Friday, April 29, 2011

Berkshire's Woodstock

While the whole David Sokol issue has been disappointing and out of character for Berkshire Hathaway, all of a sudden there are articles about breaking up the company because of the "sum of the parts" opportunity to create value. I'm sure that the financial press received spreadsheets and analyses from all the major investment banks on this hackneyed idea.

The fundamental issue is the durability of the BH business model. In my opinion, it's built on a few key elements. First, there is the enduring Graham and Dodd foundation, which is the basis on which Warren Buffett and Charlie Munger invest and look at companies. After all, Buffett himself studied at the feet of Graham & Dodd at the Columbia Business School in 1949, and his longstanding support of the value-oriented philosophy led to the creation of the Heilbrunn Center for Value Investing and the Graham & Dodd breakfast, which has always attracted top notch business leaders. Along with a disciplined analytical focus, the team of Buffett and Munger have added a fantastic intuition for simple businesses with good models and good leaders.

The next feature is the ability to reallocate cash flows among the businesses in the Berkshire portfolio. Past Chairman's letters have told stories like redeploying over a billion dollars in excess cash flow from See's Candies to other portfolio companies or for new acquisitions. This is an art that cannot be taught in a corporate finance course. Again, it comes from an analytical discipline, an ability to isolate the key issues, and a good sense for people. Looking at M&A experience in public companies, this is indeed a rare and valuable skill. This is "alpha," not "beta," and it is a skill investors should be willing to pay for.

The fact that they have done it over such a long period of time, as shown by their long and consistent growth in book value above the S&P 500 would suggest that investors are not being fooled by randomness.

Finally, there is the skill of the founders in retaining and properly motivating the founders of the portfolio companies to invest 100 percent of their energies in growing their business and in making a contribution to the portfolio by, for example, stepping to lead troubled assets from time to time. Of course, there are many, many additional subtle personal elements to the way the Buffett-Munger team operates, but these are the key elements, in my view.

Add them up, and it's quite a potent model that has proved durable and effective. Breaking up the company means that "The Song is Over," as Roger Daltrey would sing. But, if Buffett and Munger are good at leadership development and succession planning, there's no obvious reason why it should be so. However, their continued waffling about a successor, while dropping occasional hints about Ajit Jain, David Sokol and others, has really not been a good service to shareholders. While "Trust us," is okay for a time, ultimately shareholders deserve some sort of answer. I doubt that it will come in Omaha this weekend, which will do nothing but add to speculation and rumor mongering.

Wednesday, April 27, 2011

The David Sokol Affair: Shareholders Should Be Glad

Berkshire Hathaway, in surprisingly plodding fashion, has 'fessed up on L'Affaire Sokol.

Any executive officer of a public corporation with any sense would just feel in their gut, without recourse to a statute, or Code of Conduct, how to evaluate the following scenario.

December 13th, you direct Citi investment bankers to ask their client Lubrizol, if they would like to have a conversation with you, a senior executive of Berkshire Hathaway, about a possible fit for Lubrizol within the Berkshire Hathaway portfolio. The bankers would assure Lubrizol that Berkshire does not do hostile deals, and that a conversation that went nowhere would remain confidential.  The following day, the executive places a LIMIT ORDER (!) to buy 50,000 shares of Lubrizol.

Question: Doesn't everything in your business experience tell you that this is probably not a good idea? Does that little green cricket on your shoulder tell you anything? Even if it passed some legal test, isn't the question, "How would it be seen by the market?" Even better, "Wouldn't it put my boss (Mr. Buffett) in an awkward position?" If you were especially dense, you might just call your legal counsel.

It's impossible to comprehend. But a friend who's a lawyer and a corporate governance guru put it best when he drew this insight. Berkshire shareholders were fortuitously spared the terrible burden of having Mr. Sokol being appointed successor to Mr. Buffett. They should spin the track from Cream's first album, "I'm So Glad."

Monday, April 25, 2011

Out of Time for the JIT model?

For decades now, the benefits of the Japanese-pioneered JIT inventory models were trumpeted in every sort of business and management textbook. Looking at the aftermath of the tsunami, the net economic benefits of this model need to be reexamined. For practical purposes, two sets of forces came into play with the widespread adoption of JIT. The first was consolidation for things like automotive seating, in which a large, global company like Johnson Controls emerged by acquiring weaker competitors and scaling up the model for these larger automotive components. For these bigger ticket items, capital could be profitably employed and their size allowed them some bargaining power versus the manufacturers.

For traditional auto parts that involved metal bending and forming, there was also consolidation, but the economic benefits to this consolidation led to lower quality parts in response to continuing manufacturer pressure for price reductions. Medium and smaller size suppliers always operate on life support, and JIT is what took them there. Finally, all of the pressure leads to the complete lack of R&D in the parts business, so there's very little innovation.

The auto industry needs a vibrant network of parts suppliers who can provide a decent financial return to their owners on a consistent basis. In the end, consumers probably benefit too. A poorly designed accelerator assembly for Toyota cost it thousands of times more than a little more margin would have for a better designed part. I'm not saying that the industry should vertically integrate once again, but it certainly needs to look beyond the "penny wise, pound foolish" siren song of JIT.

Saturday, April 23, 2011

Backdoor SEC Registrations

SEC Commission Luis Aguilar recently gave a speech about regulation and its effect on capital formation. He made a distinction between capital formation and capital raising, which is important for our current financial markets. Capital formation is at the heart of modern economic growth theories, from Hicks, Samuleson, Solow and others. Its aim is to deploy tangible capital, together with labor and other economic inputs, to productively increase output and growth. CEO's looking to grow and sustain their businesses have to look for capital investment projects that generate value in excess of the required rate of return.

Modern captains of industry seem to have forgotten about this aspect of their economic briefs as they continue to sit on large hordes of excess capital, especially in the form of cash and equivalents. We've written about this before, so we'll move on. Commissioner Aguilar then notes that capital markets have become fixated on capital raising. He rightly talks about the importance of transparency and utility in financial disclosures, which are aimed at helping investors make better estimates of the intrinsic value of a business. Disclosure ought to be meaningful, transparent and provide a level informational playing field for all investors. Better disclosure offers investors an elment of protection too.

When he turns to the current state of capital markets, he identifies the phenomenon of"backdoor registrations," particularly by Chinese companies using public shells in the U.S. to float their businesses to domestic investors. Ironically, this past week, I discussed the case of a NASDAQ-listed company, China Media Express Holdings, Inc. briefly with my MBA Investment class as an example of risk in emerging market investing. I got the idea of discussing this stock by reading John Hempton's blog. China Media Express was touted by bulletin boarders and even by some boutique research houses, but a cursory review of their SEC disclosures made their business model seem like a financial printing press. As Hempton identified, it was too good to be true. After their US auditor resigned and the exchange threw up its hands and delisted the company, the patient prognosis is not good. The cracks in our regulations that allow these reverse mergers into public shells have been crying out for a remedy for years.

Yet, we were so mesmerized by pursuing "comprehensive" reform of the financial sector, that we still can't incrementally move towards a better solution to a specific problem. When Arthur Levitt's SEC moved on Reg FD, it seemed simple, and a "one off" kind of solution, but it yielded real benefits to all investors through better disclosures and the elimination of side channels for information. We can do better for US investors looking to get involved in emerging market issues by acting on Commissioner Aguilar's ideas.

Monday, April 18, 2011

S&P Puts A Stake In the Ground

S&P, one of the three rating agency enablers of the housing debacle, today took the astute position of downgrading the outlook for U.S. Treasury debt, ostensibly because of the forecast for budget deficits into the foreseeable future. The Treasury Department put out an insipid press release, in which a spokesperson bemoaned S&P's bad political judgment. In fact, S&P deftly succeeded in differentiating themselves from their rating agency competitors and in showing gumption by restating the blindingly obvious. There's no downside risk to S&P from their move--congratulations to their marketing department.

Wednesday, April 6, 2011

Xcel's Wind Project (Not) for The Birds

Xcel recently announced it was scrubbing plans for a $400 million Merricourt wind farm in North Dakota which has almost optimal conditions in the frequency, duration and strength of high winds. The issue turned on the dangers to migrating whooping cranes and a charming bird named the piping plover. Of course, there is some level of risk for these species: the cranes because their populations are near endangered levels, and the plovers because of their small size and large migratory squadrons. Xcel realized that no one had a good remediation scheme, and without it, they couldn't know the level of cost risk that they would be exposed to in order to meet their increasingly uneconomic mandate of 30% of electricity generated from renewables by 2020. If a project by a motivated utility in the optimum location is scrubbed what does that suggest for the absurd notion of huge, offshore wind farms off Nantucket? As an energy class, wind is a "clean" energy source for campaign speeches, but it's an improbable choice for leading us to "energy independence." MIT has a long-standing Energy Initiative Project that has done the kind of work that industry and policy makers need to think about. Their recommendations for working on the next generation nuclear power plants has sat in the file cabinets since 2003. Indian Point, Fukushima and other plants around the world are older designs, and MIT's scientists argue that a truly carbon-free source like nuclear needs to be considered through the lens of the best designs, construction materials, safeguards, and risk management. They also note that conservation is the great, relatively low cost energy source, which has long been persuasively argued in the "stabilization wedge" methodology by Princeton University researchers. MIT scientists did a heat scan of the Boston skyline to visually display the heat losses through the skins of their most famous towers. The shots looked like scans of the coronary arteries of a triple bypass patient--not good. They argue that putting money into the least efficient buildings would yield the best returns, and shave the Boston utility's peak loads substantially. Not glamorous, like wind turbines, but definitely more realistic, economic, and meaningful.

Friday, April 1, 2011

Wachtell, Lipton, Rosen and Katz on Beneficial Ownership

As a public company CFO for a growing medical device company, I always thought of myself as being on top of our capital markets position, both for purposes of understanding our ownership base and for handling our corporate share buyback program.

Imagine my chagrin when I got a phone call with the following stylized conversation: "Hello, this is Mike from Freefall Ventures. Looking at your 13D's, I'm your largest shareholder. I have a few questions." I'm somewhat confused, as I have never heard this name among our ownership base. Opening my database, and a split screen of the NASDAQ issuer's ownership screen, I see no entry for any level of ownership by this person's firm. If he were the largest, his position would have to have been a double digit percentage, as our largest holder was a well known mutual fund.

"Excuse me for asking, but I don't see any filing for your firm. Let's go ahead with your questions, and perhaps you can enlighten me later about your position and why I see no 13D filing." Of course, Mike never does. After the conversation, a call to the NASDAQ Market Intelligence desk yields absolutely nothing but a scripted commentary about the complexity of reporting. That gave didn't give me the warm fuzzies about informational efficiency in our capital markets.

Marty Lipton's firm recently sent a letter to the Secretary of the SEC on Rulemaking Under Section 13 of the '34 Act. It clearly makes the case for updating the rules to prevent the current "market manipulation and abusive tactics" by aggressive hedge funds. The firm was excoriated by the New York Times as being supportive of entrenched managements at the expense of shareholders. This argument is either woefully naiive or aimed at currying favor with the hedge funds.

Dating back to Artuhur Levitt's time as SEC Commissioner, the idea of a "level playing field" for information was articulated. In fact, this is the same underpinning behind "informationally efficient capital markets," a concept that is taught in most MBA courses on investments and modern portfolio theory. It became one of the driving forces behind Reg FD, to the benefit of all capital market participants. As an issuer, I have a right to know who owns my equity on a timely and current basis. The issue of being entrenched or not, is a red herring. As an officer of the company, I need to be able to formulate and maintain a communications and relationship building strategy that makes efficient use of management's time. This can't be done if I don't know who my audience is. As a market participant in the company's own shares, I also have a right to know where potential demand and supply might be coming from, and current positions are a useful starting point. Again, being "entrenched" or not, is irrelevant.

Examples of abuses within the current system abound and have been discussed since 1983. In the WLRK letter, they point out Pershing Square's acquiring 4.9% of JC Penney's stock (under the reporting threshhold) through open market purchases, and subsequently acquiring a total 27% position through forward purchases, call options and total return swaps BEFORE filing a 13-D! Whatever one thought of Penney management, this is an egregious example of "hedge fund activists who have gamed the window to their own advantage." This has no place in any financial market that purports to be modern, fair, equitable, transparent and informationally efficient.

We don't need to focus on things like high frequency trading and invisbility for dark pools to maintain our capital market leadership. These kinds of practices confer no economic benefit but are redistributions of benefit between classes of market participants. The WLRK letter clearly states that the window for filing a disclosure should be shortened, as have other disclosure periods like the 8-K and insider trading periods, and that ownership be defined as to capture the ability to exert economic ownership through derivatives and synthetic positions.

This is how Mike acquired a position in my company. He made a lot of money for himself, and came and went like the wind. Other shareholders who could have sold on the upticks as positions were being built or his filing was being announced were out of luck. Let's put everyone on the same level, informational playing field--we know how to do it, and it's not at all burdensome, and there's no excuse for our waffling and regulatory inaction.