned important lessons that day.

Hopefully the investment lesson is clear. During those times of financial crisis, when companies are beaten down, we as investors have the propensity to be fooled by the "It's down 50%, it can't go any lower" sentiment. That's the time to be aware of what might really be contained within a given company's situation. Is their peril lurking behind snowy white walls? Is it really worth the risk?

Charlie, if you are out there, I'd bet you wouldn't go near the Radians (RDN), MBIA's (MBI), or other such companies that have been trounced, yet may still conceal the unexpected. There may ultimately be reward, but how much risk are you willing to take?

*The author does not have positions in any of the companies mentioned. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this post.
Marty Whitman on MBIA and Radian


Marty Whitman is a legend in value investing circles, and yet he still continues to surprise. In his most recent letter to shareholders, a must read for value investors, he laid out his case for both MBIA and Radian:

THE RESIDENTIAL MORTGAGE MELTDOWN AND HOUSING COLLAPSE
TAVF is investing heavily in the common stocks of companies suffering through the current housing crisis. These companies include financial institutions, a homebuilder, a building supplier, land banks and investment builders. The Fund’s reasons for this investment program provide a good case study as to how Third Avenue’s “safe and cheap*” approach works in practice:First, the bad side of these investments:
1) The stock market pricing for these equity issues is chaotic. There is no way Fund management is able to pick a bottom for securities prices, or a near bottom.
2) Fund management has no good idea of how deep the crisis will become, or how long it will last. Our best guess is two to four years.

Second, the good side of these investments:
1) In each instance, TAVF is acquiring common stocks at meaningful discounts from readily ascertainable NAVs. In the case of certain financial institution
common stocks – MGIC Common, MBIA Common and Radian Common, the prices the Fund
is paying are no more that 40% of book value, or adjusted book value. For each of these companies, a normalized Return on Equity (equity equals book
value) (“ROE”) ranges from 8% to 14%. Assuming a 10% ROE sometime in the future, and no further dramatic deterioration in book value during the interim, probably a realistic assumption; and current pricing at 40% of book value, Third Avenue would
be paying only four times future normalized earning power. There seems to be a reasonable probability, too, that TAVF is really paying less than four times
normalized earnings, even assuming that future normalized earnings are fully taxed and even assuming some modest dilution of the common stocks.
2) Each common stock acquired, is acquired in a company which enjoys a strong financial position. While there can be no guarantees, the probabilitiesare that each of these companies will survive as solvent going concerns either without requiring
major access to capital markets for new funding, or by obtaining new funding from others on terms that are only modestly dilutive for TAVF. On December
10th, MBIA announced that it is obtaining $500 million of equity financing from Warburg Pincus; and another $500 million from a rights offering which Warburg Pincus will backstop, i.e.,underwrite. Assuming that Third Avenue participates
in the rights offering and also takes advantage of any oversubscription privileges, the capital infusion should be, at worst, only modestly dilutive for TAVF.
3) Each company seems very well managed.
4) It is possible that the crisis will become increasingly deep, and prolonged; or rating agencies will start to place great weight on soft, qualitative considerations. In those events, the companies might need capital infusions to
remain going concerns. TAVF has proposed to MBIA,Radian and USG managements that such infusions be in the form of equity, and that existing stockholders
provide the equity via pre-emptive rights offerings. MBIA proposes to raise $500 million via a rights offering. If this were to occur, and if other portfolio
companies were to follow the MBIA path, the capital infusions would be, for Third Avenue, mostly nondilutive, or anti–dilutive (if there are oversubscription
privileges). In the case of MBIA and Radian, it is crucial if they are to remain going concerns, that the national rating agencies continue to assign AAA and AA ratings, respectively, to each company’s bond insurance subsidiaries. As an aside, given current prices, TAVF would probably not lose money if Radian or MBIA
were to go into run-off rather than remain going concerns. Run-off, i.e., liquidation, simply is not a likely outcome, however.


In the past, Whitman has been a master in both distressed equity, and even distressed debt, with a keen ability to determine true value, post crisis. While Marty is one of our heroes, we for one don't have the stomach to go near either of these companies, or most other names in related sectors.

The game has changed since Marty wrote this letter, especially in the case of MBIA, but we are steering clear. Too much risk, we believe, and possibly another shoe or two yet to drop.

While we hope Marty Whitman is right in the end, we are staying on the sidelines.

*The author does not have positions in any of the companies mentioned, but does have a position in Third Avenue's Small Cap Value Fund. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this post.

Tuesday, January 15, 2008

Increasing Avalon Holdings (AWX) Position

We recently saw a further pullback in microcap Avalon Holdings(AWX)(from the $6.50 range to $4.50) as an opportunity, and added to our position. At $4.70, the company has $1.77 per share in cash, and we believe the downside is limited.

Be aware that AWX is incredibly small, has low volume, and fairly wide spreads. Please see our earlier research for more information.

10/13/06
11/23/07

*The author has a position in Avalon Holdings (AWX). This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this post.

Monday, January 14, 2008

Random Thoughts from 36000 Feet

Your Cheap Stocks Editor is writing this from 7 miles above the earth en route to Denver. The air is thin up here, so my apologies in advance if none of this makes any sense. We typically don’t write about the markets, or macroeconomic themes, but hey, the air is thin up here, and I have no access to spreadsheets, 10Q's, 10K's, or other financial data.

On Equity Market Volatility

No one should be shocked if the volatility we saw in 2007, and the fourth quarter in particular, follows us deep into 2008. During 2007, there were nearly 60 trading days-21 in the fourth quarter- that the Dow finished plus or minus 1 percent. In case youre wondering, that’s slightly less than 25% of the time. More remarkable, however, the plus and minus 1% days were nearly evenly split. What a roller coaster ride for investors, especially given the endless, up to date news constantly bombarding us; “helping” us to make wise investment decisions. Makes it difficult to think and act like long term investors when the sky is falling one day, and there’s euphoria the next.

The ride has been rocky so far in this new year, and there are a whole host of issues-credit crisis, oil, the Fed, inflation, war, the upcoming elections, recession fears- to name a handful- which will continue to cause uncertainty. What’s the lesson here? Stay informed, but don’t get caught up too much in the daily market movements, economic data releases, or calls for economic armageddon or prosperity. The truth is probably somewhere in the middle.

On The Fed

Expectations are high that the Fed will continue to ratchet down interest rates to stem the credit crisis. Some pundits are calling for a sub 3% Fed Funds rate, and the futures markets are starting to reflect this. The markets love rate cuts, and stocks typically rally in in the aftermath. But watch out if market expectations are not met, ie. if the Fed does not cut as much as expected. While we believe rates will be cut again starting on January 30th, we also believe that the Fed will ultimately stop around 3.5%. The threat of inflation is real, and consumers are already seeing this reflected in many goods they purchase on a weekly basis. Chairman Bernanke is an inflation hawk, as are many of the 2008 Fed members who have a vote, and we believe inflation fears will ultimately stop further cuts. Perhaps the damage has already been done.


On Oil

Most pundits believe that $100 (and higher) oil is here to stay, and often cite supply concerns, Asia’s growing demand, and The Peak Oil Theory, among other reasons. We believe oil will pull back significantly in 2008. The days of $10, $20, or even $40 oil may be over, but we believe we’ll see the $50’s again. The fundamentals just aren’t that bad, and the run-up to $100 has been fueled more by a weak dollar, fear premium, and speculation than increasing demand.

Don’t mistake this for the na├»ve belief that all is well in the land of fossil fuels, and that we are not running out of oil. We will run out, we do need to find alternative sources, and we do need to continue improving technology in order to recover oil from difficult places. $100, we believe, is not justified. Ultimately, the oil markets will again trade on fundamentals.

The air is thin up here........

Friday, January 04, 2008

Taking Advantage, or Being Taken Advantage of? The Case for CBRL

Mr. Market has been on a rampage so far in 2008, and it's no wonder given the daily (over)dose of news we are all the "beneficiaries" of. My personal favorite was the headline in The Wall Street Journal earlier this week, proclaiming that oil finally hit $100. If you read a little further, you learned that $100 was reached via a tiny, ceremonial trade, evidently placed for bragging rights, ie. "I made the first $100 trade in oil!" Misleading you say?. I know, "we must sell papers, we must draw viewers". I digress.

Your Cheap Stocks editor for one, is starting to see some interesting opportunities. Today, we took a position (after several years of watching, waiting and sporadic research) in CBRL Group, parent of Cracker Barrel Old Country Store Restaurants. In Peter Lynch-like fashion, we've eaten there many times over the years, never had a bad meal, and always had to wait for a table. We like the fact that CBRL owns 404 of its 565 locations--thats a rarity these days in the restaurant business.

Its no wonder restaurant stocks are getting beat up these days. Ingredient costs are rising, labor costs too (minimum wage), and speculation is that consumers will stop spending, and in turn, shun dining out. We are still not convinced consumers will pull back to a great degree, and in the event they do curtail spending, we believe Cracker Barrel will continue to attract crowds due to its attractively priced menu. The same can't be said for some of the others playing in the same space that have higher price points.

Cracker Barrel's same store sales came in down 1% earlier this week; this combined with a falling market, and overall economic worries have punished the shares to levels not seen since 2002.

We took a position not in the hope of picking the bottom, because we're not adept at doing so, but because we believe the shares are attractively priced.

CBRL Group
Tioker: CBRL
Price: $26.94
Mkt Cap: $640 million
Enterprise Value: $1.4 billion
EV/Owned Location: $3.5 million
FWD P/E (2008): 9.2
Dvd Yield: 2.3%

Previous CBRL Research: February, 2006

*The author has a position in CBRL. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this post.