Friday, August 14, 2009

Capital & Crisis Hotline -- The One Solid Bank in America… Updates LUK, SEB, PICO, APL

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Capital & Crisis Hotline -- The One Solid Bank in America… Updates LUK, SEB, PICO, APL
August 14, 2009

"It appears to be a financial axiom that whenever there is money to invest, it is invested… But a prudent and intelligent investor should avoid this temptation."
-- Benjamin Graham, Security Analysis (1934)

Dear Capital & Crisis Reader,

Investing in this market is like trying to take cheese out of a set mousetrap. It's very tempting to make a grab, but you are also fairly certain about what will happen if you do. The market's 50% rise from its March lows is stunning. It's like the cheese in the trap. But we also know that no market moves up like that for long. The kill bar is never far from such rallies.

Investors might forget that because investing this year has looked easy. And investors who have missed out on the rally must be tearing their hair out. Their money burns a hole in their pockets. In fact, the evidence is that most investors have the attention span and patience of a field mouse.

I write this after having come back from a week at the beach with the family for a little vacation. I had brought a bunch of reading material along: a new biography of Albert Camus, a collection of A.J. Liebling's essays as well as Ludwig Bemelmans' On Board Noah's Ark, about his adventures sailing the Mediterranean in the 1950s. I also had my laptop and an assortment of market-related stuff to chew on. So I was never far from the market.

A friend and reader sent along the following chart by e-mail. I have shown you this chart before, at various times. Still, it is endlessly fascinating to me. The chart shows you the average holding period for a stock on the New York Stock Exchange.

What jumps out at you right away is that the average holding period is less than a year. That means that, on average, an "investor" typically holds an NYSE stock for a matter of months. This is not investing, which is why I put the term in quotes. I don't know what it is. Mindless gambling comes to mind.

It's no surprise that the last time we were down here was in the Roaring Twenties. We all know what that was the opening act for.

This chart also speaks to a larger problem in the markets today -- there are too few owners and too many renters. Just as in real estate, owners generally take better care of a property than renters. Why should it be different with companies?

I always wonder how things might've happened differently if the banks, for instance, had more owners. What if a family trust owned a third of the shares of Citigroup? This trust oversaw the operations and carefully selected and reviewed its managers and compensated them not for taking risks, but for being careful stewards of bank capital. I wonder….

We know that banks can be intelligently run. Not everyone was such a dupe.

One of the greatest stories in this vein is that of Beal Bank, a Plano, Texas, bank owned by Andy Beal. For three years, 2004-2007, Beal Bank practically ceased making loans. Beal actually shrank the bank's assets because he thought the loan market would blow up. Beal Bank shrank from a $7 billion bank to a $3.7 billion bank. His bank pretty much did nothing while the credit boom raged on.

He had to take a lot of flack while he was doing this. Credit ratings agencies said his business model was not sustainable. He had lots of critics among regulatory agencies who wanted him to join the party and start giving money away.

(Reminds me of sitting in one of Flowserve's (FLS:nyse) presentations and listening to a Wall Street analyst chastise management for not "maximizing its balance sheet." That's code for saying that he thinks Flowserve carries too much cash and too little debt. I was so annoyed, I made a point of walking up to CEO Lewis Kling afterward and telling him why he should ignore that gum-flapping knucklehead. Fortunately, Kling agreed with me, and now Flowserve is sitting pretty while competitors scramble.)

But of course, in the aftermath of the credit debacle, Beal Bank had plenty of capital to invest. Forbes reported back in March that Beal was busy: "He is buying bonds backed by commercial planes, IOUs to power plants in the South, a mortgage on an office building in Ohio, debt backed by a Houston refinery and home loans from Alaska to Florida."

He's been buying these loans at deep discounts to face value, or par. As Beal says: "All these guys were stumbling over each other 18 months ago to pay over par," he says. "Now they can't sell fast enough at a discount. Why do people not do the great deals and do all the stupid ones? It's crazy."

Beal is an experienced banker. He's been in the business for 20 years. His bank has been one of the most profitable in the country. In 2000, American Banker officially declared it so, as Beal Bank earned a five-year return on equity of 50%. And yet Beal did it safely.

Banking is a great business when you do it right. Many fortunes originated or bloomed in banking activities -- the Medicis, the Rothschilds, the Morgan interests and more. That hardly seems the case these days, when banks -- like airlines -- have become a great way to turn billions into millions.

What's the mystery here? Is Beal just smart or what? I think that is part of it. I also think there is an overlooked fact that is more important: Beal owns 100% of his bank.

It's one reason why I like to invest in companies in which the management team is a significant owner, or where there is some strong hand behind the scenes.

This is perhaps a long way to circle back round to that chart. But I also think the market's extreme current shortsightedness creates opportunity. If the average holding period is only a matter of months, think what opportunity exists for those who can look out just over a year, or even a few years, down the road.

The great truth about stocks -- not widely appreciated by the CNBC-watching crowd -- is that the bulk of a stock's value comes from future years' cash flows. You can work this out on a spreadsheet. Even if you assume a 20-year life and a steady state of earnings, less than 10% of a stock's present-day value come from the next 12 months of earnings. The vast majority of the value comes from years two, three, four and beyond.

That is why it is silly to let quarterly earnings reports sway you much -- unless something is happening that affects that long-term earnings power.

Who is likely, again, to make better decisions about the long-term earnings power of a business? Someone who owns it or someone who is just renting it for a few months? The owner, of course. The owner knows there are good and bad years. He doesn't sell out because of one bad year.

These insights are worth keeping in mind as we pick our way through this market. The greatest opportunities are likely to lie out a year, just beyond the field of vision of most market participants. I'm looking for great discrepancies in what the market thinks now and what is likely to be the case a year from now. That, and I look to bet on owners, especially those with a track record of making hay when everyone else is putting out fires.

*** A Note From New Zealand

A New Zealander writes:
"I noticed that the map in your latest issue of Capital & Crisis shows New Zealand as having 'economic water scarcity.' This is not correct. Water is plentiful in New Zealand, both physically and economically. In fact, 60% of the country's electricity is generated from hydro resources, which gives you an idea of how much water there is."
He is right, of course. Unfairly to New Zealand, it often gets thrown in with Australia. In Australia, there are definitely water issues. That chart is kind of a rough instrument. You'll note, for instance, how the map paints all of South America with one brush, save for a few small pockets. But water is not economically scarce in parts of Brazil, for instance.

Speaking of New Zealand, I'm planning a trip there later this year. And to Australia, too. I plan to take a group of readers with me. The trip will take place in January. I'll let you know more details as soon as I have them.

*** Leucadia National

Leucadia (LUK:nyse) has bounced back strongly, as its investments in Fortescue Metals, AmeriCredit and Jeffries Group have all surged this year. Through June 30, Leucadia has reported a 37% increase in book value. Since June 30, its big publicly traded investments have risen even further.

The basic idea in owning Leucadia is that you get the wizardry of Cumming and Steinberg managing your money for you. The dynamic duo has a superb long-term track record. Even after the disaster of 2008, Leucadia has produced a 28% annual compound return for three decades.

The stock is above my buy price, but worth hanging onto.

*** Seaboard Corp.

In its usually understated fashion, Seaboard (SEB:amex) puts out a very short earnings release. The details are in the public filing, though, which is where I turn.

Seaboard is a conglomerate of sorts, involved in a handful of humble businesses. One of those is pork, which has been losing money of late. We bought in anticipation of a rebound in this segment, which ought to contribute a healthy share of earnings when it turns around. We got our first indications of that in this last report. The pork segment eked out a small profit of $4 million for the quarter, compared with a loss of $26 million the year before.

Gains in pork were offset by lower profits in its commodity trading business. Lower commodity prices this year compared with a year ago is the chief culprit. Also, not surprisingly, the company's marine segment fell to a loss, thanks to lower cargoes.

All together, Seaboard reported nearly $22 per share in earnings, which bested last year's total of nearly $19 per share. Book value per share was about $1,200 at quarter end. At today's price, the stock trades just under book.

I like the opportunistic nature of Seaboard's conglomerate; its flexibility; and its mix of salty, down-to-earth businesses. The company seems to be a doing a good job in a tough environment. It is a conservative investment, which I expect will slowly pile up gains over time. I rate Seaboard a buy.

*** PICO Holding

PICO (PICO:nasdaq) is another conglomerate of ours. This one deals mainly in water rights, but has other business interests too, such as real estate.

I've been waiting to hear from CEO John Hart on his decision to raise $95 million by selling some of PICO's stock. Hart is not a fast man with a dollar, nor is he dumb. And as he is the largest personal shareholder in the company, it is not in his best interest to dilute the value of the company. Hart, I reasoned, must want to go shopping. The bargains he has identified must be greater than the value of the stock he's giving up. (Sort of like trading 50-cent dollars to pick up 25-cent dollars.)

In this release, he gives us his thinking. As expected, he has found some things in this pileup of a financial crisis that he wants to buy:
"We decided to raise additional capital at this time to take advantage of favorable asset pricing opportunities in both real estate and water. It is uncertain how long these opportunities will last and how accommodating the financial markets might be in the future. Following the stock sale, at June 30, 2009, the PICO parent company and our noninsurance subsidiaries had more than $186 million in cash available for asset purchases and acquisitions."
Given his track record, I wouldn't bet against him. As I have often said in these pages, we like to bet on fellas with great track records. They have proven themselves the fastest horses in the field over a period of time. As Damon Runyon once wrote, the race is not always to the swiftest, but that is the way to bet.

PICO owns a subsidiary, Union Community Partners, that has been buying up residential lots. It recently picked up 1,400 of them in Monterey County, California. PICO plans to finish development that "We estimate will cost a total of approximately $40 million," Hart says. "The cost per lot is significantly below current replacement costs in a market where demand is estimated to exceed supply within three years."

You are probably cringing. Isn't the housing market falling apart? Who wants to get involved in that mess? Hart shared two exhibits, like a scientist showing off working prototypes to a doubtful public. "In one project, UCP had owned the lots for approximately 14 months and generated an internal rate of return of approximately 46%," Hart said, holding up Exhibit A. Showing his flair for theater, Exhibit B was even more impressive. "UCP had owned the lots in the other project for approximately six months, and generated an internal rate of return of approximately 90%."

I would guess that you would be happy with those returns as a shareholder. PICO also continues to identify opportunities in water. As Hart says:
"During the second quarter, Vidler Water Co. began a new water resource development project in the state of New Mexico. This is Vidler's first project in New Mexico, a state which has some of the most severe water shortages relative to future growth in the Southwest. We are conducting geophysical surveys and applying for exploratory and monitoring well permits with the State Engineer's Office of New Mexico. Vidler intends to drill exploratory and monitoring wells, with the ultimate objective of being awarded permitted water rights to satisfy demand of up to 1,500 acre-feet of water per annum in the Santa Fe region."
I think the market has knocked down the price of PICO's stock because, in part, it thinks that the slowing residential development will slow the process of converting water rights -- which PICO owns in abundance -- to cash. The market may prove right on that point. However, my bet is that the price of those water rights, which are in water-stressed regions, will only go up over time. The water rights themselves are worthy investments, in my view.

PICO remains a buy.

*** Atlas Pipeline

Atlas (APL:nyse) reported decent results as it continues to dig itself out of a hole. Distributable cash flow was nearly $80 million for the quarter and about $128 million for the six months of the year. In per share terms, that's $1.68 and $2.69, respectively. The stock is about $7 per share. It seems to have its biggest debt issues behind it, with a new credit facility and completed asset sales.

Atlas labors under a cloud, however, like an Enron accountant trying to reform. I don't think investors will give Atlas much credit until it hammers out a couple similar quarters. Once Atlas gets closer to resuming its distributions, which should happen in the first quarter of 2010, the share price should recover and trade closer to book value -- currently, $13 per share.

I have Atlas at hold. I am looking to exit the shares later in the year or early next, at a more favorable price. I have made mistakes with Atlas, as I wrote to you about before. The biggest was recommending a company with so much debt in the first place. Why I did so, despite my table-pounding emphasis on strong financial conditions, is something of a mystery to me even now. We are odd creatures, we humans. Live and learn.

Have a nice weekend, and I'll write you again next week.


Chris Mayer

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