December 2, 2009
Our fund declined 1.4% gross and 1.2% net in November vs. 6.0% for the S&P 500, 6.9% for the Dow and 4.9% for the Nasdaq. Year to date, our fund is up 31.0% gross and 24.8% net vs. 24.1% for the S&P 500, 21.5% for the Dow and 37.0% for the Nasdaq. If the year ended with these numbers, it would be our best year ever and nearly all of our investors would earn 30.0% net, reflecting the benefit of the high-water mark.
We made money during the month on the long side, led by General Growth Properties (up 59.8%), American Express (20.1%), Huntsman (19.7%), Pfizer (6.7%) and Microsoft (6.1%), offset by Borders Group (-27.8%), dELiA*s (-22.2%), Helix Energy (-14.3%), and Iridium stock (-8.0%) and warrants (-4.9%).
Not surprisingly in such a strong month for the markets, our short book dampened our returns, thanks mainly to Herbalife (up 24.6%), InterOil (22.6%), Regions Financial (21.1%) and VistaPrint (11.7%). Partially offsetting these positions were PMI (-24.0%), Radian (-22.8%), MBIA (-14.8%) and Palm (-6.0%).
In his 2004 letter to Berkshire Hathaway shareholders, Warren Buffett wrote that investors “should try to be fearful when others are greedy and greedy when others are fearful.” We believe in this maxim and have had ample opportunity to implement it over the past year: we started getting greedy a year ago after Lehman’s collapse and the resulting market panic, buying ever-cheaper stocks all the way down to the market’s final capitulation in early March. Since th then, during one of the biggest, fastest rallies in history (the S&P 500 rose 64.6% from March 9 through the end of November), we have steadily become less greedy and more fearful by doing three things: trimming our longs, adding to our shorts, and repositioning our long portfolio toward more defensive, big-cap stocks such as Berkshire Hathaway, Microsoft and Pfizer.
Today, our net long position is down to approximately 20%, the lowest it has ever been, reflecting both our top-down macro concerns (outlined in our August and September letters) as well as our core bottoms-up analysis, which is uncovering many great shorts and a paucity of attractive longs. That said, we like our long positions a great deal and are still net long, so we’re certainly not perma-bears and aren’t predicting Armageddon.
Speaking of our long positions, we wanted to share brief thoughts on a few of them.
General Growth Properties
The stock soared during the month for two reasons: first, rival mall giant Simon Properties Group announced that it had hired both Lazard and Wachtell, Lipton to “help it formulate a strategy for possibly bidding for all or part” of General Growth (see article in Appendix A). Then two days later, General Growth announced that (quoting from the article attached in Appendix B):
...it had reached a deal with lenders and servicers to restructure $8.9 billion of mortgages on 77 malls in hopes of removing them from bankruptcy by year end.” The pact is the first step for General Growth in extracting from bankruptcy court the 166 malls it put under Chapter 11 bankruptcy protection in April. The company still must strike similar pacts with lenders on another $6 billion of secured debt as well as $6.5 billion of unsecured debt.
"This moves up the entire timetable for getting out of bankruptcy," said Kevin Starke, an analyst with CRT Group LLC, which monitors distressed securities. "These guys could be out [in entirety] in the April-June timeframe."
General Growth appears to have won on some key points in the restructuring, of which details were outlined in a bankruptcy court hearing in New York.
December is off to a good start for General Growth, as it announced this morning (see Appendix C) that 92 of its properties, representing $9.7 billion of restructured debt (up from $8.9 billion less than two weeks ago), will exit bankruptcy by the end of the year, a remarkably quick timetable. This announcement also puts pressure on the remaining debtholders to accept similar terms.
When we first purchased the stock earlier this year at under $1/share, we thought there was upside potential of $20-$30, but we kept it a small position, reflecting the high risk that the equity could be worthless. Today, the best-case scenario appears to be playing out and the risk of a catastrophic outcome for the equity is far lower, but the stock price doesn’t reflect all of the positive developments in our opinion, so this is now among our largest positions
dELiA*s recently reported a mildly disappointing third quarter and gave conservative guidance for the critical fourth quarter, which triggered a sell-off of the stock. Since the company doesn’t communicate with Wall Street as frequently as most retailers and doesn’t report monthly comps, the stock is often volatile around its earnings releases.
Netting out the projected year-end cash balance of $1.50 per share, the core retail business is today essentially being valued at zero. We believe that dELiA*s business is worth at least $3 per share (plus an additional $1.50/share in cash), and would expect this value to be recognized over the next year as the company turns the corner to profitability. In the meantime, we are comfortable that the cash balance makes a further stock price decline unlikely. In addition, based on recent transactions, we have little doubt that the company could be easily sold for at least double its current share price of $1.68, but we actually hope the company remains independent because we believe there’s far more upside if management executes on its growth plan.
While dELiA*s has not yet been a profitable investment, it represents today exactly what we like in a stock: a low probability of permanent loss of capital and a good chance of making multiples of our money.
Speaking of sub-$100 million market cap retailers, we have recently been buying Borders Group, a stock we’ve had a very up and down experience with over the years. Initially it was a disaster, falling well below $1 earlier this year, at which point we bought quite a bit more and were quickly rewarded, as it rose dramatically in less than five months to $4.34. We sold most of our position, but are now getting another bite at this apple as the stock has tumbled anew (it closed yesterday at $1.29).
This is a tough business and the odds appear stacked against Borders in light of threats from Barnes & Noble, Amazon.com, and discounters like Wal-Mart. That said, we like the current management and believe that Borders can succeed.
At today’s price, Borders has a market cap of a mere $77 million, a tiny fraction of annual revenues, which exceed $3 billion. We view this stock as a mispriced option: the company could go bankrupt and wipe out our investment, but if it merely survives – which is likely, we believe – the stock should rise many-fold.
Iridium reported a strong quarter recently, but this wasn’t enough to offset the poor trading conditions that the SPAC structure created nor mitigate concerns about the risks associated with funding the new generation of satellites, Iridium Next. Based on conversations with management and the primary sponsor, Greenhill, we are confident that the company will be able to access the capital necessary for Iridium Next via existing cash on the balance sheet, operating cash flow, shared payload fees, vendor financing, and external debt and/or equity.
We continue to believe that this is an excellent company and that the stock is extremely undervalued. Comparable businesses are trading at 10x EV/EBITDA, while Iridium, which is growing significantly faster than and taking share from its competitors, trades at under 5x EBITDA. Finally, we are encouraged by the recent large insider purchases by both the CEO and Chairman of the company.
In last month’s letter, we wrote that “Berkshire Hathaway reports earnings on Friday and we are confident that it will be a blowout quarter.” Sure enough, Berkshire reported strong operating earnings and an unprecedented 10.1% increase in book value during the quarter.
The other big news during the month was the acquisition of Burlington Northern Santa Fe, which is by far Buffett’s biggest investment ever. At $100/share, equal to 19x trailing earnings, he paid a full price for the 77.4% of the company that Berkshire didn’t already own, so this was a good deal for BNI shareholders – but it’s a good deal for Berkshire shareholders as well.
Paying a full price for this business makes no sense for most buyers, but we think the acquisition makes sense for Berkshire – and only for Berkshire – because of the company’s low cost of capital, in the form of float ($62 billion worth as of the end of Q3) from Berkshire’s vast insurance operations.
The correct way to think about this acquisition, in our opinion, is that Buffett bought a business with utility-like characteristics. Burlington Northern generates consistently decent (but not spectacular) mid-teens returns on equity and will likely grow a bit more than the overall economy, basically forever. There will be no new competitors and this business won’t go offshore. If anything, as energy prices rise over time, railroads will become more competitively advantaged vs. trucking.
Our view of Berkshire’s intrinsic value is unchanged: we continue to believe it’s worth approximately $135,000/share, a 34% premium to the current price of $100,600.
In their latest Kiplinger’s column, How Contrarians Win, John Heins and Whitney highlight the importance of being willing to bet against conventional wisdom and discuss Pfizer and Yahoo.
Thank you for your continued confidence in us and the fund.