An Upset In Omaha

News crossed the wires yesterday after the market close that one of Berkshire Hathaway's senior executives suddenly resigned. David Sokol, a highly regarded manager, was CEO and Chairman of several Berkshire subsidiaries. Sokol was thought to be one of four managers that would succeed Buffett to oversee all the operating businesses of Berkshire. In a stunning revelation, it appears Sokol purchased close to 100,000 of Lubrizol (LZ), a specialty chemicial maker, shortly before he recommend to Buffett that LZ would be a good candidate for BRK to purchase. His investment was worth nearly $10 million. In fairness to Sokol, he did not know if Buffett would decide to buy LZ. However, Sokol's opinion is highly valued by Buffett as evidenced by the duties Sokol has performed across BRK businesses. Then, on March 14th, BRK announced it would buy LZ in an all cash deal worth $9.7 Billion or $135 per share. The buy-out netted Sokol close to a $3 million profit - in 3 months. While Sokol maintains that no laws were broken, this transaction does raise the eyebrows of the "street" and BRK shareholders. This event raises the concern as to whether Sokol's fiduciary responsibility to BRK shareholders was maintained. One could argue that Sokol had inside material information about the pending transaction ( he met with Citi bankers about LZ ). Buffett has always played well inside the confines of the law. He tells his managers to imagine that their actions were published on the front page of the local paper. How would your mom react if she read that headline? I don't think this event passes the front page test. Buffett also likes to say, that your reputation takes a lifetime to build and can be lost in a second. At the end of the day, this situation has made a small dent in the otherwise sterling reputation of BRK. I don't believe this event will detract materially from the long-term intrinsic value of BRK. The management pool is fairly deep at the senior level at BRK. The stock is trading down 1.5% today. If the sell-off continues, which I DON'T expect, then BRK is a buy under $80-$82.

If you are interested in reading the news release from BRK, written by Buffett himself, click here:

http://finance.yahoo.com/news/Warren-E-Buffett-CEO-of-bw-1903759416.html?x=0&.v=1

Bank Of America In The News Again...

B of A (BAC) is in the news again, regarding the Fed's decision to not allow BAC to raise their dividends. Several other banks like Citi (C) and Wells Fargo (WFC) were allowed to return capital to shareholders in the form of higher dividends and share buy backs. This has spooked the street. Several stress tests were applied to the banks to make sure they have enough capital to comply with the new Basel III capital standards. Effective 2015 banks will be required to hold 6% tier 1 capital, to which that requirement will increase over time to 8.5% in 2019. While the street doesn't like the Fed's decision now. It's worth the wait, to allow BAC to increase their capital buffer. There will be plenty of capital to return to shareholders. Wallstreet analysts are collectively estimating that BAC will earn around 30 Billion through 2012. They will likely need 20-25 Billion to meet the Basel III requirements. That leaves 5-10 Billion in "excess" capital, that will be available to shareholders in the future. BAC is perceived as a weaker bank in light of the stress tests. That's providing a buying opportunity. BAC is down from $15 at the begining of the year. I have added to BAC today @ 13.38.

The Master Speaks

Warren Buffett's annual letter to shareholders is one of the most interesting investment reads out there. Having read every letter since 1977,  you come away with a very good education in business and investing from the greatest investor of all time. You can find the letters here http://www.berkshirehathaway.com/letters/letters.html
Over the years Buffett has been reluctant to comment on what he thinks the intrinsic value of his company - Berkshire Hathaway (BRK) is. He and his partner, Charlie Munger, admit they would both come up with different numbers. That's ok, because intrinsic value is a moving target and difficult to calculate precisely. The good news is that you don't have to be too precise, you just have to be sure you in the correct "range" of intrinsic values. Then you can buy at a discount to this value and sleep at night. Buffett likes to say " it's better to be mostly right, than precisely wrong" - how true.

In this years annual letter, Mr. Buffett dropped a rare pearl of data for shareholders. He disclosed what he thinks (conservatively of course) BRK's normal earning power of their assets are. Here is what he said,

I can estimate that the normal earning power of the assets we currently own is about $17 billion pre-tax and $12 billion after-tax, excluding any capital gains or losses. Every day Charlie and I think about how we can build on this base.

(W. Buffett, 2010 Berkshire Hathaway Annual Letter)

Knowing this, we can value BRK (conservatively) and be confident in the value we derive, using Buffett's data as a pillar of support for our appraisal. So using a two-prong back-of-the-envelope approach to value BRK we can see it's roughly worth $100-$110 per share ( B shares). However, it's important to recognize that the $100 valuation is not static. With Buffett at the helm, it is not unreasonable to assume BRK's value will grow at 7%-10% over the next few years. So BRK could be worth $122 in 3 years. So how did I come up with $100? Here's the quick answer.

Investments (stocks/bonds) per share..................... $94,370
Pre-tax earnings per share X 10 multiple*............... $59,260...........using a 12 multiple $71,112
Plus net cash**.......................................................    N/A
Total Value per "A" share........................................ $153,630.....................................$165,482
Value per "B" share ( 1/1500 of an A share )...........  $102.......................................... $110

* I used a 10 multiple on pre-tax earnings as a conservative measure, you could easily argure that BRK's earnings stream, due to it's stability and growth, could be worth a 12X multiple. That's where valuations can be an art as opposed to a science.
** Net cash = Cash - Debt, BRK's cash basically cancels out it's debt. It's also important to note that BRK takes in 1 billion of cash per month (yes, per month, not a typo) that is added to the balance sheet. So debt is not an issue at BRK. That cash rate is also likely to increase over the next while as business conditions continue to improve.

So BRK is not dirt cheap right now, but looking out 3 years, you could be buying BRK at 0.70 cents on the dollar. I won't be adding here, but will continue to hold.

Flagstone Re (FSR) ... The Importance Of Moving Like A Sloth

First and foremost, our thoughts and prayers are with the people of Japan. The loss of life and damage is almost incomprehensible. We should count ourselves very lucky that we live in a country with minimal seismic activity. There are many ways to help, here is one; http://www.redcross.ca/
___________________

Two of my favorite Warren Buffett quotes are as follows;

Lethargy, bordering on sloth should remain the cornerstone of any investment style.  

An investor should act as though he had a lifetime decision card with just twenty punches on it.

In the above quotes, Buffett is telling investors to take their time and buy/sell carefully - move slowly. As a typical value investor I have sometimes been impatient and moved too fast and bought/sold too early. Value investors tend to get to the party early and leave early. There is a fine line between being "early" and being wrong.

Within the last year I came across a small re-insurer based in Luxembourg. I was attracted by the discount to book, low P/E and strong balance sheet. Also, by the fact that the company went public in 2007 at $13.50. Any time I can buy a company significantly cheaper than the IPO price, I'll at least have a look. That's how I found International Coal Group (ICO). I did a quick "back of the envelope" series of calculations to see if there was any value there and if I should continue to dig deeper. I figured, at the time ( 6 months ago / $11) that FSR was worth around $15-$18 per share. I decided not to buy as I needed a bigger margin of safety. I also needed to dig deeper and learn more about FSR. Moving slowly on FSR combined with a little luck kept me out of the 30% fall FSR has recently experienced. The market is reappraising FSR (sliced off 190 million in market cap) due a slew of natural disasters that they will be required to pay out on. FSR will pay 60-80 million in claims for the Austrailian floods and 60-90 million in claims for the New Zealand earth quake losses. They also write significant coverage in Japan ( which I didn't know until recently ), to which, they don't know what the ultimate cost will be.
FSR has ceded some of these liabilities to other re-insurers, but this will certainly damage the balance sheet. When the loss estimates come in from Japan I will rework my numbers and see how much the intrinsic value of FSR has been reduced. There could still be downside for FSR, but it is becoming more and more interesting at these levels. I'll continue to move like a sloth on this one...

Green Shoots In The Forest

A couple of articles ago, I wrote about the shipping industry. I noted how it's currently out of favour, which is usually good (creates low priced stocks), but the industry lacks improving earnings power due to a super-surplus of ships. So it's a pass for me. However, there's another out of favour industry that is starting to show improved earnings power. The pulp/paper and lumber products industry has undergone significant change over the past few years. The forest products sector has traditionally been very cyclical. Pulp and paper ( newsprint )volumes have been in decline for most of the last 10 years, as media  has moved to the internet. I think I'm the last person on my street who still subscribes to an actual newspaper. Lumber prices have been in decline since 2005 until bottoming out during the recession of 2008-2009. However, there are some fundamental changes for the better that the market hasn't fully priced in. Firstly, many weak lumber producers have buckled under heavy debt loads and have ceased operations. By removing this dead wood ( pardon the pun ) the industry has reduced supply and been able to rationalize pricing ( raise prices to where they can make money ). The academics say that lumber has "inelasticity of supply", which means supply can not come online very quickly, as trees take a longtime to grow. That places additional pressure on prices when demand perks up.  Newsprint volumes in emerging markets ( China, India, Brazil ) are actually on the rise as there is less digital media available. Also, China has begun to embrace western building techniques. They are building 2X4 framed houses similar to ours. This is a whole new market that lumber producers of the past did not supply and it's a big market. Lastly, housing starts in the U.S. have been very low (500K per year) over the past 3 years. Eventually housing will turn, and America will build 1.5 million homes per year, as they have done on average for much of the past 20 years. All these factors will bode well for the few producers that are left. There is value in companies like Catalyst Paper, Acadian Timber (for income investors), Canfor, AbitibiBowater and Weyerhaeuser. Many of these companies are trading at less than replacement value. Some are of higher quality than others, so do your homework. Some still have significant debt. I am particularly intrigued by AbitibiBowter, which just emerged from bankruptcy in December of 2010. They shed over $5.5 billion of debt and are now one of the lower cost producers.They continue to sell non-core assets to improve their balance sheet. Abitibi could earn $2.50/share this year. Abitibi could be worth $37-$40 a few years out. These companies ( the ones who own a lot of standing timber ) could also be a good hedge against inflation as their assets would be worth more during a period of rising prices.