Lance Helfert on CNBC Again

My boss at West Coast Asset Management was on CNBC again last week discussing some of our recent research on two of WCAM's positions, Clorox (CLX) and Kimberly-Clark (KMB). While I am certainly not bullish on the S&P 500 as whole (given that it is trading at a Shiller P/E ratio around 23x), it is remarkable how much consumer staples have been left behind in this rally. Everything that is cyclical and small has gone straight up since the announcement of QE2 and everything that is safe and stable has lagged by a large margin. These are tough times for value investors but if you believe in reversion to the mean it is unlikely that the current return disparity will last much longer.

1 Million Home Foreclosures: Just the Beginning

The recent numbers released by RealtyTrac¹ are startling. The fact that 1 million homes were foreclosed upon in 2010 is clearly quite troubling. However, I believe that the full impact of the supply glut of foreclosed houses on the market is still yet to come. The reason is that there is a huge “shadow inventory” of homes that are either in the foreclosure pipeline or are now held on the banks’ balance sheets. As discussed in an article² from CNNMoney.com, Standard and Poor’s estimates the shadow inventory by adding the number of houses whose borrowers are 90 days or more delinquent on their payments to those that are in foreclosure or are now owned by the banks. How many houses fit this description? Well, according to S&P, there are 1.7 million homes in this category, an inventory so large that based on the current rate of home sales, it apparently could take up to 44 months to work off.

Ok then; housing prices won’t rise for a few years until the excess supply is absorbed. So what? Actually, my concern is that these numbers only represent a fraction of the total foreclosures that will occur during this painful housing cycle. Specifically, the trouble lies in the number of homeowners who are underwater on their mortgages. Simply, if a person’s outstanding mortgage balance is nominally higher than the current value of the associated house, that person is deemed to be underwater or have negative equity in his or her home. Recently, there has been a back and forth between Zillow, a firm that tries to estimate the number of homes that have negative equity, and the so-called Numbers Guy, Paul Bialik, of the Wall Street Journal. As many people are undoubtebly aware, it is not uncommon to hear a talking head on venerable stations such as CNBC assert that one in four US homeowners is underwater. In fact, Zillow.com estimates³ that the appropriate figure was 23.2% at the end of Q3 2010. However, the article in the WSJ⁴ makes some valid points that suggest that such disturbing estimates may be a tad high. In response, the people at Zillow acknowledge the fallibility of their estimates but claim is that the true number is closer to 23% than it is to 15%, as Mr. Bialik suggests.

So, what does seemingly harmless argument have to do with future housing prices? Well, the important thing to consider is not necessarily the total number of homeowners who are underwater but instead by how much the balance of an individual mortgage exceeds the value of the property. For example, if a person owns a house worth $90K and has an outstanding balance of $100K, chances are the person will hesitate before exercising his put option on the house. But, what if housing prices see another large leg down? According to the most recent Case-Shiller housing data from October 2010⁵, national housing prices have already started to double dip. Thus, given an already weak housing market, my worry is that when the shadow inventory of homes eventually comes onto the market (even if it occurs at a snail’s pace), prices will see even more weakness. Then, the fact that there are already so many homes with negative equity suggests that people will find themselves even further underwater in the near future.

What if a number of borrowers are currently at a tipping point from which a renewed decline in home prices will cause a cascade of strategic defaults? Going back to the hypothetical borrower discussed above; if the house price falls by another 10% and he is now $19K underwater, is that enough to push him over the edge? If it is, then the foreclosure pipeline will continue to increase and there will be a structural overhang that limits home price stabilization for years to come. If you were wondering why some professional investors are still so bearish on the housing market, you now know why.

Sources:

1. http://www.cnbc.com/id/41059824
2. http://money.cnn.com/2011/01/20/real_estate/shadow_inventory_rise/index.htm
3. http://www.zillow.com/blog/research/2011/01/24/debating-negative-equity/
4. http://online.wsj.com/article/SB10001424052748704739504576067822437434618.html
5. http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----

Value Investors Unite!

Readers,

This past weekend I hosted an event that included 14 other value investors, most of whom are from the Los Angeles area. The dinner went very well and in an attempt to keep our momentum going I have created a LinkedIn group for the value investors in Southern California. The group is called SoCal Value Investors. If you would like to join and be on the list for upcoming events such as idea and 10-K review dinners, please email me or search for the group on LinkedIn. For right now, we are trying to limit the group to people who either are currently working in the investment management industry or have in the past. However, I view value investing as a non-exclusive discipline. As such, if you don't fit the above criteria please email me at inoculatedinvestor@gmail.com and maybe we can figure something out.

Of course, regardless of what I try to do to build my network, I am always being outdone by my good friend Miguel Barbosa of Simoleonsense. Miguel is organizing an event for January 27th at 6pm for value investors who work on the buyside in Chicago. Here is the link to the event if you are in the area and want to attend. You can also email Miguel at miguel@simoleonsense.com if you want details. It sounds like he is expecting a lot of people so it will probably be a great networking event. I encourage anyone who can to attend.

In any case I really like this trend of value investors getting together. Despite what you may hear on CNBC or from US government officials, the global economy and financial markets are still on a little bit of thin ice. Accordingly, every investor should be looking for ways to protect his or her investments from unexpected events. Therefore, I think establishing a network of people to bounce ideas off of is invaluable.

Good luck in 2011,

Ben

My M&A Article on MarketWatch

The following is an article I co-wrote with Lance Helfert of West Coast Asset Management about M&A. It appeared on MarketWatch starting January 3rd, 2011:

http://www.marketwatch.com/story/four-ways-to-bet-on-ma-2011-01-03?pagenumber=1

Four ways to bet on M&A

Commentary: Likely candidates are in tech, financials, consumer

By Lance Helfert

SANTA BARBARA, Calif. (MarketWatch) — Economic forces have come into play, making a wave of mergers and acquisitions a very real possibility in the near future.

First, with corporate bond yields near historical lows, companies have the ability to raise cheap debt to help facilitate deals. Second, as reported in a recent Wall Street Journal article, non-financial firms were sitting on $1.93 trillion of cash and other liquid assets as of the end of September. Many large firms have amassed war chests that can be used to supplement organic growth with acquisitions.

Furthermore, many private-equity funds are holding large sums of cash that were raised prior to the Great Recession, and this money is starting to burn a hole in their pockets.

According to another Wall Street Journal article, buyout firms are holding more than $450 billion in capital that has yet to be committed to new deals, and these firms are most certainly feeling pressure from their investors to put the money to work.

Firms that are speculated to be takeout candidates often trade at premium valuations. Consequently, investing solely in anticipation of a company being taken over is risky business. A more prudent approach may be to identify undervalued companies with attractive fundamentals that represent logical acquisition candidates but are not currently the subject of takeover speculation.

This strategy provides a win-win scenario, regardless of whether an attractive buyout offer surfaces. Here are four companies that fit the mold:

Yahoo

Many investors may recall that in early 2008, Microsoft Corp. (NASDAQ:MSFT) offered $33 a share to buy Yahoo Inc. (NASDAQ:YHOO), but the company eventually rejected the price and Microsoft walked away. However, Yahoo still has a number of attractive assets.

Specifically, Yahoo Search could still be an interesting asset for Microsoft as it tries to compete with Google. Additionally, the company’s large investments in Alibaba (THE:HK:1688) of China and Yahoo Japan offer a potential acquirer a way to tap growth of Internet advertising revenues in Asia. These two stakes are carried on the balance sheet at about $3.78 billion, but the market value of the Yahoo Japan investment alone is around $6.6 billion at the current stock price.

Despite these positive factors, Yahoo seems to be trading at a very reasonable valuation. The company has an enterprise value of about $19.4 billion. But if $636 million in long-term marketable securities and a conservative $9 billion estimate for the value of the Asian investments are subtracted out, the enterprise value falls to $9.76 billion. Given that the company has generated about $1.399 billion in EBITDA over the last 12 months, the stock is trading at less than 7 times EBITDA.

As such, Yahoo may begin to attract both strategic and private-equity buyers once again.

Molson Coors

In recent years, there has been a lot of consolidation in the global alcoholic-beverages industry. The largest example was InBev’s purchase of Anheuser-Busch (NYSE:BUD) . Given all of the activity, it is not hard to imagine an acquirer being interested in controlling Molson Coors Brewing Co.’s (NYSE:TAP) portfolio of beers.

The world-class beers under the Molson Coors umbrella include names such as Coors Light, Blue Moon and Carling. Clearly, at the right price these brands would be a great addition to any product line.

Furthermore, the company has been making inroads into growing international markets. In China, Molson Coors entered into a joint venture with the Hebei Si`hai Beer Co. Then in Russia, the company launched Coors Light. But investors should not forget that the company also owns 42% of MillerCoors LLC — a stake that gives TAP a foothold in the U.S. market that could be attractive to a foreign company like SABMiller (LONDON:UK:SAB) that is interested in expanding its U.S. exposure.

Given these factors, it is hard to believe that the company is only trading at about 12 times trailing 12-month earnings. Shares of TAP appear to offer great value and with a 2.2% dividend yield, investors get paid to wait for the market or strategic buyers to recognize the opportunity.

Broadridge Financial

Even though Broadridge Financial Solutions Inc. (THE:BR) is not a household name, the company has a dominant position in the investor-communications niche. In fact, in fiscal 2010 the company processed approximately 66% of the outstanding shares in the United States in the performance of proxy services. In addition, the company has a very stable and sustainable business model that might make it an ideal private-equity takeout candidate.

For instance, BR’s position as the industry leader leads to large barriers to entry and a durable competitive advantage that shows up in its robust operating margins in the mid-teens. Therefore, a larger firm with similar businesses such as Fiserv Inc. (NASDAQ:FISV) or a trust bank that already offers shareholder services such as State Street Corp. (NYSE:STT) may be interested in adding BR to its portfolio.

Even though the company pays a healthy dividend (2.7% yield and growing), the shares only trade at about 14.3 times trailing earnings. BR’s management team clearly believes the stock is undervalued. So far this year it has bought back close to 4.5 million shares and the board recently authorized the purchase of another 10 million shares.

Live Nation

Live Nation Entertainment Inc. (NYSE:LYV) is the largest entertainment company in the world, connecting millions of fans to thousands of events all over the globe. Early this year, the company merged with Ticketmaster, which is the largest live-event ticketing firm in the world. The combined entity now has a dominant position in the North American concert-ticket market.

According to a Pollstar report cited in the company’s filings, in 2009 North American gross concert revenue increased to $4.6 billion, a 9% compounded increase over 2007. As such, the company now has a near-monopoly position in a growing market with very little opportunity for competitors to steal away market share.

Furthermore, the largest shareholder of the company is Liberty Media Corp. (NASDAQ:LINTA), the John Malone-led company that holds more than 18% of the total shares. Malone proposed to double his company’s stake with a $12 tender offer, but was rejected by shareholders who wanted a higher price.

Currently, the stock trades below Malone’s tender offer. Given Malone’s past interest in owning more of the company and his obvious desire to turn Liberty Media into a dominant media conglomerate, it would not be surprising to see him attempt to gain control of the entire business by offering a premium large enough to entice current shareholders to relinquish their shares.

None of these companies is guaranteed to be bought out in the future. However, all of them have attractive features that make them strong candidates to be taken out. In the meantime, shareholders of these companies can take comfort in the fact that all of them appear to be undervalued and may appreciate, even if a buyout never materializes.

Lance Helfert is president of West Coast Asset Management and the co-author of “The Entrepreneurial Investor — The Art, Science and Business of Value Investing.”

Disclosure: The stocks identified above do not represent all of the securities purchased, sold or recommended for advisory clients; West Coast Asset Management maintains a list of all recommendations made in the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities that were discussed in this article. Past performance does not guarantee future results.

WCAM's Lance Helfert on Fast Money (12/29/2010)

Dear Readers,

First off, I wanted to wish everyone a Happy New Year. I hope that 2011 is a prosperous year for all of you.

My boss, Lance Helfert, was on CNBC again this past week discussing smart, value-biased stock picks for 2011. These are companies that are in WCAM's portfolio and for which I continue to be involved in the research process. It sure is nice to see the fruits of my labor on national television!

Switzerland: A Safe Haven No More?

The Backdrop

Anyone who has been following the currency markets recently has probably noticed that the Swiss franc (CHF) has been appreciated against the Euro at a pretty sustained pace. Specifically, check out the following chart from Xorte.com. What it shows is that since last year at this time the EUR/CHF ratio has fallen from about 1.5 to 1.25, a 16.7% drop.

Ostensibly, the appreciation of the CHF versus the Euro has to do with investors’ perceptions of the strength of the Swiss economy relative to that of the Euro Zone as a whole. Switzerland has certainly for a long time been associated with financial stability and conservatism. Additionally, Swiss banks have traditionally been viewed as a safe haven in an uncertain banking world. But is this still true today? What would happen if the Swiss government was forced to bail out its banks again? Does it have the resources? What would be the impact on the country’s bonds?

The current issue

The reason I began to think about these issues is that I was contacted by a wealthy friend and mentor of mine who owns a very large real estate company. After years of hard work, he is now concerned about US dollar-denominated assets and has invested some of his wealth into Swiss bonds and the Swiss franc. He also owns some physical gold that is held at a Swiss bank. When we started to talk about the issues that the Euro Zone faced, he asked me if he should be worried about his gold and his Swiss bonds. While I am inclined to think that his assets are safe, I do believe that the recent troubles with the European banks have caused the number of potential economic and fiscal outcomes to increase. So, while I am certainly not an expert on Europe, currencies or sovereign debt, it is not hard to justify being a little concerned about Swiss bonds and Swiss banks if some admittedly unlikely, but certainly possible scenarios actually play out.

Given that context, the following represents a brief analysis of the current state of Switzerland. My goal is not to scare or alarm anyone. I have no ability to predict how Swiss bonds or the franc will perform under different economic circumstances. But, based on my initial research, there are a few things that investors who own Swiss bonds and Swiss francs should analyze with a skeptical eye:

Swiss Debt/GDP

The good news is that Switzerland’s government debt to GDP ratio does not look disturbingly high. According to an October 2010 report from the IMF¹, the 2010 baseline debt to GDP ratio for Switzerland is projected to be 39.5% and even in a low growth scenario that number only would jump to 44.5% by 2015. This is compared to 2010 baseline projections of 92.7% in the US (yikes!), 130.2% in Greece and an astonishing 225.5% in Japan. So, in the event that the Swiss needed to borrow money to help bail out the banking system, there is definitely some room to add

government debt. Although, I would make the argument that the country should do everything it can to avoid maintaining anywhere near the debt to GDP levels of the US, Greece and Japan.

European sovereign debt

I was not sure how much sovereign debt the traditionally conservative Swiss banks had accumulated but if they were like other European banks, I suspected that they had gotten stuck with a lot of Spanish, Greek, Irish, Italian and Portuguese bonds that may eventually trade at less than 100 cents on the dollar. For example, any default on or restructuring of these countries debt would force banks to realize losses on their holdings. However, according to the latest release from the Bank of International Settlements², as of June 2010 the numbers weren’t too bad. Here is the total Swiss bank exposure (according to the BIS) to the debt of the PIIGS countries:

Portugal: $2,780 million

Ireland: $17,602 million

Italy: $11,382 million

Greece: $2,403 million

Spain: $11,758 million

Total PIIGS Exposure: $25,543 million or about 5.2% of the country’s 2009 GDP of $494.6 billion³

Now, $25.5 billion may sound like a lot, but it is nothing in comparison to the exposure of the UK banks. Specifically, the UK banks owned about $360.5 billion in PIIGS’s debt as of June 2010. This figure represents an astounding 16.6% of UK GDP that amounted to $2.175 trillion in 2009⁴. Let’s all hope that the UK never has to bail out its entire banking system by borrowing money from investors and thus placing the burden of the private sector on taxpayers. With government debt to GDP projected to be 76.7% in 2010¹, the UK may not have the capacity to add much more debt before interest rates spike and investors begin to get nervous.

Total bank assets

Take a look at this chart I found from last January on Forbes’s website⁵:

It shows that Switzerland had the 3rd highest bank assets to GDP ratio (only behind that of Ireland and Iceland!). Just eyeballing the chart indicates that the banks’ assets represent somewhere near 750% of the country’s GDP. So, if the banks were ever forced to write down more assets (sovereign debt, real estate loans, securities tied to the US housing market) they might subsequently have to be bailed as a result of their consistent inability to avoid bad assets. Given the worldwide aversion to letting bondholders lose penny, a bailout would likely require a ton of government borrowing that could represent a large portion of GDP. If the borrowing got to be too high (Reinhart and Rogoff suggest that the debt to GDP tipping point is around 90%) then the ultimate ability of the Swiss to repay their debt might come into question, an event that would certainly not be good for Swiss bonds.

Physical Gold

The other thing investors need to think about the security and liquidity of physical gold held at the once impenetrable Swiss banks. I have heard some (admittedly anecdotal) stories recently from gold bugs James Turk of Goldmoney.com⁶ and Jim Rickards of Omnis⁷ that indicate that people who thought they had allocated gold holdings in Swiss banks have not been able to get their gold in a timely manner. The implication is that the banks either lent out or sold the gold but still continued to charge the storage fee. Aside from potentially being fraudulent behavior, these stories highlight the dangers of depending on the banks to act in the best interest of their customers.

Accordingly, I think that it makes sense for all investors to look at their arrangements with the banks and see if they have the ability to lend or sell your gold, a situation that essentially leads the bank to be short gold. In a rising price, high demand environment banks might not have the ability to locate an ample supply of physical gold. At that point owners wouldn't have the protection they wanted. As such, the recommendation from the gold bugs referenced above is to hold gold outside the banking system with a company like Brink's.

Takeaways

For people who still look at Switzerland as a safe haven and a suitable place to park assets, I don't exactly know what the takeaway of the information presented above should be. I guess I just want people to be aware of the downside risks. I think that it is very unlikely that Swiss bonds will be not be paid in full. While a rising interest rate environment could lead to mark to market losses on recently purchased bonds, as long as they are held to maturity investors are still likely to get their full principal back.

Furthermore, I think that there is only a remote chance that investors would not eventually be able to get their gold if they wanted it. However, as the price rises and physical supply gets tighter, there is always the risk that it might take longer than anticipated to obtain physical gold. This is always the problem with gold. It is a store of value, but it is not free to store and it is very difficult to transport and protect. Gold bulls always say that there is no counterparty risk with gold. That is true if you own your own vault. But, in the case of an investor who holds his or her gold with a bank, there is always the risk that the bank will not be able to live up to its end of the bargain. At that point, an investor might have to wait years to receive just compensation for the breach of contract and by that time the benefits he or she hoped to accrue from gold ownership may no longer be applicable.

I know we all have plenty to worry about right now but I want to caution everyone from getting lulled to sleep to by the apparent security and long history of stability of Switzerland. Just like Iceland and Ireland, it has let it banks get to be far too large relative to the size of the economy. It is probably true that if the global economy improves and the contagion in Europe never fully materializes, Switzerland is a smart place to shift dollar-based assets to. However, if there are any bumps in the road, the extremely high bank asset to GDP ratio represents a type of leverage that makes the whole financial system unstable.

Where do we go from here?

The sad thing is that I don't know where to find a true safe haven right now. I wish I did. Therefore, if I were very wealthy and running my own fund I would buy some catastrophe insurance. There are two ways to think about such insurance. The first is as a hedge against risks that individual investors are exposed to. My friend owns a large commercial real estate company so buying out of the money puts on publicly traded REITs could be a decent hedge against price and rental declines in the real estate markets. Second, investors can identify situations in the world that seem unlikely to remain static. For instance, given Japan’s projected 2010 government debt to GDP ratio of 225.5%, it is shocking to see that the 10 year JGB only yields 1.2%¹⁰. With a declining population, an interest expense that continues to make up a large percentage of revenue, and a strong Yen that is killing exports, at some point investors are going to start to get nervous that the Japanese may not even have the capacity to repay their debts.

With this in mind, here are some examples of both types of hedges:

1. Constant Maturity Swap Rate Caps that make a lot of money if the yield on Japanese bonds (finally) increases (see Julian Robertson’s similar bet against US Treasuries⁸)
2. Credit default swaps on Swiss bonds (to protect any Swiss bond holdings)
3. Credit default swaps on the Swiss banks that hold investors’ gold
4. Far out of the money puts on the S&P 500
5. Out of the money calls on commodity ETFs just in case inflation ever kicks in and commodities sky rocket

If the world recovers and sovereign debt issues disappear, then by investing in some of the above hedges all that would be lost is what amounted to an insurance premium. With the S&P VIX as low as it is (look at this amazing chart of the roller coaster ride that is the VIX⁹) and clear over-optimism about the situations in the Euro Zone and Japan, some of these hedges might not even be that expensive. But, if we go back into financial crisis then investors have the opportunity to make multiples of their premiums and thus offset losses in other arenas. The point is that the perfect time to protect assets and initiate hedges is precisely when other people are dismissive of risk. This is one case in which waiting for more information or for another shoe to drop could be very costly.

References

1. http://www.imf.org/external/pubs/ft/gfsr/2010/02/pdf/chap1.pdf
2. http://www.bis.org/publ/qtrpdf/r_qa1012.pdf
3. http://www.state.gov/r/pa/ei/bgn/3431.htm
4. http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP.pdf
5. http://www.forbes.com/forbes/2010/0208/debt-recession-worldwide-finances-global-debt-bomb.html
6. http://www.kingworldnews.com/kingworldnews/Broadcast/Entries/2010/12/11_James_Turk.html
7. http://www.kingworldnews.com/kingworldnews/Broadcast/Entries/2010/12/4_Jim_Rickards.html
8. http://pragcap.com/julian-robertson-shifts-from-curve-steepener-to-curve-caps
9. http://finance.yahoo.com/echarts?s=^VIX+Interactive#chart1:symbol=^vix;range=5y;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined
10. http://www.bloomberg.com/markets/rates-bonds/government-bonds/japan/

My Boss Lance Helfert on CNBC

My boss and West Coast Asset Management co-founder, Lance Helfert, was on CNBC this morning. He discussed 3 stocks, Broadridge Financial (BR), Molson Coors (TAP) and Yahoo! (YHOO), that we think could be takeover candidates. We are also working on an article for a well-known financial website in which we will discuss these companies in more depth. For now, check out Lance talking about the research he and I did on these companies: