ValuePlays Portfolio- Update

Q1- 2007 (since 1/18/2007)

ValuePlays= +5.1%
S&P = -.6%

I have written about quite a few stocks here and have been asked by readers, "do you own all these stocks"? Well, no. I have put together an "Official Value Plays Portfolio" so you can track my suggestions and in turn, measure my results against others and the market as a whole. Just so everyone understands what the following chart means and how I am going to measure the results, here are the ground rules:

1- The "buy price" is the price the day I email Enhanced Features Members a "Trade Alert" that says "buy". A post suggesting the same will hit the blog several days later giving EF Members ample time to buy ahead of others. Even though I have owned several of these picks for years, I cannot prove this to you so the date of the email will now be the "buy price". For stocks we advise you avoid, we will track those by the price per share the day I recommend you avoid them.

2- Dividends, splits or spin offs will be treated as a reduction in the purchase price to show the "true return" on the investment. For example, I buy a stock for $20 and it pays a 25 cent quarterly dividend. Each quarter I will reflect that payment (gain) buy reducing our purchase price by 25 cents. That reduction will be noted in the "actual cost" category. This will be the same for the upcoming Kraft spin off by Altria, I will reflect the investment gain of the Kraft shares we receive (since I will not keep them) by reducing my purchase price for the Altria shares by the value of the Kraft shares. Should I change my mind and keep the shares, this will be reflected by a decrease in the purchase price of the Altria shares to reflect the gain and then a purchase of the Kraft shares in the same amount.These situations will be footnoted for individual explanation.

3- Should I recommend the purchase of additional shares of a security, that will be reflected by another entry for that security and that price (to assure consistency with the new post).

4- I update comments on results weekly to Enhanced Features Members and provide them more detailed information about the stocks in the portfolio (weekly and quartely #'s by their requests). The blog will receive periodic updates on securities. Since I am "long term" oriented, I will not break out results quarterly or annually on the blog. If you have read my posts, the conditions that will trigger a security to be sold will not be a temporary drop in the stock price, so monthly and quarterly results are essentially irrelevant. I have found that the shorter I make the tracking time frame of an investment, the more likely people are to make decisions based on short term events and not long term fundamentals. This is counter to my philosophy, so to help prevent that, all results will be "from inception". By default since this is new, the initial results must be short term but as time goes on this will change. The benchmark I will use for comparison will be the S&P 500. It also will be tracked from the inception of my first post 1/18/2007.

5- I will rarely if ever "short" stocks (sell them first in the hopes of buying them back at a later date at a lower price). I will track the results of stocks I advise you avoid again in the interest of full disclosure and honesty.

6- I may engage in some options purchases or sales. If I do these will also be reflected on the tracking.

7- Portfolio assumes an equal weighting of shares for each security. By default this means I have more dollars invested in higher priced stocks like MO, and SHLD. I am very comfortable with this. Again, should we want to add additional shares of a security, we will note that by another entry.

8- Updates are current prices (20 min delay) through Google Finance.

Ethanol: Bet The Farm

Since the US crop report is coming out in 15 minutes this morning at 8:30 am, I though I should comment on it since I have been both an advocate and investor in renewable fuel for quite some time through Archer Daniels Midland (ADM). First things first, the crop report. Estimates for corn are an increase of 10 million acres for a total of 88 million acres being planted. My estimate is a minimum of 90 million acres. People for far too long have underestimated both the US farmer and the ethanol industries desire and ability to make ethanol a staple fuel source. Things begin to really change this summer. $4 a gallon gas will be reached and this will be the summer consumers finally have had enough and start to rise up in chorus to demand more ethanol at their pumps.

Currently ethanol is blended in 3% of gas in the US. We could up that number to 10% and need no modifications to any vehicle on the road. Million of people are driving E85 capable vehicles and are not even aware of it. My 2005 Suburban bought in Massachusetts for example, can run on E85 and I would be using it were it available. I would, and ever study done to date has confirmed that people would be willing to pay more for a home grown fuel than for gas from oil from the middle east.

The renewable fuels standard President bush signed in 2005 called for refiners to use 4.7 billions gallon of ethanol by the end of 2007 and it increases gradually to 7.4 billion gallon by 2012. Many ethanol critics use this as proof that were it not for the mandate, ethanol would not be used. To illustrate why this is false one must consider that in 2006, 4.8 billion gallons were produced for a demand of 5.3 billion gallons. Were the mandate the only reason for ethanol demand, these numbers would not exist. By the end of 2008 a minimum of 8 billion gallons will be available and no slackening in demand is seen. Why? Ethanol extends gas supplies and keeps the cost of gas down. Demand for E85 in the Midwest cannot be met. In short, famrers and the ethanol industry have made the "required standard" irrelevant.

Has there ever been a product that the majority of Americans wanted that business did not find a way to produce affordably and in quantites to satisfy them? I can't think of any either....Do not ever bet against American ingenuity

Here are some more ethanol tidbits:


FACT: In 2005, the ethanol industry supported the creation of more than 153,725 jobs in all sectors of the U.S. economy, boosting U.S. household income by $5.7 billion.

Ethanol industry operations and spending for new construction added $1.9 billion of tax revenue for the Federal government and $1.6 billion for state and local governments. And the combination of spending for annual plant operations and capital spending for new plants under construction added more than $32.2 billion to gross output in the U.S. economy.

Source: Contribution of the U.S. Ethanol Industry to the Economy of the U.S. in 2005

FACT: By increasing the demand for corn, and thus raising corn prices, ethanol helps to lower federal farm program costs.

In 2004, USDA estimates ethanol production reduced farm program costs by $3.2 billion.


FACT: Ethanol refineries serve as local economic power houses. Click here for information on how a 50 and 100 million gallon ethanol refinery can benefit your community.


FACT: If ethanol were removed from the market, a shortfall would have to be made up from expensive imports.

Gasoline prices would increase 14.6% in the short term (36.5 cpg if gas is $2.50/gal). Prices would increase 3.7% in the long term (9.25 cpg if gas is $2.50/gal) even after refiners built new capacity or secured additional sources of supply.

Source: LECG, LLC, May 2004


FACT: The federal ethanol program generates revenue for the U.S. Treasury.

The federal ethanol incentive, which is available to gasoline marketers and oil companies (not ethanol producers) as an incentive to blend their gasoline with clean, domestic, renewable ethanol, is a cost-effective program. It actually returns more revenue to the U.S. Treasury than it costs, due to increased wages and taxes and reduced unemployment benefits and farm program payments, while at the same time holding down the price of gasoline and helping the American farmer.

The federal ethanol program was established following the OPEC oil embargoes of the 1970s, which exposed our dangerous dependence on imported oil. As an alternative to petroleum, ethanol directly displaces imported oil and reduces tailpipe emissions while helping to bolster the domestic economy. Yet today we import more petroleum than ever before. With rising crude oil prices and increasing international instability, incentives for production and use of domestic ethanol are critical.

We have subsidized the oil industry substantially since the early 1900s, and continue to do so. In fact, according to the General Accounting Office in an October 2000 report, the oil industry has received over $130 billion in tax incentives just in the past 30 years - dwarfing the roughly $11 billion provided for renewable fuels. During this time, U.S. oil production has fallen while annual U.S. ethanol production has grown dramatically.(GAO/RCED-00-301R)

FACT: In 2005, the use of ethanol reduced the U.S. trade deficit by $8.7 billion by eliminating the need to import 170 million barrels of oil.

Source: LECG, LLC January 2006

FACT: In 2005, the U.S. ethanol industry increased household income by $5.7 billion, money that flows directly into the pockets of American consumers.

Source: Contribution of the Ethanol Industry to the Economy of the U.S. in 2005

FACT: The U.S. ethanol industry has a proven track record of cost-effectively replacing MTBE and expanding gasoline supplies from coast to coast.

When California, New York and Connecticut switched from MTBE to ethanol in 2004, the transition went smoothly and both state and federal officials agree there was no negative impact on gasoline supplies or prices. The industry continues to expand and is prepared to assist any state confronting water quality issues or high gasoline prices.

Source: "Removing MTBE from Gasoline: Implications for the Northeast Gasoline Supply"

FACT: A modern dry-mill ethanol refinery produces approximately 2.8 gallons of ethanol and 17 pounds of highly valuable feed coproducts called distillers grains from one bushel of corn.

In 2005, ethanol dry mills produced approximately 9 million metric tons of distillers grains. Ethanol wet mills produced approximately 430,000 metric tons of corn gluten meal, 2.4 million metric tons of corn gluten feed and germ meal, and 565 million pounds of corn oil. The U.S. exports distillers dried grains with solubles mainly to Ireland, the UK, Europe, Mexico and Canada. Click here for more information on co-products.


FACT: Ethanol production does not reduce the amount of food available for human consumption.

Ethanol is produced from field corn fed to livestock, not sweet corn fed to humans. Importantly, ethanol production utilizes only the starch portion of the corn kernel, which is abundant and of low value. The remaining vitamins, minerals, protein and fiber are sold as high-value livestock feed.

An increasing amount of ethanol is produced from nontraditional feedstocks such as waste products from the beverage, food and forestry industries. In the very near future we will also produce ethanol from agricultural residues such as rice straw, sugar cane bagasse and corn stover, municipal solid waste, and energy crops such as switchgrass.

FACT: Most nations have an import tariff on fuel ethanol, and comparatively the U.S. tariff is nearly non-existent.

The U.S. ad valorem tariff is 2.5% of the product value, and is lower than any other country in the world. To prevent U.S. tax dollars from further subsidizing foreign-produced ethanol, which has already received support from the country of origin, there is a secondary duty of 14.27 cents per liter or 54 cents per gallon. The secondary duty was created to offset the value of the ethanol tax credit taken by the petroleum industry when ethanol, both domestic and imported, is blended with gasoline. As evident by the history of ethanol imports into the U.S., the secondary tariff is not a barrier to market entry.

There are exceptions to this rule. First, in some of our bilateral trade agreements like the U.S.-Israel Free Trade Agreement and the North American Free Trade Agreement, we allow ethanol that is fully produced with feedstocks from those countries to enter the U.S. duty-free.

Secondly, Congress has created some unilateral trade preference programs, such as the Caribbean Basin Initiative and the Andean Trade Preference Act that allow ethanol produced in those countries to enter the U.S. duty free. This means that ethanol producers in those countries avoid the secondary tariff as long as the ethanol is produced from within their own country. The purpose of this program is to encourage economic development in the Andean and Caribbean region, which helps fight poverty and drug trafficking. Notably, to date, these trade agreements and preference programs have not led to significant ethanol imports to the U.S.

Click here for more information on import tariffs and trade.

Get more ethanol information here:

Why You Should Enroll In A DRIP Plan

Recently I have been corresponding with several readers about their holdings and and in the course of our conversations, I suggested to many of them that they enroll in a DRIP plan for a certain security. Many of them did not know what they were, how they worked or how they helped their investments. So naturally, when I have a bunch of folks asking the same question, it then becomes time for a post about it.

First things first: What is a DRIP plan? It is short for "dividend re-investment plan". Now the next question you probably have is what does that mean? It means that instead of getting cash each time the company you have stock in pays a dividend, they give you more stock. What does this do for you? A couple of things

• It allows you to acquire more stock without paying brokerage fees (commissions)
• Keeps dividends in your account accruing, rather than being spent.
• Increases your return on the original investment at a greater rate than had you just received them in cash (more on this below).
• Dividends are only taxed at 15%, so compounding your returns via them vs. ordinary income reduces your tax burden.

Now, how does all this work? Lets go through an example. I will make it as simple as possible but as usual, please email me any questions. We are buying stock in ABC Corp. We buy 100 shares at $20 a share for a total investment of $2000. ABC pays an annual dividend of $1 a share (5%) that increases 10% annually. Now, for simplicity, lets assume that the price of ABC stock never changes for 10 years and stays the same as we bought it at, $20. This way we can measure the true effect of the DRIP plan.

After 10 years, the no-drip plan investment would have returned to you $1593.74 in dividends for a total return on your original $2000 investment of 79%, or a average of 7.9% annually.

Now, lets look at what a DRIP plan can do to those same results. Remember, we are now getting our dividends in stock, not cash. This means that our results are going to be compounded by the extra shares we will be receiving which we will then be receiving dividends on. I will go through the first few years and then extrapolate it out to the final result:

Year 1
Shares = 100
Dividend = $100 or 5 more shares ($100 divided by the $20 a share price)
Non-DRIP plan dividend= $100

Year 2
Shares= 105 (100 + 5 from year 1 dividend)
Dividend= $115 or 5.75 more shares ($115 divided by the $20 a share price)
Non-DRIP dividend = $110

Year 3
Shares = 110.75 (105 + 5.75)
Dividend= $134 or 6.7 more shares ($134 divided by the $20 a share price)
Non-DRIP dividend= $121

You can see that after only 3 years, because our dividends are buying us more shares, we are increasing our annual dividend over the no-drip holders. Lets fast forward to the end of the ten years and see where we end up

Year 10
Shares= 191.84
Dividend= $450 or 22.5 more shares
Non-DRIP dividend= $235.79

At the end of ten years, the DRIP plan has a total of 214.48 shares in the account. At the stable price of $20 a share, this brings the DRIP account value to $4,289.60 for a gain of 114% or 11.4% annually. This also means that the drip plan delivered a 48% greater return than the non DRIP plan.

Drips also have the advantage of protecting you if the stock price drops. Should the price of the stock drop, your drip plan is purchasing you MORE shares of the company. This is in a way an insurance policy.

Enrolling in a DRIP usually takes less that a minute. If you use a broker like E*trade, you can do it online without filling out a form. Just click and submit.

DRIP plans are an easy way to increase your returns without doing any extra work on your end. Remember, these results were accomplished without the price of the stock increasing a single penny!! Had it increases at all, the returns would have been magnified.

Time For Sherwin-Williams (SHW) Shareholders To Go On Offense

"I got the best deal that was available," Patrick Lynch, RI Attorney General commenting on Lead Paint settlement with DuPont

“What makes this announcement so gratifying is that this money will go straight to cleaning up the mess". Lynch commenting to press at announcement

"Just.....follow the money" Deep Throat, All The President's Men


Have you ever turned over a compost pile? The more you dig and the deeper you get into it, the more it smells. I am getting the same whiff as I dig deeper into the Rhode Island Lead Paint litigation.

The first trial against lead paint manufacturers ended in a hung jury in 2002, before the start of the second trial, Patrick Lynch, Rhode Island’s Attorney General, announced that he settled the State’s claims against the DuPont Co. Interestingly,however, it appears that the settlement may not be a ‘‘settlement.’’ Both Lynch and DuPont (DD ) say the deal was not a legal settlement but simply an agreement. Because it is not a settlement, DuPont is not giving money to the state. In return for dropping DuPont from its lawsuit, DuPont agreed to donate $12.5 million to charity. Moreover, because it was not a ‘‘settlement,’’ Lynch’s private law firms had to agree to waive their customary attorneys’ fees. Specifically, the settlement requires DuPont to donate $9 million to the Children’s Health Forum, $1 million to Brown University and $2.5 Million to the Dana-Farber/Brigham and Women’s Cancer Center in Boston. Lynch’s office described the DuPont deal as a major victory for the state because at the time of the agreement, it was unclear whether Rhode Island would ever see a penny from the lawsuit that already had one trial end with a hung jury. At first blush, this settlement appears to be a reasonable deal for Rhode Island.

However, as the old saying goes, ‘‘the Devil is in the details’’– and those details came to light in 2006. At the time of the settlement, Attorney General Patrick Lynch described Children’s Health Forum (‘‘CHF’’) as a national nonprofit organization focused on preventing childhood exposure to lead. He failed to mention, however, that:

1. The Washington-based Children’s Health Forum was founded in 2002 by a lawyer hired by DuPont to work on lead poisoning issues.
2. It has received most of its funding from DuPont
3. Most of its board members have ties to DuPont.
4. CHF leases its office space from the Dewey Square Group, a high-powered Washington lobbying and public-affairs firm that DuPont uses as its consultant on ‘‘communications’’ issues, including lead paint.

If that was not enough, CHF’s executive director, Olivia Morgan, is a partner in the Dewey Square Group. Lynch’s spokesman claims that the attorney general did not know the group had a relationship with DuPont when he struck the deal, and DuPont is silent about whether it ever informed the attorney general about its relationship with CHF. While Lynch may have been ignorant about DuPont’s relationship with CHF, his chief of staff, Leonard Lopes, who sat in on talks with Du-Pont, was aware that there was a relationship between the two. Thus, $9 million of the $12.5 million ‘‘agreement’’ is being controlled by a Washington, D.C., based charitable group with extremely close ties to DuPont. Interestingly, there is no written agreement stating how CHF is to spend the DuPont donation.While CHF is supposed to dole the monies out to groups in Rhode Island, that apparently will seek it through an advisory commission set up by Lynch, CHF could arguably spend the money in any manner it chooses.

The International Mesothelioma Program at Brigham and Women’s Hospital.

Although DuPont was unwilling to allow any money to be used as attorneys’ fees, it was willing to donate an equivalent amount ($2.5 million) to charity and asked Lynch to identify which charity he wanted to receive the money. Instead of deciding which Rhode Island charity should benefit from the $2.5 million DuPont gift, Lynch asked Jack McConnell (Motley Rice’s lead lawyer in the lead-paint case) if he had a favorite charity. Mr. McConnell identified the International Mesothelioma Program at Brigham and Women’s Hospital in Boston, Massachusetts. Lynch honored Motley Rice’s request and told DuPont to make the gift to that program. As a result, the money is not going to a Rhode Island hospital, it is going to a Boston hospital. Moreover, mesothelioma is not related to any lead-based health hazard. Mesothelioma is a deadly cancer of the tissue surrounding the lungs that is caused by exposure to asbestos. Hence, millions of dollars generated by resolution of claims against a major defendant in a "Rhode Island public nuisance case involving lead are going to a Massachusetts program that addresses asbestos related illnesses.

How such a diversion serves the public interest or benefits the public health of Rhode Island citizens is an unfathomable mystery. Motley Rice identified that charity because when the law firm joined the executive advisory board of the International Mesothelioma Program, it made a $3 million pledge to the program; a pledge that could be funded with monies raised from other sources, as opposed to a check written by the law firm or its lawyers. Thus,while Motley Rice agreed to waive its attorneys’ fees, it saw no problem with using equivalent monies to fund the majority of the firm’s financial obligation to the mesothelioma program. Motley Rice, however, is not the only law firm wanting monies to go to this program. It turns out that another law firm Lynch hired to serve as co-counsel on this case — Thornton & Naumes — also sits on the board of the mesothelioma program and also has a $3-million pledge to the same program. Neil Leifer, a Thornton & Naumes lawyer who worked on the lead case, said it ‘‘seems reasonable’’ that his firm should also receive a credit toward its $3 million pledge to Brigham and Women’s.

Both Motley Rice and Thornton & Naumes attempt to justify the monies being used to settle their pledges because they both waived their legal fees associated with the Rhode Island case. Donald A. Migliori, an attorney with Motley Rice, told the press that: ‘‘[w]e’tr not ashamed – this money isn’t going to pay our legal fees.; Our law firm’s work in asbestos litigation over the years has enabled us to finance the lead-paint litigation for the past nine years.’’Neil Leifer echoed a similar sentiment when he said it ‘‘seems reasonable’’ that his firm’s share of the waived legal fee should be credited toward the $3 million that it has pledged to Brigham and Women’s. ‘‘I’m not sure why it would be inappropriate.’’Some people, however, see things a bit differently. Leonard Decof, one of the state’s original lawyers in the lead-paint case, argues that $2.5 million is a‘‘de facto’’ legal fee, and that he is therefore entitled to a portion of this money for his past services. At this time, it is not certain whether any of the $2.5 million DuPont gift will be credited toward Motley Rice’s $3-million pledge. A spokesman for Brigham and Women’s said hospital officials have had no conversations with Motley Rice about whether the $2.5 million from DuPont will be credited toward the law firm’s pledge. According to DuPont’s spokeswoman, the company was not aware of Motley Rice’s ties to the mesothelioma program, but simply agreed to donate the $2.5 million to Brigham and Women’s as the charity designated by Lynch. DuPont has released a statement saying that it ‘‘has instructed the hospital that its payment should not be credited to any pledge or obligation of Mr. McConnell, his law firm, or any other entity.’’

The basis of tort law is the compensation of victims for wrongs committed against them. Everyday thousands of plaintiffs lawyers across the country fight for their clients. These are real people with real injuries. These lawyers do us all a service in that they assure our workplaces are safer, drivers exercise more caution, environmental laws are followed, the products we consume are made as safe as possible and when we are injured through the preventable negligence of others, we are compensated. Across our country each day people who's lives would be ruined and left penniless due to injuries caused by another have it essentially saved by a plaintiffs lawyer fighting for them and assuring that those responsible are not allowed to just walk away from their actions. You cannot fully appreciate the service these honest people perform until the day comes you are lying in a hospital bed, unable to work and provide for your family because of the careless actions of another and your lawyer prevents your total financial destitution. The Rhode Island lead paint litigation encompasses none of these scenarios and in one fell swoop tarnishes the situations of all tort victims. The genesis of the RI legal action was the "harmful effects of lead on the children of Rhode Island". Yet when an "agreement" or "settlement" with a manufacturer is reached, not only does this money evade managing to find its way to the hands of these alleged "victims", 92% of it does not even stay in the state of RI, and what did manage to stay there went to a private university, Brown (why not a public one like URI?) for research, not clean up efforts. The Brown University website makes no mention of the funds.

Recently, Lynch commented: "today's ruling has enormously positive ramifications on the health, safety, and welfare of Rhode Island's children." It is a great sound bite, if only it were true. I am sure this is not the result the people of RI hoped for when they read about the settlement in the newspapers. Where is the voter outrage in RI? Do they enjoy being duped? Why aren't they demanding the money be returned to Rhode Island? I have been unable, despite Mr. Lynch's claims, to find any evidence that any of this money has actually been used to clean up a single Rhode Island home.

I was recently sent what I consider to be the most comprehensive lead paint analysis to date. Please read it here. It should also be noted portions of this post were taken from that report. A very interesting part is a section showing where lead currently exists in our lives and how that may be poisoning the children of Rhode Island, not paint.

Recently shareholders of corporation have become very aggressive legally with those inside the company who, through questionable or dubious actions, destroy shareholder value. It is time that we at Sherwin-Williams (SHW) get as equally aggressive with those outside the company. Let's take the bull by the horns here. If not the state of RI, then the AG or theirlaw-firm, Motley Rice. Time to go on offense. I for one am getting sick of being on defense all day.

An interesting comment from a Wall St. insider in Jane Genova's blog Law and More: ..."damages from an unconstitutional act such as a contingency-based-lawsuit can be addressed to the plaintiff firm of Motley Rice and to possible Rhode Island parties who deemed to benefit. This could be highly likely given the possible missteps of Rhode Island Attorney General Patrick Lynch in what I perceive as alleged preferential treatment of DuPont. I will add this: The state of Rhode Island has a major hurdle to get past the contingency issue. From that, there could well be an onslaught of litigation directed at Attorney General Patrick Lynch and the plaintiff law firm of Motley Rice."


Mr. Lynch, this is not over by a long shot.....

No Docs? No Problem... Until Now

"Okay, pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy low. Which means that the people who own the pork belly contracts are saying, "Hey, we're losing all our damn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip! And my wife ain't gonna f... my wife ain't gonna make love to me if I got no money!" So they're panicking right now, they're screaming "SELL! SELL!" to get out before the price keeps dropping. They're panicking out there right now, I can feel it." Eddie Murphy, Trading Places


First let me apologize. In a previous post I stated I would not comment on housing anymore after "my initial" post. Conditions, however, force me to go back on my word. This must be done for a few reasons. First, I have received a host of emails from readers on the subject and do feel obligated to address them lest they think they are being ignored and second, I seem to be the only person who is not in the process of packing up my family, withdrawing all our cash from the bank, gathering whatever canned goods we can scrounge up and heading to the hills incoherently stammering like Hunter Thompson in some bizarre Y2K panic induced flashback.

Are you surprised?
Housing has been on a tear for the last decade. Before the last year and a half, things became insane. It is relatively easy to spot the beginning of the end in a bubble when you are not wrapped up in it. During the tech bubble in 1999-2000 when any mammal with an opposable thumb and a mouse could make money, that moment was arrived at when novel little things like earnings were no longer important and took a back seat to revenue growth, "website hits" and "click through" metrics. It was a time when a company could actually report quarterly numbers, have increasing losses, mounting debt, but because revenue and other internet traffic metrics grew, its stock would explode to the upside. The inevitable happened, people realized if a company is not able to earn a profit, or even demonstrate a realistic plan of how they might, it really is not worth $144 a share and the prices of these stocks then fell off a cliff. You also had prices of stocks in companies like Home Depot (HD) and Coke (KO) included by the frothing hoards in this mania. These were companies who actually had earnings, but were growing them at rates in the teens who were selling at 50 times those earnings. These companies, caught up in the euphoric irrationality of the millennium also suffered as people then realized that while these companies were actually able to earn a profit, paying 50 times them for companies who make screwdrivers and Coke had the same effect as getting married in Vegas after a weekend of drinking screwdrivers and doing coke. Both decisions in retrospect left people wondering what the hell they were thinking. The answer? They weren't.

Enter housing. With people petrified of stocks and interest rates obscenely low, they poured money into housing. Predictably, prices soared. For a real example. My wife and I bought out first house in 1997 after we were married. We paid $107,000 for it and put about $20,000 of cosmetic changes into it (painting, some updated wiring and insulation). Three years later we sold it for $285,000. Our second house was bought for $117,000 and comped out 4 years later for $368,000. There is no logical reason for this. When we bought both houses they "comped" out similar to other houses in the area so we were not the recipients of an unusual bargain and when we sold them, similar "comps" applied so the buyers did not get "ripped off" compared to what other buyers were paying. The market was just clearly running as all buyers were paying these prices, the buyers and sellers were not insane, the market was. So when did the seams begin to come apart? Two words:

No Documentation
You really have to read this stuff to get an understanding of why the market ran up and why lenders are now in trouble. This is from Lending Tree.com:

There are three main categories of no-documentation mortgages:


1. NINA (no income, no asset) mortgages
How to qualify: NINA mortgages come the closest to being truly no-documentation loans. When you apply for one, you won’t need to supply information about your income, employment or assets. All the lender will check is your credit score and the assessed value of the property.
Interest rate: Because the lender is going on so little, your credit score needs to be very high to obtain this type of mortgage. If you are approved, your score will be a big factor in setting the interest rate, which will typically be 1 to 1.5 percent higher than a traditional mortgage, but may be as much as 3 percent higher.
Who it may be right for: People with excellent credit who do not want to disclose the details of their holdings; people who rigorously guard their privacy.

2. No-ratio mortgages
How to qualify: With a no-ratio mortgage you don’t need to declare your income, so a lender can’t calculate your debt-to-income ratio (your monthly loan payments divided by your monthly income -- a ratio lenders usually prefer to remain below 36 percent). Lenders will still require other documentation, however, such as assets, other debts and employment. They’ll often require that you’ve been in the same job for two years.
Interest rate: You’ll pay a higher rate than you would for a traditional loan, but not as high as with a NINA.
Who it may be right for: People who would have difficulty obtaining a traditional mortgage because of their high debt-to-income ratio; people who have income that is difficult to verify.

3. Stated-income mortgages
How to qualify: With a stated-income mortgage, you do not need to prove your income with pay stubs or W2 forms. You must be able to document the nature of your employment (again, two years in the same job is usually required), but you can simply declare an income level that is reasonable for your line of work.
Interest rate: Because you supply other documentation and will be able to show a healthy debt-to-income ratio, this type of mortgage carries only a slightly higher rate than a traditional loan. About half a percent is typical, though it varies with other factors such as credit score, the size of the down payment and how stable your income is.
Who it may be right for: Borrowers who have a good income but find it hard to prove, such as self-employed people with a lot of tax write-offs, or people who earn much of their income in cash or tips.


What is shocking is the justifications they give for those who these loans "may be right for". You are buying a house, you are borrowing money from a bank to do so. The expectation is that you will need to have money to put down on it and actually be able to demonstrate an ability to pay the bank back. The phrase "take my word for it" should never enter the conversation. It did though and that is the genesis of the current situation. When buying a $500,000 house involved less paperwork than buying a Ford Escort, red flags ought to have been going up.

In 2005 and 2006 the number of both mortgage brokers and real estate agents hit historic highs. A mortgage is a commodity, give me a price and a rate and I will choose a broker. There is very little a broker can do to distinguish themselves from each other. With so many brokers and a limited number of qualified mortgage applicants, brokers had to find new applicants. The only place for them to go was the pool of people who under the current rules not only did not qualify for a mortgage would not receive credit from a bookie were they to ask. The new motto was "If they don't fit under the current set of rules, change the rules". So they did. What they failed to realize was, the rules were there for a reason, they worked. We are now realizing that people who do not want to provide proof of what they do for a living, how they earn income, what that income actually is or where their down payment is coming from are not doing so out of some symbolic "privacy concern", but because what they are saying is quite frankly, bull. Who has trouble "verifying income"? Crack dealers? Illegal immigrants working under the table and not paying taxes? Contractors who cheat on their taxes? If you want my money, prove you can pay it back or take a walk and let the next person in line step up, unless of course the line is small, the others are just like you and we really need to give you the money... thus the mortgage industry dilemma the past few years. Like I have said more than a few times before, the surprise here is not that this happened, it is that it did not happen sooner.

Where do we go from here? A slow decent to normalcy. That is all. Not a crash, not a recession, not a depression, just normal housing conditions with realistic lending guidelines. Bernanke will not allow a recession and to be quite honest, the overall economy is performing so well, it will resist it. We have record profits, record corporate cash levels, full employment and moderate sustainable growth. This may end up actually benefiting stocks as all the money that chased real estate the past 4-5 years will now look to stocks for superior returns since it will not be in real estate for a while. There are trillions out there looking for a home to grow in, what happens to the bottom 1% or 2% to the mortgage market will not really effect us except entice those trillions to look for a better home. The US stock market welcomes you.

Do not let the doomsayers out there scare you, let them panic and keep your cool like Billy Ray Valentine... see the movie.

Altria Spin-Off of Kraft: Q & A

Altria Letter to shareholders

QUESTIONS AND ANSWERS REGARDING THE SPIN-OFF OF KRAFT FOODS INC.


1. I own Altria shares. What will I receive as a result of the spin-off?
Altria will distribute 0.692024 of a share of Kraft Class A common stock for each share of Altria common stock outstanding as of the Record Date for the Distribution, subject to adjustment as provided herein. The distribution ratio is based on the number of Kraft shares owned by Altria divided by the Altria shares outstanding on that date.

2. What do I need to do to receive my Kraft shares?
No action is required by Altria’s shareholders to receive their Kraft Class A common stock. The Distribution of Kraft’s outstanding shares owned by Altria will be made on the Distribution Date.

3. What is the Record Date for the Distribution, and when will the Distribution occur?
The Record Date is March 16, 2007, and ownership is determined as of 5:00 p.m. Eastern Time on that date. Shares of Kraft Class A common stock will be distributed on March 30, 2007. We refer to this date as the Distribution Date.

4. What do I have to do to participate in the Distribution?
You will receive 0.692024 of a share of Kraft Class A common stock for each share of Altria common stock held as of the Record Date, subject to adjustment as provided herein. You may also participate in the Distribution if you purchase Altria common stock in the “regular way” market and retain your Altria shares through the Distribution Date.

5. If I sell my shares of Altria common stock before the Distribution Date, will I still be entitled to receive Kraft shares in the Distribution?
If you sell your shares of Altria common stock prior to or on the Distribution Date, you may also be selling your right to receive shares of Kraft Class A common stock. You are encouraged to consult with your financial advisor regarding the specific implications of selling your Altria common stock prior to or on the Distribution Date.

6. How will the spin-off affect the number of shares of Altria I currently hold?
The number of shares of Altria held by a shareholder will be unchanged. On the Distribution Date, Altria’s shareholders will receive 0.692024 of a share of Kraft Class A common stock for each share of Altria common stock that they own, subject to adjustment as provided herein. The market value of each Altria share, however, will adjust to reflect the spin-off and, hence, the loss of the valueof the Kraft stock.

7. What are the tax consequences of the Distribution to Altria shareholders?
Altria has received an opinion from outside legal counsel to the effect that the Distribution will be tax free to its shareholders for U.S. federal income tax purposes, except for any cash received in lieu of a fractional share of Kraft Class A common stock. You should consult your own tax advisor regarding the particular consequences of the Distribution to you, including the applicability and effect of any U.S. federal, state and local and foreign tax laws. Altria will provide its U.S. shareholders with information to enable them to compute their tax basis in both Altria and Kraft shares. This information will be posted on Altria’s website,
www.altria.com/Kraftspinoff, on or around March 30, 2007.

8. When will I receive my Kraft shares? Will I receive a stock certificate for Kraft shares distributed as a result of the spin-off?
Registered holders of Altria common stock who are entitled to receive the Distribution will receive a book-entry account statement reflecting their ownership of Kraft Class A common stock. For additional information, registered shareholders in the U.S. and Canada should contact Altria’s transfer agent, Computershare Trust Company, at 1-866-538-5172 or by e-mail at altria@computershare.com. Shareholders from outside the U.S. and Canada may call 1-781-575-3572. If you would like to receive physical certificates evidencing your Kraft shares, please contact Kraft’s transfer agent. See “Kraft Transfer Agent and Registrar,” on page 8.

9. What if I hold my shares through a broker, bank or other nominee?
Altria shareholders who hold their shares through a broker, bank or other nominee will have their brokerage account credited with Kraft Class A common stock. For additional information, those shareholders should contact their broker or bank directly. Questions regarding the Distribution can also be directed to our information agent, D.F. King & Co., Inc., at 1-800-290-6431.

10. What if I have stock certificates reflecting my shares of Altria common stock? Should I send them to the transfer agent or to Altria?
No, you should not send your stock certificates to the transfer agent or to Altria. You should retain your Altria stock certificates. No certificates representing your shares of Kraft Class A common stock will be mailed to you. Kraft Class A common stock will be issued as uncertificated shares registered in book-entry form through the direct registration system.

11. If I was enrolled in an Altria dividend reinvestment plan, will I automatically be enrolled in the Kraft dividend reinvestment plan?
Yes. If you elected to have your Altria cash dividends applied toward the purchase of additional Altria shares, the Kraft shares you receive in the Distribution will be automatically enrolled in the Kraft Direct Stock Purchase and Dividend Reinvestment Plan sponsored by Computershare Trust Company (Kraft’s transfer agent and registrar), unless you notify Computershare that you do not want to reinvest any Kraft cash dividends in additional Kraft shares. Contact information for the Kraft plan sponsor (Computershare) is provided on page 8 of this Information Statement. Additional frequently asked questions and other information are available at www.altria.com/Kraftspinoff.

Festival of Stock's at Gannon on Investing

Visit the site: Gannon on Investing to see the latest "Festival of Stocks" for the week of March 19th. The host, in this case Geoff Gannon, of the festival chooses what they feel to be the best posts currently and does the work to organize them for us. It is a great way to see a variety of posts from different authors. Geoff did a great job this time and has organized the posts by subject.

Here are some samples from the festival.


Topps

Disappointing Offer for Topps: Why this Deal is $7.55, Not $9.75 By Cheap Stocks
The recently announced Topps deal is met with some tough words and common sense in this post from Cheap Stocks. Those words mean even more coming from a former shareholder who specializes in stocks with a lot of excess cash on the balance sheet.
Stocks: TOPP

Against the Topps Deal By Gannon On Investing
For those who just can't get enough of the Topps deal or who simply enjoy falling asleep in front of their computer screens, here are 5,000+ words of vitriolic analysis often approaching pure philippic – written by yours truly.
Stocks: TOPP

Buybacks

Stock Buybacks and Dividend Payments Remain Strong By Disciplined Approach to Investing
David Templeton takes a look at stock buybacks and dividend payments. According to a press release from Standard & Poor's, S&P 500 companies spent $105 billion buying back their own shares during the fourth quarter of 2006.

The Buyback Indicator Still Going Strong? By CXOAG Investing Notes
In a related post, the CXOAG blog cites a recent paper discussing the stock repurchase anomaly in recent years. Based on that paper's findings, it appears investor awareness of the anomaly's existence has not served to eliminate it.

Stock Analysis

This Panther is Ready to Pounce By ValuePlays
A detailed post reviewing Owens Corning's latest conference call. The author clearly likes the stock. Much of the post is devoted to discussing the (conservative) assumptions present in the company's earnings estimate.
Stocks: OC

Handleman is Still a Bargain By The Picky Investor
In this follow-up to an earlier post, the author explains why Handleman is still a bargain, despite suspending its quarterly dividend. The post discusses qualitative as well as quantitative aspects of the business and its merits as an investment.
Stocks: HDL

Manitowoc Company "Revisiting a Stock Pick" By Stock Picks Bob's Advice
Following his usual format, Bob Freedland revisits Manitowoc Company for the second time. He first wrote about the company in November of 2004; then, revisited it in January of 2006. This is his latest update on Manitowoc.
Stocks: MTW

Conviction Buy List By One Guy's Investments
Travis Johnson rips a page from Goldman Sachs' playbook and presents a "conviction buy" list of his own. It consists of four very different companies: Gol Linhas Aereas Inteligentes, American Science and Engineering, Cemex, and Exelixis.
Stocks: GOL, ASEI, CX, EXEL

Investing

Profit With Split-Offs By Fat Pitch Financials
George is at his best in posts like these. Here, he leads investors through the split-off process, step by step. He explains what split-offs are (and how they differ from their better known brethren, spin-offs), why they can be profitable for individual investors, and where you can start looking for future opportunities in this area. He also provides two examples of recent split-offs.
Stocks: MCD, CMG.B, WY, UFS

Great Companies Don't Always Make Great Stocks By The Peridot Capitalist
A short post on an important topic. Why do the portfolios of even the best value investors always look so ugly? Why can't sell-side analysts distinguish between a business and a stock? Why do America's least admired companies outperform America's most admired companies? Simple, because great companies don't always make great stocks.
Stocks: BBY, RSH

Dow Chemical CEO Letter To Shareholders

I will have more on this next week. Here is the summary from the DOW website.

MIDLAND, Mich., March 23 /PRNewswire-FirstCall/ -- In his annual letter to shareholders, Andrew Liveris, chairman and chief executive officer of The Dow Chemical Company, summed up 2006 as "a very good year." And he underscored the Company's commitment to a transformational growth strategy, focused on reshaping its integrated business portfolio in order to enhance its earnings profile.

In his letter, headlined 'Strong today. Stronger tomorrow', Liveris said: "Although our 2006 performance represents an important milestone for our Company, we believe 2007 will be even more significant."

In 2006, Dow reported record sales of $49 billion, the second highest earnings in the company's history, a 12% increase in the dividend, the repurchase of more than 18 million shares and the approval of an additional $2 billion in share buy-backs.

Commenting on Dow's future, Liveris said: "We have the right strategy. We are implementing it with discipline and speed, and our initial results are showing great promise. Going forward, shareholders can expect more innovation, more market-facing businesses, more asset-light joint ventures, continued financial strength and flexibility, and a higher ratio of Performance businesses."

Liveris also wrote of how Dow delivered against the strategy it laid out a year ago, "Early in 2006, we put some public stakes in the ground regarding our future plans. We said then that we would remain a diversified, integrated, global company, and we think our 2006 results bear out the wisdom of that statement. We said that we would take action to strengthen our franchise Basics businesses and grow through joint ventures, not only building new plants with JV partners, but in some cases, placing our existing assets into JVs-similar to what we did in 2004 with ethylene glycol and the formation of MEGlobal. We call this our "asset light" strategy, and we have made substantial progress in this area."

Looking toward 2007, Liveris highlighted the Company's key initiatives related to technological innovation, environmental sustainability and joint venture partnerships.

"With the Basics portfolio, as with our Performance portfolio, we will continue to take aggressive action throughout 2007, including new business models that will make our Basics portfolio more 'asset light' and more competitive for the long term," said Liveris.

"Dow has a long history of innovation ... we are funding more than 600 projects that either strengthen our position in key franchises or break into entirely new areas of technology," said Liveris. "We will continue to invest in the technologies, businesses, regions and markets that are the most promising; prune non-strategic businesses and non-competitive assets; and keep ongoing costs under control."

Liveris also discussed the Company's launch of its 2015 Sustainability Goals that commit Dow to addressing humanity's most pressing environmental problems including: access to clean water, shelter and health care, climate change, and reducing greenhouse gases.

"I made a public commitment at the United Nations' headquarters in New York City that our Company would apply the full power of its technology- including three major breakthroughs during the 10 years of the program-as well as dedicate our philanthropy and volunteerism to help solve these and other challenges."

Liveris's letter was issued today as part of Dow's 2006 10-K and Stockholder Summary, which has been mailed to all Dow stockholders along with the 2006 Corporate Report and Dow's 2007 Proxy Statement. Copies of all three documents are available on Dow's website at http://www.dowannualreport.com/.

Rhode Island Lead Trial--- A Travesty

I receive several emails yesterday after my Sherwin Williams (SHW) post on Wednesday asking how I could be so sure the lower courts decision would eventually be tossed. I am going to direct you to a paper from the Washington Legal Foundation that eviscerates the lower court's handling of the case. It a matter of "when" not "if" this ludicrous ruling will get tossed. A note: The text below (except for the comments at the end beginning with "Sherwin's stock...") is taken from the paper and I have noted here what I feel are the most important sections for those of you who do not wish to read all 34 pages.

On a cold gray February day in 2006, a jury in Rhode Island found three companies liable for creating a “public nuisance.” In that case, styled as Rhode Island v. Atlantic Richfield Co, the State of Rhode Island sued four former manufacturers of lead pigment. The State claimed that the manufacturers were responsible for creating a “public nuisance” in Rhode Island during the century before residential sale of lead paint was banned in 1978. The case made national headlines because, for the first time, lead pigment manufacturers were found liable for problems allegedly caused by poorly maintained lead-based paint in privately owed homes.

One year later, on another cold gray February day, the Rhode Island trial court (the “Court”) issued a long awaited decision regarding the Defendants’ post verdict motions. In a 198 page decision, the Court found that a multitude of alleged legal errors by the Court an alleged misconduct by the State’s trial team either did not occur or were not sufficiently serious to require a new trial. In the same decision, the Court ruled that the State’s “non-delegable” duty to perform lead abatements was in fact partially delegable – so long as the State remained ultimately responsible. But the Court’s ruling was much more than a lengthy disposition of procedural and substantive issues regarding the trial and the verdict. In a decision that dispensed with the most fundamental requirements of American tort law, this Rhode Island trial court held that merely manufacturing and marketing a product is sufficient to impose liability on a defendant—even in the absence of any evidence that a defendant's product produced harm to any person where the nuisance allegedly exists. With this broad stroke, the Court ruled that neither product identification nor evidence of specific injuries attributable to a particular defendant is necessary before a defendant is ordered to abate a nuisance.

As a result of this ruling—which is preliminary and may not be subject to appeal presently (it now is- my comment) —this Rhode Island Court has created an extraordinarily dangerous vehicle for lawsuit abuse—a tort where liability is based upon unidentified ills allegedly suffered by unidentified people caused by unidentified products in unidentified locations. At least in Rhode Island, product liability law has been swallowed up by the amorphous concept of “public nuisance”—a development that should alert every industry to the dangerous alliance of public authorities and private counsel, and their opportunistic distortions of traditional legal principles.

The extensive trial held in 2006 was not the first trial in this case. In 2002, a jury deadlocked 4-2 against the State’s original public nuisance claim.The jury deadlocked because they were not able to agree as to whether the State had established the existence of a public nuisance. In response, the State persuaded the Court to lower the threshold for finding a public nuisance. Additionally, in the second “all-in” trial, the Court allowed the State to try the manufacturers not on their own conduct, but on the conduct of their trade associations, conduct that did not occur in Rhode Island, but rather happened in other states. And then, in the second trial, the State refused to disclose new evidence that, by the State’s own standards, the childhood lead poisoning “problem” in Rhode Island was eliminated before the trial ended. In spite of this evidence, known only to the State, the State argued to the jury that the level of childhood lead poisoning in the State had reached a “plateau,” and was no longer declining. Thus, the jury was deprived of critical evidence—unknown to Defendants until after the verdict was returned—that flatly undermined the presence of the “nuisance” the State wrongly claimed to exist.

As a result of the Court’s jury instructions, and the State’s trial tactics, the jury’s decision against the Defendants, in hindsight, now seems predictable and, indeed, inevitable. Although the second jury was also initially deadlocked 4-2 in favor of the defense, post-verdict interviews indicated that the Court’s jury instructions essentially directed a finding liability.According to one juror, the jury instructions “didn’t give the paint companies much of a window to crawl through”. Some, such as the private contingent fee lawyers that Rhode Island hired to prosecute its case, claim that what happened in Rhode Island constitutes “justice.”

Others, including these authors, take a different view. The Judge’s rulings and the State’s conduct resulted in a monstrous mosaic of serious errors, many of which, standing alone, constitute reversible error. When viewed as a whole, the Rhode Island Court’s decision abdicates the judiciary’s fundamental role to ensure procedural and substantive fairness to all parties—a role that is enshrined in our most honored jurisprudential traditions. It is not the role of the judiciary—and certainly not the role of a trial judge—to blithely “change the law” when precedents raise barriers to a plaintiffs’ recovery, especially when, in order to do so, the court must sweep centuries of common law tradition under the rug. Such an analogy is particularly apt in this case because, like soil under the carpet, the injustice of the Court’s ruling persists—even when covered by almost 200 pages of creative justifications.

According to the Court, “based on the evidence that a public nuisance exists … and on common sense, the jury properly could have concluded that whoever sold and promoted lead pigment in Rhode Island proximately caused the public nuisance. In effect, the sale and promotion would complete the chain of causation that begins at manufacture, and ends with the existence of the public nuisance.” The authors wonder if “common sense” also dictated that the Court ignore all of the landlords and property owners who improperly maintained the lead-based paint or allowed it to deteriorate to where it became a health hazard.

The trial court defined a public nuisance injury simply as “the cumulative presence of lead pigment in paints and coatings in [or] on buildings in the state of Rhode Island". This wrongly suggests that an injury to a large number of individuals is the same as an injury to the community as a whole. Case law clearly states that “harm to individual members of the public” (no matter how many) is not the same as harm “to the public generally". In its jury instructions, the Court altered the language in comment g of §821B of the Restatement (“A public right is one common to all members of the general public”). Instead of following the Restatement, the Court instructed the jury that: "A right common to the general public is a right or an interest that belongs to the community-at-large. It is a right that is collective in nature. A public right is a right collective in nature and not like an individual right that everyone has not to be assaulted defamed, or defrauded, or negligently injured".

As will be discussed elsewhere in this article, the State provided no proof that the “nuisance” existed anywhere except in private residences. Accordingly, the alleged problems did not threaten the exercise of any rights held by the public at large, such as the use of public buildings or resources, but rather related to the exercise of private rights by private individuals in their private abodes. Since no “collective” right was impacted that applied to the general public, the trial court’s instructions overstepped the bounds of public nuisance as defined by the common law, and dissolved the distinction between public and private nuisance as separate causes of action.

Thus, for the first time in common law jurisprudence, the Rhode Island Court held that the characterization of a nuisance as “public” or “private” depends not upon its impact on rights held by the community at large, but rather upon the number of persons allegedly affected by the problem. The State’s intrusion into areas governed previously by personal claims is an alarming expansion of governmental power. Using the “common law” to justify such a usurpation of private interests is not only unprecedented, but also sets a dangerous precedent that may be used to justify even greater expansions of governmental authority into private spheres.

As the situation now stands, the Rhode Island trial court has unleashed a phenomenon bounded only by its own ingenuity—a phenomenon that contains seeds of abuse that, unless constrained, threaten the fundamental structures of representative democracy by imposing liability without wrongdoing and remedies without injury. At its essence, the new “claim” imposes liability solely upon the basis of a person’s status as a product manufacturer, making them responsible not for what they have done, but rather for who they are.

Sherwin's stock is being held back by this abhorrence, once this cloud is duly lifted, the stock will run. What I would like to see for a change is a shareholder lawsuit against the State of Rhode Island for the financial harm we have suffered as owners. Our loss would be both the artificial stagnation of the stock price, the money spent on this litigation that cannot be used for corporate purposes or returned to us owners as a dividends or share repurchases and the time executives have spent on the litigation, not the selling of paint and coatings.

Perhaps that would put an end to these games and discourage those greedy little localities in Ohio contemplating a similar exploitation of our legal system.

Interview with Geoff Gannon

Recently I was interviewed by Geoff Gannon from one of my favorite sites, Gannon on Investing as part of his "20 questions" series. Please visit his site to see other "20 Questions" interviews.

Below is the transcript.

Todd Sullivan is a value investor who writes the ValuePlays blog. ValuePlays is a value investing site focusing on individual stock analysis, investing concepts, and market commentary.

Visit ValuePlays

1. Are you a value investor?

Yes.

2. What is value investing?

Purchasing a piece of a company at a price that is below a reasonable valuation.

3. What is your approach to investing?

Look for the current "red headed step children" and pick out the gems.

4. How do you evaluate a stock?

I look for industry leading companies who:

- Have a valuation that is equal to or at a small premium to other shares with a comparable earnings growth rate.

- Have a total return yield greater than the current corp. bond rates.

- Are buying back shares.

- Are increasing the dividend.

- And are increasing cash flow from operations.

All that takes about 20 minutes, if it passes those tests, I begin to dig deeper into SEC filings, annual reports, etc. Earnings call transcripts on Seeking Alpha recently have been providing me a ton of insight, not necessarily for the details, but the general "tone" of management.

5. Why do you buy a stock?

To own a piece of a company.

6. Why do you sell a stock?

The business deteriorates or its valuation becomes irrationally high.

7. What investment decision are you most proud of?

MO at the height of the litigation woes in 2003 and MCD during the "mad cow" scare of Jan 2003.

8. What investment decision do you most regret?

Selling USG in June of that year.

9. Why do you blog?

I love the market and love to write. It also makes me a better investor by forcing more detailed analysis and making me stick to my guns.

10. What's your best post?

Did SBUX's Donald Really say that?

Picked up in the WSJ Online

11. What's your worst post?

SHLD: What Will Eddy Do? Just guess work. Of course if I turn out right, pure genius. :)

12. What financial publications do you read?

WSJ, Barons.

13. What investing blogs do you read?

Value Investing News, The Stockmasters, Seeking Alpha, Fat Pitch, Gannon, Peridot, Interactive Investor.

14. What's the best investment book you've read?

"Buffett: The Making Of An American Capitalist"

15. What's the last investment book you've read?

"The Intelligent Investor" – I try to read it at least once a year.

16. When did you start investing?

At 19. I've always loved the idea of being able to buy a piece of a company and "go along for the ride".

17. How have you improved as an investor?

One word: Patience.

18. How do you need to improve as an investor?

Believe in my choices more, my biggest mistakes have not been picking the wrong companies but getting out too soon or not buying at all because I doubted my reasoning.... (see USG, CHD).

19. Where are the bargains in today's market?

I am sky high on Owens Corning (OC)... SHLD: Eddie Lampert + $4 billion in the bank.

20. What's the most interesting company we haven't heard of?

Based on its small float and daily volume, Owens Corning. It is a leader in all its product categories, fresh off asbestos bankruptcy and just posted strong results despite the housing market and a benign hurricane season. When things turn around in those areas, they take off. Trades at about 6 times earnings.

Visit Gannon on Investing

Housing: Enough already!!

"I got two words for you, shut the **** up" Robert De Niro, Midnight Run


Am I the only person who has had it with all the "housing" and "subprime" talk? My god, it is almost as if nothing else is happening out there. When the media get stuck on something they are like Rainman obsessing about Wapner being on in 5 minutes. Let it go gang. For two years all we have heard is "housing must slow down" and "there are too many risky loans out there". Now that the housing market has slowed down and the home buyers with those risky (subprime) loans did exactly what we knew they would do, default, this is suddenly a big deal? Just in case you are not already sufficiently nauseated by the deluge of housing rhetoric out there, here is my one and only "two cents" on it. I want to go on record and say I am only posting on this topic as a response to emails I have gotten so I do not plan to comment further on this except to update this post much later to test its accuracy. Why? This is not really the big deal it is being made out to be. Some numbers:

• Approximately 80% of the mortgage market as "A" credit
  
• For "A" paper, the delinquency rate is in a comfortable 2.5% range.
• 20% of the market as "subprime" of all types and terms.
• Of the 20% slice, the Mortgage Bankers Association reported this week that some 13% of those loans were in some stage of delinquency, a number which has steadily risen over recent quarters.
  
• While alarming, the flip side is that some 87% of subprime loans are performing fine
  
• Only 6 percent of homeowners hold subprime ARMs (adjustable rate)
• Even if we hit a 20% default rate among subprime ARM holders -- a rate twice as high as the foreclosure peak after the 2001 recession, that is only about 1% of the national mortgage market.

Simply put, for homeowners out there 95 out of 100 of us are having no problems with their mortgages (or at least are not delinquent). So why the hysteria? Easy, we have 24 hour news coverage to fill and saying the housing market is "slowing down like expected" just does not capture a headline like "subprime carnage threatens to lead US into recession", does it? But it is as good an excuse as anything though, right? In mean, most people cannot follow (nor do they want to) the intricacies of the Japanese yen carry trade that the talking heads blamed the market sell off a few weeks ago on but, most people own homes so lets go with that, at least they can relate to it.

The reality is that unless you are one of the unfortunate "subprime folks" who are stuck, these headlines will have no effect on you. What is of note here is in the majority of excess defaults are the "no documentation" loans. These were mortgages given to folks whose credit was so bad they were not forced to provided credit histories and in return agreed to pay interest rates in many cases more than twice the national average. So, we are now supposed to be surprised they defaulted? Another oft overlooked detail of many of these loans is that those taking them were not required to provide proof of citizenship. While the exact number may never be known, how many of these defaults are people just walking away from homes after some of the immigration raids that have littered the news lately? Chances are these were bought with invalid social security numbers anyway so there is no actual risk to their credit rating or future ability to purchase another house in another town as fake social security cards are as easy to get as a ham sandwich. Basically you have a mess of subprime mortgages created by lenders who gave money to anyone with a pulse (I am sure we will get reports of dead people getting loans soon enough). Faltering home prices are likely to blame for another portion of the default of loans. Borrowers with little equity (5% or zero down loans) who face difficult economic times or rising monthly payments (adjustable loans) have little chance to refinance their mortgages or sell their homes in hopes of making full repayment if the market hasn't produced any "instant equity" for them to utilize. There is no easy way out, except to mail the keys back to their lender.

Now let's look at housing. Personally the gauge I look at the most closely is inventory. It is the most basic economic law, supply and demand. High supply is bad for sellers (this includes home builders) because the more homes sitting out there for sale, the lower the prices they then command. Since homes are valued on a "comparative" basis, the lower the price of the home for sale next to you, the less your home now becomes worth. The lower the supply, the higher prices homes then command and then all the above issues become moot as they resolve themselves. So, for me, inventory rules. Let's look.

Inventory (months of supply, New and Existing homes):

Year --------------New------------- Existing
2002 ---------------5.8------------------ 4.7
2003 ---------------5.5------------------ 4.6
2004 ---------------4.1----------------- 4.3
2005 ---------------4.8----------------- 4.5
2006 (Jan) --------5.7 -----------------6.5
2006 (July)-- - 7.2----------------- 7.3
2007 (Jan) -------6.8------------------ 6.6

What can we deduce from these numbers? It would seem that the worst of the housing market was in July of 2006. It is my opinion that we in a trough now and probably will remain here until the new home inventory is worked off. As the new home inventory falls, buyers will begin to automatically work off the excess existing home inventory as by default less new home are available. The economy is strong and unemployment is low so there are no exterior factors pushing the market lower. The problems now were created by excesses on the part of lenders and homebuilders. Once they have taken their medicine, things will turn around.

Builder confidence in the market for new single-family homes receded in March, largely on concerns about deepening problems in the subprime mortgage arena, according to the National Association of Home Builders/Wells Fargo Housing Market Index (HMI), released today. After rising fairly steadily since its recent low last September, the HMI declined three points from a downwardly revised 39 reading in February to 36 in March. This too is good news as pessimistic builders will refrain from new projects, further reducing inventory.

So when will that happen? I have no idea and neither does anyone else. My guess is that we will see things start to improve by the end of the summer (this does assume no dramatic exterior events like another war, terrorist attacks etc..). The recovery and subsequent growth will be more orderly and restrained as lenders and builders avoid the Mardi Gras type behavior that got them into the present predicaments.

Another reason the market may have bottomed? Famed "Legendary stock picker Bill Miller (Seeking Alpha, Mar. 18th): , portfolio manager for the $20.8 billion Legg Mason Value Trust [LMVTX]: Recent Buys For Legg Mason Value Trust: Homebuilder Centex (CTX): 597,000 shares (cost: $28.4 million); total position now 6.1 million shares. For those of you who read Sunday's post, Bill Miller is the only fund manager to beat the S&P 15 years in a row in the past 40 years, paying attention to what he feels is undervalued is usually a good idea.

I hope housing turns around soon, if for no other reason I won't have to read or hear about it all day long....

---

A Reveiw of Bogle's "Little Book"

So here is the review. First, so that I do not error, here is the book description from the publisher:

"To learn how to make index investing work for you, there’s no better mentor than legendary mutual fund industry veteran John C. Bogle. Over the course of his long career, Bogle—founder of the Vanguard Group and creator of the world’s first index mutual fund—has relied primarily on index investing to help Vanguard’s clients build substantial wealth. Now, with The Little Book of Common Sense Investing, he wants to help you do the same.

Filled with in-depth insights and practical advice, The Little Book of Common Sense Investing will show you how to incorporate this proven investment strategy into your portfolio. It will also change the very way you think about investing. Successful investing is not easy. (It requires discipline and patience.) But it is simple. For it’s all about common sense.

With The Little Book of Common Sense Investing as your guide, you’ll discover how to make investing a winner’s game:

• Why business reality—dividend yields and earnings growth—is more important than market expectations
• How to overcome the powerful impact of investment costs, taxes, and inflation
• How the magic of compounding returns is overwhelmed by the tyranny of compounding costs
• What expert investors and brilliant academics—from Warren Buffett and Benjamin Graham to Paul Samuelson and Burton Malkiel—have to say about index investing

About the Author: JOHN C. BOGLE is founder of the Vanguard Group, Inc., and President of its Bogle Financial Markets Research Center. He created Vanguard in 1974 and served as chairman and chief executive officer until 1996 and senior chairman until 2000. In 1999, Fortune magazine named Mr. Bogle as one of the four "Investment Giants" of the twentieth century; in 2004, Time named him one of the world’s 100 most powerful and influential people, and Institutional Investor presented him with its Lifetime Achievement Award.

My two cents:

Bogle Maintains:

1. Mutual fund investors are bound to lose (and in most cases you pay the fund manager outrageous sums to lose you money)
   
2. Most investor are ill-equipped to pick individual stocks
3. Index funds are the best way for the average person to invest in the market and reap the full benefits of the US economy.

I have some agreement and disagreements with him. I strongly agree that entrusting your money to 90% (maybe more) of mutual fund managers is a losing game long term. Some facts from the book:

1. Between 1994 and 2004 Morningstar 5 Star (Top Rated) Funds returned 6.9% annually vs 11% for the Total Market
   
2. After the market bubble of 1997-1999, the "Top 10" funds from those years plummeted. From 2000-2002, not a single one was ranked higher than 790 and they were outperformed by 95% of their peers.
3. From 1982-1992, the top fund in each year averaged a ranking of 285 the following year.
4. From 1995-2005 the top fund in each year averaged a ranking of 619 the following year
5. Of the 1,400 mutual funds out there, in the last 40 years, only 1 has beaten the market for 15 consecutive years (and that streak just ended in 2006) Legg Mason Value run by Bill Miller.

That being said, if you do not want to do the homework but want to own stocks, index funds are the way to go. A caveat, there has been an explosion of these funds in the past 3 years and you can now buy an index fund for almost anything. If you truly want to mirror the results of the overall market, your only choice is an S&P index fund.

Personally, I strongly believe (and have been able to) that beating the market with individual stock picks is something people can do and you do not have to have an MBA or Harvard education to do it. According to Buffet, when it comes to investing "The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective".

Picking stocks is not all that difficult, people just make so.

Another Buffetism: referring to investing, "there seems to be a perverse human characteristic that needs to take simple things and make them difficult."

We all have it in us to be successful investors, if you do not want to try, or do not have the time to dedicate to doing the necessary homework, do yourself a favor, spend the $11 for Bogle's book (click on the link above, you can read it in a weekend and it is written for the novice investor), dump all your mutual funds and put your money into index funds.....

Dow - Something Brewing?

Dow has been the subject a quite a few rumors lately:

First, a British newspaper printed a rumor in February that a group lead by KKR and Carlyle were going to make a $60 a share offer for the company. I went on record at the time with my plea to CEO Andrew Liveris to not sell the company. The rumor subsided (did not "go away") and then market was hit with the events of the past two weeks that commanded everybody's attention.

Then, Tuesday on CNBC's "Mad Money" show Jim Cramer (who I beat to the punch on Google ) commented on the rumors admitting he has been waiting since February for DOW and AA to dip after takeover rumors which were printed a British newspaper. While he discouraged speculation on potential buyouts if the fundamentals are not strong, "the fundies for both DOW and AA are pretty good." According to the rumors, Dow could be purchased by private equity firms at $60 a share, a substantial premium from its present rate of $42.94. He noted the company has a 3.5% dividend yield, has been raising prices and cutting costs. "Buy Dow and Alcoa because when there's smoke, there's fire." Now, while I am not a fan of Jim's bi-polar investment style, I do place value on his market commentary and the insights he gives on the "why" things happen. I also assume that he has plenty of "friends in high places" on Wall St. and given his obvious egomanism, he would not lend credence to a rumor unless the was a good chance there was actually something there. That is not to say that the interested parties are KKR and Carlyle specifically but that Dow is highly undervalued and people are taking a real close look.

Now there are rumors that Dow an India's Reliance Industries are considering a joint venture or a merger. India's top petrochemicals maker, Reliance Industries Ltd , is set to form a joint venture with Dow Chemical Co. for plastics and chemical businesses, the Economic Times said on Thursday."Talks are at an advanced stage and the two sides are expected to make a formal announcement by the weekend," the newspaper said, quoting unnamed sources. Top Reliance officials led by Chairman Mukesh Ambani are scheduled to meet Dow Chief Executive Officer Andrew Liveris and a memorandum of understanding may be signed. A Reliance spokesman denied a deal was in the offing, the newspaper said, while a Dow spokesman said it was not the company's policy to comment on rumors about itself or its activities. The newspaper said Dow was unable to unlock the full value of its huge commodity chemicals and plastics business because of rising cost of feedstock and raw materials in the West. Dow's basic chemicals and plastics business would be spun off into a separate company, with Reliance paying about $12 billion for its stake and Dow picking up the remainder, the paper said in an unsourced report. The Economic Times had reported on Thursday a deal could be be finalized soon and that the two companies were expected to make a formal announcement by the weekend. The Times of India said Reliance would hold the right to buy Dow's proposed 41 percent holding in the joint venture if a third party offered to buy the American firm's stake. Reliance was likely to fund the joint venture by selling some of its stock either to Dow directly or to investors and then investing the cash in the joint venture, the Times of India said.


In my plea the Liveris I expressed my belief that Dow was worth far more on its own long term to me than the quick $60 payoff a buyout would bring. If this joint venture comes to fruition, he would at least seem to believe the same and is taking steps to unlock Dow's long term value. Since taking over in 2004 Liveris has done a brilliant job fixing Dow's financial ship and is now embarking on growth and expansion. The easy thing for him to do would be to cash out at the $60 and walk away. The right thing for us shareholders is for him to keep doing what he is doing..

The business is financially sound and growing. It's stock price is well below its real value and people are starting to notice. It was only a matter of time.

This Panther Is Ready to Pounce

Owens Corning (OC) held an investors conference on Wednesday, March 7th.. These things are usually a regurgitation of the most recent earnings call and to be honest, rather dull but, there were a couple of important take aways here that have me more enthusiastic about my investment than ever:

Management estimates income from operations in 2007 to be $415 million ($4.02 a share), down from $433 million ($4.20 a share) in 2006 for a 4% decline. Bad news? No. This is based on housing starts consistent with NAHB estimates of 1.56 million (down 14%). It does NOT include additional profits from the St.Gobain joint venture expected to close in mid 2007, nor does it include revenue from the expected sale of the vinyl siding business and it also assumes a hurricane season similar to 2006 (almost non existent) and the effects of the 5% stock buyback recently announced are not considered. In short, this is a painfully conservative estimate which is something I like to see.

Why is it conservative? Could we have a worse hurricane season that the ZERO major storms we had in 2006? No. Is there a chance it will be equal too? Yes, But that result is what these earnings estimates are based on. Will the St. Gobain venture get regulatory approval? Yes, the question is not "if" but "how much" it will add to earnings. Will they sell the siding business? Yes. None of these events are included in the 2007 estimate and all will add to 2007 earnings. Because management at OC has no way of knowing the "how much", they omitted their potential contribution. Good.

Now for housing, could it get worse? Yes. Will it? Not if you believe Toll Brother's (and me) who expect things to turn around late this summer. Let's assume it does get worse, OC did say that things would have to "dramatically deteriorate" for them to lower their forecast. I for one think we are at the housing trough and things are due to begin to climb. Now, that may take 4 months or a year, but OC has based its earnings, production and pricing forecasts on a 14% year over year decline. Any improvement here quickly adds to the bottom line. The following may an odd barometer but if nothing else it will teach us to pay attention to things other than our traditional data sources. I have a friend who is a firefighter. We were talking recently and he was saying how he has been really busy at work lately. When I asked why, he said "fire alarm inspections." When a property is bought or sold, a fire alarm inspection certificate is required on the property (both residential and commercial). The more work my friend does, the more properties are changing hands. He said the past 3-4 weeks have been unusually busy. This may be just a seasonal trend or a sign of a housing turn around but, either way, it is not bad news. Now, if this gauge is accurate it may not show up for another month or so in the housing data since inspections are done before the closing on the property. I will be paying close attention.

So, what do we have? An estimate of earnings that assumes a worse case scenario for hurricanes, a negative housing view and one that does not include the value of a segment sale and join venture. If the buyback is completed this year, it alone will boost earnings of $415 million to $4.23 a share excluding all other factors.

An interesting note here. There was a great discussion (and I think the analysts missed this as I have not read anything else on it) on the hurricane effect. In anticipation of the "end of the world" scenario forecasters gave us prior to the summer of 2006, OC ramped up production of asphalt shingles. They did this during the late spring and early summer as these forecasts began coming out which, unfortunately also happens to be the most expensive time of year to produce these shingles (demand for asphalt is higher). Even in low grade hurricanes (Cat 1 or Cat 2) the majority of damage is roofing related. As a result of the invisible 2006 season that resulted, OC was left with an unprecedented surplus of expensive shingles that then commanded lower prices due to the non-existent demand. This inventory has since been worked off and prices have firmed. Why does this matter for 2007? An active 2007 hurricane season of any substance (by "any" I mean more than zero) will help offset housing weakness. An extreme season has the potential to make the housing market almost irrelevant. Another rather morbid result of an active hurricane season is that it does stimulate the housing market by creating unanticipated demand for new housing. Please do not email me claiming I am hoping for hurricanes so I can profit. I am not, but we need to be realistic. As unlucky as we were in 2005, we were just as lucky in 2006. Somewhere in the middle is the number of storms we should anticipate and it is far greater than zero. They are as inevitable in the South as snow is here in New England. That being said, a return to mere "normal" hurricane levels will provide OC with a substantial boost to earnings. How much? This segment's sales which are about 25% of the total fell 38% last year. Even if this sales level stays the same, the lack of abnormally high priced inventory will improve earnings here.

In short OC has done a wonderful job of dampening expectations so that they are able to blow them away later or, if everything does go wrong, they are then able to meet them Even in the worse case scenario you have a company selling for just over 6 times earnings and buying back its stock Look for the first two quarters to be a bit slow with things really ramping up in the second half of 2007. Remember, as value investors we want to get in when things are at their worst, all of OC's markets are in troughs now yet they are managing the business brilliantly through it, when things eventually turn around (they always do)...... boom

In the cartoon the Pink Panther always won.....what makes you think he won't now?

Moody's - Flunking Out At Lampert U

"What we've got here.........is a failure to communicate. Some men you just can't reach...." Strother Martin in "Cool Hand Luke"



Yesterday I was doing my reading on Seeking Alpha and came across Chad Brand's blog The Peridot Capitalist and his post pertaining to RadioShack (RSH). Since he was the first to recommend it as far as I know, I will direct you to his site when my posts reference them (got to give credit where it is due). Moody's investment rating services recently downgraded the debt of The Shack saying:

"Moody's Investor Services downgraded RadioShack Corp.'s long-term senior unsecured rating and short-term commercial paper Monday on lackluster sales and operations. The ratings agency lowered the electronics retailer's senior unsecured rating to "Ba1" from "Baa3." The move means the company's senior unsecured rating is no longer investment grade. Moody's also cut RadioShack's commercial paper rating to "Not Prime" from "Prime-3."

After reading it, the first thing that came to my mind was Sears Holdings (SHLD ) as the similarities are stunning. In his annual shareholder missive, Chairman Eddie Lampert lamented:

"We ended the year with more cash on hand than debt. On a combined basis (including Sears Canada) we have $4.0 billion of cash and only $2.8 billion of debt (excluding capital lease obligations of $0.8 billion). Domestically, our $3.3 billion of cash exceeds our debt balance of $2.3 billion (excluding $0.7 billion of capital lease obligations). Furthermore, approximately $350 million of the outstanding domestic debt represents borrowings by our Orchard Supply Hardware subsidiary, which is non-recourse to Sears Holdings. Despite the conservative nature of our capital structure and our improved profitability, the rating agencies have not upgraded us and continue to hold a non-investment grade rating on our debt. We believe Sears Holdings is an investment-grade company; the lack of response by the agencies is puzzling and is certainly something we continue to hope will change."

Luke: Yeah, well, sometimes nothin' can be a real cool hand.

Why is this a big deal? The downgrade, aside from being a negative in the eyes of potential investors means that when Sears and Radioshack do borrow money, it will cost them more. What did Radioshack due to deserve the downgrade? They had lower sales (it should be noted this was inevitable to fix The Shack). When CEO Julian Day, an Eddie Lampert U graduate took over Radioshack, it was stuck in the dead end loop of growing sales and decreasing profits. In an attempt to "just get bigger", Radioshack fell into the "sales at all cost" mentality. It worked. Sales increase but the unfortunate cost of those sales was decreased profits. This apparently is fine with Moody's as Radioshack had an "investment grade" rating on its debt (memo to Moody's: This is bad). Day recognized that this was an unsustainable business model and that unprofitable locations had to be closed and the system wide discounting that was crushing margins and profits had to stop. The result of this would be lower sales initially but if done properly, increased profits. It worked as 4th quarter profits jumped 55% (Day took over in June) and crushed "analyst" expectations. In almost a year now, Day has decreased debt at Radioshack by 30% and increased cash on hand by a whopping 110%. According to Moody's this was bad?

Boss: Sorry, Luke. I'm just doing my job. You gotta appreciate that.
Luke:: Nah - calling it your job don't make it right, Boss.

Both Sears and Radioshack have business model that Moody's clearly just does not understand. Here is the really odd part, they both have the ability at this second, to write a check and pay off all their debt and, have plenty left over! How can any reasonable person consider this a negative? This is even more bizarre when you consider that when both Day and Lampert took over their prospective companies, neither had the ability to pay off even 1/2 their debt and Radioshack was then considered "investment grade." Let's pretend you are applying for a mortgage. You have $250,000 in the bank , no other debt and are asking for a mortgage of $175,000. What would you say to the loan officer if he claimed you were a "bad credit risk" because as a sales person you only made $95,000 vs the $100,000 you made the year before (Radioshack had a 5% sales decline in 2006 vs 2005)? Personally, I would resist my initial urge to assault them and then inquire as to what they had drank or smoked for breakfast that morning.

What is Moody's communicating to retailers? Sales are what count. Annoying things like profits, debt levels and cash levels are secondary. Lampert and Day are both saying by their actions that they have this cute little idea that profits and increasing shareholder value are what really count. Both Sears and Radioshack are in the best financial condition in years yet Moody's just can't seem to grasp (or refuses to) the Lampert U concept. Thank god for us shareholders that Lampert and Day ignore Moody's and do not manage their business's to appease them..

Maybe a "night in the box" will help Moody's see the light.....Don't get it? Watch the movie

Taking A "Leap"

LeapFrog Enterprises, Inc. (LeapFrog ) designs, develops and markets technology-based educational products and related content, dedicated to making learning effective and engaging. The Company designs its products to help infants and toddlers through high school students learn age- and skill-appropriate subject matter, including phonics, reading, writing, math, spelling, science, geography, history and music. Leapfrog's products include learning platforms, which are affordable hardware devices; educational software-based content, such as interactive books and cartridges, and standalone educational products. The Company conducts its businesses through three segments: United States Consumer, International, and Education and Training.

Since 2004, LF has been a subsidiary of Mollusk Holdings, LLC, an entity controlled by Lawrence J. Ellison. In 2006, the Company purchased software products and support services from Oracle Corporation (ORCL) totaling $391. As of December 31, 2006, Lawrence J. Ellison, the Chief Executive Officer of Oracle Corporation, may be deemed to have or share the power to direct the voting and disposition, and therefore, to have beneficial ownership of approximately 16,750,000 shares of the Company’s Class B common stock. The Class A common stock entitles its holders to one vote per share, and the Class B common stock entitles its holders to ten votes per share on all matters submitted to a vote of stockholders. Lawrence J. Ellison and entities control of approximately 16.7 million shares of the Class B common stock, which represents approximately 53% of the combined voting power of our Class A common stock and Class B common stock mean that as a result, Mr.. Ellison controls all stockholder voting power. I cannot decide if this is a good or bad thing. Larry is no dummy but, when you are worth $20 billion, one has to wonder how much interest he has in a company that in its best year earned $74 million. Now $74 million is not a large amount, but when you consider there are only 63 million shares out there, it does not take much to make the stock move and his investment is $167 million. I am guessing he is loath to lose any money no matter how small the amount so I will side with the "good thing" side until proven different.

LeapFrog’s business is highly seasonal, with retail customers making up a large percentage of all purchases during the back-to-school and traditional holiday seasons and although they are expanding their retail presence by selling products online as well as to electronics and office supply stores, the vast majority of U.S. sales are to a few large retailers. Net sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for approximately 70% of U.S. segment sales in 2006 compared to 80% in 2005 and 86% in 2004.

Sales in all segments declined during 2006 primarily as a result of significant reduction in the sales of LeapPad family of products whose design was overhauled. They increased their promotional activities to reduce existing FLY Pentop inventories as they plan to replace the FLY Pentop Computer with the FLY Fusion Pentop Computer in 2007. Sales of screen-based products were down slightly as retailers worked off excess inventories. Retailers’ inventories fell an estimated 40% at the end of 2006 compared to the same period last year, which also negatively impacted 2006 sales. To invigorate sales and margins, the company plans to introduce many new products in 2007, including the afore mentioned FLY Fusion PenTop Computer system, the largest launch of Leapster software titles (many of these will be licensed products through Disney (Cars, Nemo etc..). Nickelodean, and others), a ClickStart My First Computer system, and other products geared toward infants and preschool children.

The 2006 results? LeapFrog went from 28 cents a share in earnings in 2005 to a loss of $2.31 in 2006. That makes 2006 a "do over" year, meaning that new management realized the need to "do over" their main product lines and used 2006 to clear the deck. Now, it should be noted that the new team that did the deck clearing has an impressive resume. Let's look at them:

Jeffrey G. Katz, Chief Executive Officer and President since July 2006 and as a member of the board of directors since June 2005. Mr. Katz served as the Chairman and Chief Executive Officer of Orbitz, Inc. from 2000 to 2004.

Nancy G. MacIntyre, Executive Vice President, Product, Innovation, and Marketing since February 2007. From May 2005 through January 2007, Ms. MacIntyre served on the executive team at LucasArts, a LucasFilm company, most recently as Vice President of Global Sales and Marketing. Previously, she had been with Atari, Inc as Vice President, Marketing from 2001 through 2005 and with Atari, Inc.’s predecessor Hasbro Interactive from 1998 to 2001 in senior sales and marketing positions.

Martin A. Pidel , Executive Vice President, International since January 2007. From 1997 through December 2006, he served in varying capacities with HASBRO, Inc. including key roles in Europe and the US, most recently as Vice President of International Marketing.

Michael J. Lorion , President, SchoolHouse since December 2006. Prior to that, he served at varying capacities at LeapFrog since June 2005. Prior to joining LeapFrog, Lorion served in different capacities at palmOne, Inc. from February 2000 to April 2005, most recently as Vice President, Vertical Markets Sales & Marketing.

While I expect these changes will improve performance, I would not expect them to contribute substantially until after 2007, due to the lead time associated with product development, and due to the year end seasonality that drives substantially (75%) all sales volume. So, expect a modest sales decline in 2007, improved gross margins from 2006 due to 2006 inventory reduction efforts and improved product mix and a decline in operating expenses from 2006, consistent with the decline in sales. Overall, expect a loss in 2007 but, I expect it to be significantly less than the loss for 2006.

Okay Todd, so why would we invest? A couple of reasons:

Cash:
Currently Leapfrog is sitting on over $200 million or $3.22 a share in cash. This is cash from operations since debt stands at zero, not "cash from financing". Using our "if we were to buy the whole company" process, if we were to pay todays price of approx. $10.50 a share, we would be essentially be getting cash back of 30%, reducing our actual cost to $7.28 a share. This makes LeapFrog a potential takeover candidate in my mind but that is not a reason to invest. Now, here is where it gets interesting. By using that cash, they could in theory buy back 20 million shares of 1/3 of the company. They won't and here is why. Just like share buybacks increase EPS when you are making money, they increase losses per share when you lose money. For instance, if you have 10 shares outstanding and lose $1 your EPS is -$.10 a share (10 divided by -$1). Now if you buy back 5 of those shares your loss per share jumps to 20 cents a share (5 divided by -$1). So, do not expect a share buy back in 2007 but, I would expect one in 2008 and this has the potential to make 2008 earnings per share to explode to the upside (that is the interesting part).

Debt:
None and the best news is none will be needed for the current plans of management. They have a $75 million line a credit that has not been tapped.

Products:
I have seen the new LeapFrog products and they are great. They are usable by my 4 year olds and are educational, not just entertaining. The quality is good, meaning they would have to work at breaking them and they are affordable. A Leapster Learning Game System in Target runs about $60 and the games are about $20-$25 a piece. Best of all, the kids really love them and they are learning (to read and write, not blow things up, it's the little things).

Costs:
Capital expenditures for 2007 will be similar to prior years. In 2006 and 2005, capital expenditures were $20.1 million and $16.7 million. Much of the heavy R&D work on new products is done and those costs are in the 2006 results. 2007 will see the fruits of them. Account collections have been reduced from 90 to about 45 days.

Other Shareholders:
Marty Whitman who runs Third Avenue Management LLC and has one the best track record in history (disclosure: my son's Coverdale accounts hold positions in his Value Fund ) holds 8.6 million shares (almost 14%) of the company. Marty was an early investor with Eddie Lampert in both Kmart and Sears (we know how that turned out) and still holds a large position there. It behooves us to look closely at his actions.

What To Do?
At just over $10 a share I am going to take a "Leap of faith" (pun intended). Based on the first 6 months of Mr. Katz's reign, he is doing everything right. Keep your position small because it is a bit speculative and the payoff will most likely be a bit off down the road. It will be added to the portfolio at the price I purchased it on Monday ($10.54) and this post hit the site the Tuesday giving Enhanced Features Subscribers a day to get in early. Here is how I did it. I bought the shares on the market and then sold a Sept. 2007, $10 put. This lowered my effective purchase price by 81 cents or (7.6%). Should the price fall, this does give us some downside protection. Should the price fall below $10 and we get "put" the shares, meaning we have to buy additional shares at $10, the trade is a plus as long as shares are above $9.19, ($10 minus the .81 cents we received for selling the put). If after Sept, the share price of LF is above $10, we keep the premium and maybe do it over again. All prices are the actual trade prices.

The option will be accounted for in the portfolio at it's sales price. Since I have no plans to "buy it back", the only price of it that matters is the price we receive. Now, if after Sept. it is not exercised, its proceeds will be reflected in the portfolio by a reduction in our purchase price of our original shares.

Be prepared for more put selling for some of out "watch list" shares.

Ignore The "Noise"

"If a business does well, the stock eventually follows." Warren Buffett

The past two weeks have been the perfect example of why, as an investor you must ignore the market action as it pertains to your existing portfolio and focus on the reason you bought shares of the companies in it in the first place. I am going to use my favorite and largest holding in the ValuePlays Portfolio, Sears Holdings (SHLD) as an example.

We first have to remember the reasons why we bought Sears:
1- Retail operations improving
2- Increasing cash hoard for Eddie Lampert to invest (this is a large part of the "value" in SHLD, his 16 yr. track record of 28% annual returns)
3- Reducing debt and shares outstanding
4- Growing profits


Now we have to look at the past two weeks and follow the events of them. We will then see why we were wise to ignore those events and then what that did for us. Feb 26th saw the S&P (.INX) begin what would end up being a 5.2% decline over the next two weeks (it should be noted we added another 1.7% to our lead over the S&P during this slide). If you picked up a paper or watched CNBC you were inundated with dire prognostications.

We had Alan Greenspan aimlessly wandering around the Asian continent incoherently mumbling to any innocent bystander who would listen the US had a "1/3 chance of recession by the end of the year". It was only after officials found him, reminder him that he no longer was the head of the Fed and that all economic indicators point to the opposite, he changed his statement to, "it is possible we could get a recession toward the end of this year, but I don't think it's probable." Right, and it is also possible your reporter wife Ms. Saywer was first attracted to your chiseled looks, not your decades long access to Washington's inner circles, but not probable. Alan, its over buddy, go home, take a bath, read a book, do whatever, just please shut up, Ben's the guy now. Your predecessors where classy enough to be quiet and let you do your job, lets try to exhibit the same to Mr. Bernake and let him do his.

In Asia, the Bank of Japan raised rates 1/4 of a point. This set off a chain of events as people who had borrowed (we are talking billions of dollars here) money in Japan where it was cheaper to buy stocks here no longer enjoyed the lower rate (the "carry trade" you have heard about). This caused them to to then have to sell the stocks they had bought with that money to have to pay off those loans, putting downward pressure on the market.

We then had a sub-prime (these are mortgages given to the most risky prospects) mortgage implosion which, for some reason seemed to make everyone panic. They were actually surprised that when you give as person with a marginal credit history a mortgage you know they probably will eventually not be able to afford, they default on it. The only surprise was that it did not happen 6 months ago. The fear was that the defaults "would spread into the prime market". Right, so because my neighbor bought a house he could not afford with financing he was not really qualified for and invariably defaulted on his loan, now I should on mine? This is the type of logic we are dealing with folks...

To top it off we had a home builder executive telling us in no uncertain terms that "2007 is going to suck". An important note here: January 2007 home figures were the 3rd highest in history (despite the declines), this "sucks?" What he really should have said was "look we are fools, we bought way to much land because we thought the party would never end and now it is time to pay the piper." Real estate has been in a bubble phase for 5 years now and just because they got stuck with their pants down does not mean it will suck, it just won't be as good. Nothing goes up at a record rate forever and home-builders bought land and started building homes like it would. These guys are like a lottery winner who, after getting his winnings sprints into the nearest bar yelling "the drink are on me". He then proceeds to fill up the bar with booze, turn around and only then realizes he is at an AA meeting.

All these events, when looked at individually were probably not enough to cause the problem but when you consider the S&P had not had a significant drop in almost a year (remember nothing goes up uninterrupted) you had the mix for panic. We got it.

In the middle of this mess Sears released 4th quarter and full years results. On March.1, the day of the earnings report, shares opened at $180.25 a share. What happened?

Profits- Increased 27%
Debt- Reduced by $815 million
Shares Repurchased- $429 million
Cash On Hand- $4 billion
Retail Margins- Improved 25%

On every metric we bought shares in the company on, it has improved. Would anything you saw make you think about selling your shares? Me neither. But lots of people, listening to the noise above and ignoring these results did as shares dropped $4 that day to $176. Those of us who sat tight and laughed at the panic stricken hoards watched as shares not only climbed out of the hole, but finished this past week at $180.38.

"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years" says Buffett. If the market was shut down and you looked at Sears last earnings report you would be thrilled, do not let to those who trade pieces of paper and do not "buy pieces of companies" affect your outlook of an investment, let the investment itself do that. The past week and a half saw a ton of "noise" and ton of panic but, those of us who stayed calm and focused came out just fine.

To quote Jesus (of the traders), "They know not what they do...."

More Great Value Blogs

Here are couple more of my favorite sites. Both of these are littered with the wisdom of Buffet. It is my belief that you cannot read enough Buffet because it is necessary to reinforce the tenants of value investing and calm yourself during turbulent times like the past two weeks. If you are a regular ValuePlays reader I would suggest checking out these sites as the sentiment I express is echoed here.

Fat Pitch Financials

Fat Pitch Financials is a value investing and personal finance blog.

George seeks to invest with a wide margin of safety in companies that have wide moats (i.e., sustainable competitive advantages). This is very similar to Warren Buffett's style of investing. We both try to wait for so called "fat pitches".

While he waits for these fat pitches, he also researches arbitrage and special situation opportunities that provide individual investors an edge in short term opportunities. These include going private transactions, odd-lot tender offers, spin-offs, split-offs, and other opportunities. The inspiration for this type of trading was Joel Greenblatt, as well as Warren Buffett.

The current going private transactions table that he maintains is what originally attracted many of Fat Pitch Financials' readers. That content, along with most of my other special situation tracking, is now in the premium section of Fat Pitch Financials called Contributor's Corner.

He tracks two portfolios at Fat Pitch Financials so my readers can know how he's doing. The first portfolio is the Fat Pitch Financials Port that is a virtual portfolio tracked at Marketocracy. This portfolio focuses on "Fat Pitch" discoveries.

The second portfolio, the Special Situations Real Money Portfolio, is a Coverdell Education Savings Account he started for his son at about the time Fat Pitch Financials started in 2004. This portfolio is very small and focuses on going private transactions and other special situation opportunities. It is based on the research provided in Fat Pitch Financials Contributor's Corner.

Value Investing News

Value Investing News is a community driven value investing news site.
You can submit links to news items, bid up stories to the front page, bid down stories, and make comments. There is also a forum and a user powered link directory is starting to roll out.

Members are rewarded for the success of Value Investing News by sharing in the Adsense revenue.

There is also a monthly user contest. This month they are giving away a free pass to the Value Investing Congress West (This is the most valuable prize so far.)

Value Investing News leverages several web2.0 technologies including social bookmarking, social networking, user powered ratings, collaborative filtering recommendations, RSS feeds, and a submission bookmarklet. The goal is to harness the network effect of web2.0 technologies to help fellow value investors save time following the news.

Eddie Lampert's Annual Letter- SHLD

Last weekend I listed what I thought were the notable comments from Warren's letter to the Berkshire Hathaway shareholders. Since I have entrusted the largest portion of my personal portfolio to Eddie Lampert at Sears Holdings, I ought to post the important "notables" from his.


Retail Operations
"Lands’ End had a record year in profitability in its traditional business (i.e., catalog, online, and inlet stores). In addition, we saw a significant improvement in the profit performance of Lands’ End merchandise in our Sears stores. With a new leadership team and a more integrated approach to working across Sears Holdings, the business is moving in the right direction. Our customers are embracing the opportunity to buy Lands’ End quality merchandise in our stores, on the phone, and on the Internet, and we are working hard to make Lands’ End available across more of the chain."

If anyone has seen the Land's End "store in a store" concept in Sears, it is a real winner. I am fast becoming convinced that the future direction of Sears apparel will predominately be Land's End merchandise.

"Home Services is another business that achieved a record year of profitability in 2006. Home Services is not only a highly profitable business for us, but also an important strategic asset as it provides a point of differentiation from many of our competitors."

"The apparel businesses at both Kmart and Sears also showed continued improvement. Kmart is further along in partnering with our sourcing and design groups, and we believe that we have improved our offering for our customers with higher quality, better fit, and appropriate fashion at great value. Sears apparel has turned around the decline that occurred in 2005 when it moved away from the styles our customers wanted to buy. The team has made significant progress this year, and is focused on creating the kind of breakthrough improvement that would return Sears to its previous levels of profitability in this area."

On Cash flow

While we like to think of ourselves as a start-up, we are different from most start-ups in our cash flow generation. Since the merger closed in 2005, we have demonstrated a consistent ability to generate cash flow. This strong source of cash provides us the flexibility to deploy capital in the manner that we believe is best calculated to create long-term shareholder value. (Emphasis mine).

Ratings Agencies

We ended the year with more cash on hand than debt. On a combined basis (including Sears Canada) we have $4.0 billion of cash and only $2.8 billion of debt (excluding capital lease obligations of $0.8 billion). Domestically, our $3.3 billion of cash exceeds our debt balance of $2.3 billion (excluding $0.7 billion of capital lease obligations). Furthermore, approximately $350 million of the outstanding domestic debt represents borrowings by our Orchard Supply Hardware subsidiary, which is non-recourse to Sears Holdings. Despite the conservative nature of our capital structure and our improved profitability, the rating agencies have not upgraded us and continue to hold a non-investment grade rating on our debt. We believe Sears Holdings is an investment-grade company; the lack of response by the agencies is puzzling and is certainly something we continue to hope will change. Then again, we have taken these measures not out of a desire to please the rating agencies, but rather because we believe they are the right moves for our Company at this time.

Derivative Instruments

Our disclosure in 2006 that we had entered into total return swap transactions generated a fair bit of media attention and speculation. Perhaps this was prompted by the disclosures that we provided relating to the risk of the investments. As we disclosed in our filings, these total return swaps are derivatives, a term used broadly to describe a vast spectrum of financial instruments, which often have very different characteristics and purposes. Derivatives are so labeled because their value is tied to, or "derived" from, the value of one or more defined underlying indices, prices, or other variables. But it is important to remember that derivatives come in a myriad of forms and carry various levels of risk.

In our case, we entered into total return swaps, whose value is directly derived from changes in the value of the underlying securities. We could have purchased the underlying securities directly, but we elected to make our investments in the form of total return swaps because it can be a more efficient and cost-effective means of managing capital. As of February 3, 2007, the notional value of these derivatives was less than $400 million.

While we chose to include risk disclosures to make clear that, as with all investments, there is risk associated with the total return swaps, it is also the case that every company takes risks every day. Indeed, business is about managing risk. When these risks come in other forms, they are not always accompanied by the same level of detailed disclosure in public filings. Doing business in California will always carry "earthquake risk" and doing apparel business in winter clothing will carry "weather risk." Investors and executives focus on some of these risks and tend to overlook others. If a company’s risk-management process is a robust one, the level of focus will be proportionate to the amount of risk and the probability of the risk occurring, as well as whether or not the risk can be effectively managed. At Sears Holdings, we try to manage risk in an effective way - whether it is in our investment decisions, our real estate decisions, or our product line decisions - and we are prepared to take risks where we believe the probability of success justifies the investment. We will not always be successful, but if we do a good job of evaluating opportunities and executing on them, we believe that our shareholders will be well rewarded.

A Strategy of Disciplined Growth

As we look ahead, I want there to be no doubt about one thing: It is certainly our intention to grow Sears Holdings. Some commentators have asserted that we want to shrink the Company, but that is simply not so. No great company would aspire to become smaller, and we certainly do not. But before embarking on a growth plan, it is critical to provide a sound base from which to grow. To this end, we have set out to improve the profitability of our business model. Our objective is disciplined growth. We do not want to grow simply for the sake of becoming bigger. Rather, our aim is to become more profitable, and as such we need to ensure that any revenue growth occurs at an appropriate level of profitability.

As we have said before, we do not want to spend $1 too much or $50,000 too little on our stores. Unless we believe we will receive an adequate return on investment, we will not spend money on capital expenditures to build new stores or upgrade our existing base simply because our competitors do. If share repurchases or acquisitions appear to be more productive, then we will allocate capital to those options appropriately. We will seek superior returns, wherever they may be found.

Many of our largest competitors, on the other hand, are primarily focused on growing their top line. To that end, and consistent with the conventional wisdom, they are quickly building new stores. This is a highly capital-intensive way to try to drive returns for shareholders, but provided the return on their investment in new stores is more attractive than their alternatives, it may be the best use of capital for them. Over the past three years, by contrast, we have shown that there are other ways to create value for shareholders. Sears Holdings’ stock has been one of the top retail performers for each of the past two years, as was its predecessor Kmart in 2004, in spite of this non-traditional approach.

We believe we have managed to create a lot of value for shareholders without excessive spending partly because of our disciplined stewardship of our shareholders’ capital. For Sears Holdings, in the near term we believe the greatest value will come not from increasing our store base, but primarily from better utilizing our existing assets to deliver more value to our customers and ultimately our shareholders.

Compensation

I believe one of the causes of the many well-known accounting abuses was this myopic focus on moving share price by driving short-term earnings. As we have explained, we do not attempt to manage earnings or expectations, we generally do not meet with Wall Street analysts, and, except in a few select cases, we have not provided options to our associates. Stock options can play an important role in compensation arrangements if handled correctly, and many companies have used them to motivate and compensate their executives and employees appropriately. The requirement that companies account for stock options as an expense is helpful in highlighting to investors and directors the cost of these programs.

At Sears Holdings, we have linked a very significant part of our executives’ variable compensation to the EBITDA of Sears Holdings or one of its businesses, adjusted for certain items that are not within the control of our associates. We consider EBITDA a superior measure of operational performance, as it provides a clearer picture of operating results and cash flows by eliminating expenses that are not reflective of underlying business performance. We have both a one-year EBITDA goal used for annual bonuses and a longer-term goal that is generally based on EBITDA performance that we have used for our Long Term Incentive Plans (LTIPs). Unlike some companies, which set targets at levels that are difficult to miss, we set targets that are achievable but require us to perform - it is important to set goals that challenge and stretch us.

Members Of The Military

One aspect of Sears Holdings’ commitment to the military - our Military Service pay differential and benefits continuation program - has received a fair bit of grassroots attention in the past couple of years. I have seen a number of emails and blog entries about this program, most of which ask whether it’s true or an urban legend. The initial skepticism is understandable, given the unfounded rumors and exaggerations that can circulate on the Internet, but in this case the program is real. For associates of Sears Holdings (other than certain part-time and seasonal associates) who are called to duty in the National Guard or Reserve, we make up any difference between the associate’s pay at Sears Holdings and his or her military pay - for up to five years. We will also hold a comparable position for an eligible deployed employee for up to five years, and allow those employees to continue most benefits while deployed. Since 2001, we have had over 3,500 associates participate in our military leave program; at present, there are about 400 Sears Holdings associates in the program. We are proud to support these individuals as they serve our Nation.

A Book, A Robbery & A Great Blog To Visit

Friday Tidbits:

* Publisher John Wiley has sent me a copy of "The Little Book of Common Sense Investing" by the legendary John Bogle. I will try to get through it this weekend and if I decide to recommend it will post an Amazon link here for you if you then wish to purchase it.

* Topps (TOPP).

Founded in 1938 as Topps Chewing Gum, and in its early years produced a popular penny "Topps Gum" from a factory in Brooklyn, N.Y. After World War II, the company developed Bazooka Bubble Gum, and in 1950, added trading cards to its product line. Baseball cards appeared in 1951 and quickly became a vital part of pop culture, a tradition that continues to this day, and includes football (both American and European) and basketball, in addition to entertainment cards and stickers and albums. In July 2003, Topps acquired WizKids, LLC a designer and marketer of collectible strategy games. Topps maintains offices in Canada, the United Kingdom, Ireland, Italy, and Argentina, in addition to the U.S. Topps also manufactures the popular lollipop brands marketed as Ring Pops, Push Pops, Baby Bottle Pops and other novelty candy and gum products. Now headquartered in New York City, the company has worldwide distribution, annual net sales for Fiscal 2006 of $293,838,000, and employs over 487 people worldwide.

Recently, Micheal Eisner lead group that offered $385 million for the company. In what might be the best and latest example of boardroom incompetence, Topps agreed to the buyout. This should be criminal. A cursory look reveals what I am talking about.

Topps
Cash on hand $81 million
Shares Outstanding 39 million
Debt - ZERO
Cash per Share $2.07
Offer Price $9.75
Closing Price Day Before Offer $8.91

Do you see where this is going? We have to subtract the cash on hand from the offer price because Eisner's group will receive that cash (and have no debt to pay off) once the deal closes. We then take the offer price of $9.75 minus cash on hand of $2.07 and we have an answer of $7.68. What does that mean? If you are a shareholder your management just agreed to sell the company 13.8% BELOW the current market value! If you are one of those "lucky" shareholders you now know how Ned Beatty felt in "Deliverance."

Here what it should look like, $8.91 closing price plus $2.07 in cash = $10.98 starting price for bids.

Fortunately there is a white knight: Topps director Arnaud Ajdler, along with the investment firm Crescendo Partners II, have launched a campaign to kill the deal. Crescendo owns about 6.6 percent of the company's shares, according to filings with the Securities and Exchange Commission. Ajdler is also a managing partner of Crescendo. In his filing he says "Since the Board of Directors has decided to pursue this transaction over the significant concerns which I have continually and repeatedly voiced to the Board, I intend to actively solicit votes and campaign against the proposed transaction."

Here's hoping he succeeds.........


Recommended Blog:

Gannon On Investing

"Value investing blog and value investing podcast influenced by Benjamin Graham, Joel Greenblatt, and Warren Buffett's value investing model. Built upon the value investor insights of intrinsic value, margin of safety, competitive advantage, and protection of principal."

Basically, it's a value investing blog with longer articles about investing concepts, specific stocks (analysis), and the market (at least insofar as my normalized P/E posts go). He has some stuff from three other contributors in the "Columns" and "Book Reviews" sections.

Some people might like the "Encyclopedia" section which links to and contain entries like this one:

Finally, there's the directory of other investing sites. Also, there's the podcast - new visitors might enjoy listening to the podcast episodes.

He does a "20 Questions" series with other bloggers that is something I enjoy (and will be features on soon)

Some of his best work is on "normalized PE ratios", definitely worth checking out.

Ethanol- Debunking A Few Myths

Since President Bush is in Brazil this week to talk about ethanol, I though it would be appropriate to present portions of a paper by Vinod Khosla, a venture capitalist who, for those who do not know him was a internet pioneer and a founder of Sun Microsytems. You can view a bio of him here. Kholsa is himself investing millions of his own dollars building ethanol plants. The paper here, is very long and detailed. I am going to present the most topically relevant items based on what the media usually presents.

Much has been said about the energy balance of ethanol:

Kholsa answers:
"Energy balance is not even the right question to answer. It is not the energy balance of ethanol that matters but the energy balance of ethanol relative to the energy balance of gasoline. Dr Wang at Argonne National Labs has built one of the most rigorous and transparent public models for energy balance calculations. His results indicate that corn ethanol has almost twice the energy balance compared to gasoline, yet this crucial fact is seldom mentioned in the press. According to the majority of studies, corn ethanol has an energy balance between 1.3-1.8 while gasoline is substantially worse, at about 0.8 (since it takes energy to extract, transport, refine and handle gasoline). Electricity has an energy balance four times worse than corn ethanol. Do we stop using electricity? No, because as Dr. Wang concludes, this is not even the right question. Dr. Wang goes on to say that energy balance is “not a meaningful number for any fuel in evaluating its benefits”.

Why then does the press continue mentioning it? Why do they fail to mention that electricity has a substantially worse energy balance than ethanol? Do they recommend we stop using electricity? What is often inferred by the press is that it takes more petroleum to make ethanol than is displaced. This is emphatically NOT true, even in the most vintage of plants. Ethanol causes a very significant (more than 90%) reduction in petroleum use. The debate in scientific circles is about whether producing ethanol uses more fossil energy (not petroleum) than it creates. That is an entirely different question because if the objectives are lower cost gasoline replacement fuel, energy security and less reliance on imported oil, then in fact converting non-petroleum forms of fossil energy (mostly natural gas in the case of corn ethanol plants) into ethanol would be a perfectly acceptable strategy, especially since the production costs of a gallon of ethanol are lower today than the cost of gasoline produced from oil. Only when the climate change questions are addressed is energy balance even a relevant question (though carbon emissions per mile driven is a much more appropriate question). In fact if we have to pick an alternative to gasoline then ethanol is the best choice today.

More importantly it is a choice that starts a progression to increasingly “better” technologies and has far more room to improve technologically on feedstocks, development process, and ethanol and ethanol like fuels (biohols) that are more compatible with the existing infrastructure than alternative technologies. Equally important, ethanol is compatible and complementary to other petroleum reduction technologies like hybrids and plug-in electric hybrid cars. Even more critically, the key question is not energy balance but rather the greenhouse gas emissions. Certain energy sources like natural gas (the principal fossil fuel in the majority of ethanol plants) are much cleaner and greener than others, like coal. It is not the energy input but rather the total greenhouse gas emissions, from source feedstock, production and consumption of the fuel (per mile driven) that is most important according to the NRDC. Energy balance is the wrong question. Greenhouse gas emissions per mile driven is the right question."

Increasing Production Yields:

Not your father’s ethanol anymore: The energy required to produce corn ethanol is declining every year. Corn yields are increasing and fertilizer intensity is decreasing, further improving its energy balance. In five or so years we should start to see corn crops with a nitrogen fixation gene, materially reducing the fertilizer requirements and the energy consumption it entails. Even the crops used to produce ethanol will diversify. Sweet sorghum for example, uses a lot less water and fertilizer, can be harvested twice a year, and makes for a cost effective and environmentally better feedstock that can be grown on marginal lands, lands that ordinarily cannot be effectively used for feedstock. It is the major source of feedstock for ethanol being investigated in India. But such “optimizing” options will not be seriously pursued till after the market for corn ethanol is established. Once ethanol becomes a substantial market, all parts of the production process, crops & feedstocks, manufacturing, chemistries, transportation, and more will be the subject of intensive attention and innovation. The world does not stay still when large scale economics are involved.

As to the production process, again the Wall Street Journal reports that the Broin Cos., based in Sioux Falls, S.D., has pioneered a method to convert corn to ethanol at 90 degrees, rather than the previous 230 to 250 degrees, improving energy efficiency by 10% to 12%, according to co-founder and Chief Executive Jeff Broin. And E3 Biofuels LLC is finding ways to get more out of all parts of the corn, by building plants near dairy farms and feeding cows the byproducts of ethanol processing, then using energy from the animal waste to help power the plants. "Wastes are converted to valuable products, such as biogas and biofertilizers, which replace fossil fuels and their derivatives," according to David Hallberg, co-founder of Omaha-based E3. E3 Biofuels achieves an energy balance for corn ethanol of approximately five, using the Argonne National Labs GREET model – a number higher than what many cite for cellulosic ethanol! We have seen plants at every point in the continuum form old energy inefficient plants to highly optimized plants.

Myth: Not Enough Cropland

The next question we see a lot of fear, uncertainty and doubt about is the question of land and the related issue of food. Is there enough land to meet our energy needs? Beyond the traditional critique of ‘energy balance’ mentioned above, the question of land use is often cited by critics. If all the ethanol were produced using the ‘corn-to-ethanol’ process, we would simply not have enough land. Quite true, but equally obvious is the fact that relatively predictable pathways exist to cellulosic ethanol. Using switchgrass as an energy crop, the NRDC estimates we would need about 114 million acres of land. We need to look at this another way - 73 million acres of soybeans have been planted. Why can’t we do the same with energy crops? Instead of exporting soybeans we could be reducing oil imports. In addition we have 40 million acres of CRP lands. What if we used them for energy production by growing natural prairie crops like switchgrass (more likely grass “cocktails”) on them? Between export crops and CRP lands we have more than 120 million acres in this country. We believe that a fraction of our export crop lands could more than replace all our oil imports while improving our trade balance, increasing farm incomes, improving biodiversity in the fields, and making our fuel cheaper.

Improved efficiency in ethanol production and use of waste biomass like corn stover, rice husks, and sugarcane baggasse, leads to a smaller land area requirement. Former Secretary of State George Schultz and former CIA Director Jim Woolsey have estimated that, with some efficiency improvements, we will need only thirty million acres of soil bank lands to meet half our gasoline needs by 2025, in total, a small fraction of the land mass devoted to the soy crop. The Department of Energy estimates in an April 2005 report that 1.3 billion tons of biomass could be made available relatively easily from existing cropland, resulting in over a hundred billion gallons of cellulosic ethanol without changing agricultural practices materially.

Myth: Food Prices Will Go Up

To allay another common misconception, it is extremely unlikely that ethanol will be competing materially with food. The current process takes the starch from corn to make ethanol and leaves the protein and fiber for livestock feed. A current rule of thumb is that 1 lb of dried distillers grains (DDGs), the corn ethanol byproduct, replaces a ½ lb of corn and a ½ lb of soybean meal in a cattle feed ration. By the time we get to needing sufficient quantities of ethanol, we will be producing most of it from cellulosic feedstocks. This is why the land use arguments are incorrect. In fact many energy crops like switchgrass and miscanthus perhaps could make for excellent crop rotation plants with traditional row crop agriculture. The idea is to develop mixed grass “cocktails” that will serve as crop rotation crops for today’s row crops , increasing bio-diversity , while producing feedstock for liquid fuels. This mix will enhance the soil, keeping farmland more productive and biodiverse, according to the NRDC study “Growing Energy”.

Some impact on food prices is possible, even likely over the short term, but we suspect total household costs for food and transportation fuels will go down. It is worth noting that for the US as a whole we are most likely to do crop rotation of energy crops with traditional row crops like corn and replace export crops (like soybean) with energy crops. Export crops will be replaced by reduced imports with higher value to farmers and a better balance of payments for our economy. Since a majority of our agricultural land is used to produce animal feed proteins, the NDRC believes in the potential of producing cellulose for ethanol and feed protein simultaneously. The land use argument and the related food price argument really disappear in that case.

At the international level, why have the developing countries been fighting so hard to eliminate the food subsidies? The press likes to conjure up images of food supply shortages, when the reality is that we have had burdensome surplus crops in the last few years, large enough that the western world has to support its farmers with subsidies. There is no scarcity of food but rather a scarcity of income to buy it for the poorest of the poor. The current Doha round of talks on international trade broke down mostly over this issue.

Myth: Ethanol Is More expensive

Production costs and market prices are different things. Today, prices may be high caused by the rapid demand spike we have seen as oil companies have rapidly switched away from MTBE to avoid the legal liability they are incurring today, and to avoid the potential of additional liability they will surely incur from volatile organics, especially benzene, that are material components of today’s gasoline and are known carcinogens. The Foundation for Consumer & Taxpayer Rights released a new study of rising gasoline prices in California that found corporate markups and profiteering are responsible for spring price spikes, not rising crude costs or the switchover to higher-cost ethanol, as the oil industry claims.

But just as surely as profits are high and margins exorbitant for ethanol producers today, additional capacity, maybe even excess capacity is coming on line rapidly. There is more capacity under construction and under planning today (planned to be operational by 2008) than we have built in the last twenty years in this country. Payback periods for new plants are six months instead of the seven years investors would normally expect! Ethanol production costs in the US today are about $1.00 per gallon before any subsidies or taxes,

Myth: Ethanol Cannot Use Existing Infrastructure

Not really true. Brazilian experts laugh at these misleading assertions. Brazil has thousands of gas stations using the same tanks, pumps, tankers for transportation, some with minor modifications and Brazil is building new pipelines to transport ethanol. For sure not every tank or tanker can be used as is, and we have environmental regulations more stringent than Brazil that will require us to have new nozzles for our gas pumps, but the dollars required to achieve this are immaterial compared to the size of the market. For a multi-hundred billion dollar market, I estimate that to convert 10% of the stations to offer at least one E85 pump will take no more than a few hundred million dollars over about five years, or less than 0.1% of revenue annually. Many (but not all – and we only need 10% in my estimation to kick start the market) of the same pumps in the ground can be cleaned and adopted. Ethanol can be piped in pipelines contrary to popular belief, but not if the ethanol is going to be used as an additive to gasoline. Piping E85 or E100 ethanol is no problem since the small amounts of water it may pickup in the pipeline is only problematic when added to gasoline in low blends like E6 or E10 (6% and 10% ethanol respectively). But the opponents like to spread these myths as general roadblocks when it is only an issue for the narrow use of ethanol as a blend stock. There are thousands of leaking underground tanks at our gas stations and we have an existing multi-billion dollar fund for replacing leaking underground storage tanks (LUST Funds). When this “fix “ is done, we can use tanks that will accommodate both ethanol and gasoline. Maybe E85 is the reason to expedite the replacement of these leaking tanks?

I believe ethanol is the answer to our oil dependence. I said it in a previous post ValuePlays Portfolio member Archer Daniel's Midland, ticker (ADM) is the best way to go if you want to invest in it. ADM is already doing cellulosic research on current feedstocks. The process involves thermochemically treating corn hulls—or cellulose from corn waste—to allow part of the fiber to be fermented to alcohol. "We believe this process would boost our production of ethanol by 15% without requiring an additional ear of corn," says Woertz. "Cellulosic applications such as this, on existing feedstocks, may be as little as 2 years away. Other technologies, involving other feedstocks, may arrive in 5 to 7 years. "We believe that advanced levels of federal research and development will be needed to speed new solutions to market," she says. "Funding for this research should be technology neutral, feedstock neutral and look for the best solutions from all options.

PS. More irony... Do you Bush bashers out there have a hard time admitting that Bush "the oil man" has done more for the "alternative fuel" movement in this country than any other President? History will look at his Presidency as the turning point in these fuels from a novelty to mainstream acceptance.

AIG's Insurance Business: Not Really Improving

"AIG reported solid increases in income in 2006. Our results for 2006 were lead by our General Insurance business". AIG President and CEO Martin J. Sullivan (no relation) 3/1/2007


I make it a point to talk to my friends about the businesses they work in. This is not an effort to get "inside" information about a company, but to learn more about the businesses they are in and the challenges and opportunities they face. Last summer several friends of mine who practice personal injury law (worker's compensation and auto) were lamenting that AIG just "stopped settling cases." Now, had this been one person in one office in one state, I would have brushed it off as being associated only with him and not indicative of AIG business practices. But, when you have different lawyers in different states whose businesses are unrelated to each other saying the same thing, one has too wonder. I made a mental note about it and did not think too much about it after that. Recently, I was talking again to a few of them again and heard the same refrain from them, "AIG will not settle cases." I waited until AIG released their 2006 10-K and decided to dig through it to determine if their claims had merit. Let's break down some numbers: All the following pertain to the Domestic Insurance Operations.

Underwriting Profit. This is simple to determine. It is equal to Net premiums minus net losses (payments to insureds)

Personal (Auto) Underwriting Gain (Loss)- Millions
2005 $74
2006 $204
Domestic Brokerage (Workers Comp) Underwriting Gain (Loss)
2005 ($1.5) Billion
2006 $2.4 Billion

Conclusion? AIG experienced a gargantuan improvement in results in 2006. It should be noted that 2005 results here do not include losses from catastrophes like hurricanes, floods, etc. These numbers are from ordinary operations to make comparisons relevant. It should also be noted that Domestic Brokerage results are not all worker's comp (WC), but that is the category WC is classified in and AIG does not break it out. It is a fair comparison as WC is the largest single variable in this category so WC results have the largest impact on this segment. This improved profit picture alone does not prove our point though, it is possible that AIG wrote more policies and from those new policies netted more profits. Well let's look:

Domestic Lines Premiums Earned
2004 +5.6%
2006 +5%

For the past two years premium earned have been essentially flat so it cannot be responsible for the 540% increase in profits. Maybe they cut costs to the bone? Let's just look closer again:

Combined Domestic Expense Ratio
2005 21.0
2006 21.5

By looking at the expense ratio, we can determine that the percentage of expenses associated with domestic operations remained the same so this eliminates expense cutting as the cause of the gain. This tells us that $21 of every $100 in premiums went to expenses, virtually identical in 2004 and 2005.

Once the insurance company has premiums (float), they invest them. It is possible that AIG had a banner year investing the money and that accounts for the profit difference. The answer?

Return On Invested Assets
2004 4.4%
2005 4.7%
2006 5.6%

While investing results were improved, they do not account for the surge in profits. The investing benefit to earnings was that they had more to invest, not that they earned that much more on what they invested. So we still need to find the reason they had "more to invest".

Let's review, profits surged in 2006 and it was not due to additional premium's earned, expense cutting or abnormal investing gains. That leaves us only one way they could increase profits, pay out less claims. But that does not necessarily mean "they just stopped" settling claims and thus had to pay. Let's look closer again. In the insurance industry, there is a metric called the loss ratio. This number tells us out of every $100 in premium's, how many dollars are paid out as claims (losses). Barring a catastrophe, this number should be somewhat consistent year to year for a huge insurer like AIG. The following numbers are again excluding catastrophe losses in 2004 and 2005.

Combined Domestic Loss Ratio
2004 81.3
2005 82.5
2006 69.1

After consistent results in 2004 & 2005, AIG's results dramatically improved. These numbers mean that after paying out over 80 cents of every dollar in premiums in 2004 and 2005, AIG suddenly paid out only 69 cents of every dollar in 2006. While 11 or 12 cents of each dollar does not seem like much, when you consider AIG had $108 billion in revenue last year, a little bit easily becomes something big.

It is looking like my friends complaints may be correct but, there is one more necessary step we need to do before we can know for certain. It is possible that there just were not as many claims in 2006 so AIG by default paid less settlements and thus realized more profits. If this is the case, then the rise in profits is perfectly understandable. We need to understand the claim process first. When a case (claim) comes in, the insurance adjuster for AIG sets a "reserve" on the it. This reserve is an approximate value of the case in terms of settlement. This allows AIG to gauge future labilities. When the case is settled, the amount of the reserve is reduce by the amount the adjuster set aside and the settlement amount then goes into the "loss" column when the check is cut.

We can now accurately conclude that since AIG did not write more polices to grow income, did not cut expenses to do it and did not realize dramatically improved investing gains, the only way they could have grown income over 500% would have been to either had a large reduction in claims OR, just not settle cases (and then be forced to pay). If it is a case where they refused to settle, we would see a surge in the "reserves" on the books for these claims as reserves are only lowered when cases are actually settled (this also lowers earnings), if the case is they did not have more claims, reserves would remain relatively constant. Now, these reserves are subtracted from earnings for accounting but what having money here does is give AIG vastly larger sums to invest (hence the "more to invest") and the results of that increase earnings. What? If AIG sets aside $10 for reserves on cases, they take a $10 hit to earnings, but, they are then able to invest that $10 and add the results back to earnings, the more to invest, the more to earnings. Essentially they can "play" with the money until they need to cut a check. The longer they delay actually cutting a check, the more they can earn on the money. AIG in their 10-k said 2006 revenue growth "was primarily attributable to the growth in net premiums earned and net investment income from General Insurance." Now we have to assume that AIG is accurately accounting for its reserves. Meaning if they say we need $100 million to add to reserves, when the claims are paid, it does equal $100 million. If they under report them they are forced to take an "adverse development" charge. If they are consistently taking these charges, we know that they are under reporting their reserves vs actual payments. 2005 was a hurricane year so we will not count that but in 2006 there were no catastrophes yet in Domestic Insurance alone AIG took a $110 million "adverse development charge" meaning they underestimated reserves by that amount. Here we go:

Workers Compensation Loss Reserves-Billions
2005 $11.6 Billion
2006 $13.4 Billion

BINGO...... AIG added $1.8 billion or 16% to it's reserves for WC in 2006 (this is by far the largest reserve AIG maintains for all line of insurance business both domestic and international). This means that the surge in profits was due largely in part to AIG refusing to settle WC cases and thus not have to pay claims. This only pushes these liabilities off into the future. Here is the real irony, AIG is paying people who are out on WC a weekly wage check (the amount differs from state to state so I will not get into details but it is normally about 60% of their gross wages). In many cases AIG's weekly payments will eventually surpass what they would have paid if they just settled a year ago. It should also be noted that this does not absolve them of a settlement amount either. In most states there is a formula based on the employees loss of function, weekly wages, age and other factors that dictate a range of settlement amounts. AIG will have to pay, it is just a matter of "when", not "if". This means that AIG will eventually end up paying almost twice these cases initial value when all is said and done.

While AIG's strategy of refusing to settle claims may have helped them last year, there is a growing bulge in future liabilities out there that will have to get paid. Investor's beware....

PS. Does anyone else find it ironic that when an insurance company does what it is designed to do, pay a claim, they refer to it as a "loss"? Isn't it just a cost of doing business? Isn't this akin to a restaurant classifying the food people eat as a "loss"?

The New Gap CEO- A Lampert University Grad...Please?

Having mention Gap (GPS) as a possible investment in a previous post , we must revisit the most recent conference call to see if any of the goals we set for it are being met.



Gap earnings call highlights (at least the ones that matter to me)

-2006 Earnings down and 2007 does not look much better- No surprise

-Closing Forth & Towne. Given the sales, productivity levels, and the traffic momentum we had seen to date, they felt that the probability of achieving an acceptable return on investment from a full rollout of the brand was too low. As a result, they will close 19 Forth & Towne stores by the end of June, 2007.

- Converting Old Navy outlet stores to Old Navy stores. Given the change in competitive environment, there is no longer a clear distinction between the two businesses. They expect to convert the 45 outlet stores by October of this year. This decision has no impact on Gap Outlet and Banana Republic factory stores.

- In addition to gaining cost efficiencies in management structure, this decision also allows them to close one of our Northern Kentucky distribution centers. The expenses associated with converting the Old Navy outlet stores and closing the distribution center will be about $6 million in 2007. However, annual savings from these measures are estimated to be $12 million.

- Regarding share repurchases, they plan to continue to use excess cash to opportunistically repurchase shares. At the end of the fourth quarter, they still had $200 million available under the current authorization. Gap has plenty of cash and still generates enough to buy much more back. My guess is that it will be left for the new CEO to announce the new amount to get him (her) off to a good start with shareholders.

- The real estate strategy for 2007. At this time, they expect to open about 230 new stores and to close about 200. The openings are weighted towards Old Navy as they continue to believe there is additional real estate opportunity and the returns remain attractive, and the closures are weighted to Gap and include the impact of the 19 Forth & Towne store closures. Please also note the 45 Old Navy outlet conversions will be recorded as both a closure and opening to reflect the reassignment. Full year net square footage is expected to be up about 1%.

Gap is off to a decent albeit anemic start. The Forth & Towne closing was a no brainer because it should have never been attempted in the first place. As for the other closings, there will be net gain of 49 stores at year end, mostly Old Navy. Of the 135 stores to close, most will be Gap. Here is my issue, they are only scratching the surface here. Gap does not need to get bigger, it needs to get more profitable and when you are not performing well given the present scale of your company, what make you think being bigger will magically fix that? In 2006, Banana Republic sales were up 14%. Old Navy's were flat and Gap was down 6%, so we aren't in a situation where the whole company is struggling, just Gap brands. The move to convert a few of them to Old Navy stores again is a good one but still not enough. What was not discussed was Banana Republic, why not convert some Gap's into them? Currently Gap is a retailer with an excellent premium brand (Banana Republic), a good value brand (Old Navy) and a John Candy like bloated mid-level brand (Gap). I need somebody to come in a say "we need to be more profitable, not bigger" because the two are not always directly related.

The CEO search continues and I cannot even think about investing until I know the who's and what's of what they plan to do. If they are of the Julian Day of Radioshack (RSK) or Eddie Lampert of Sears Holdings, (SHLD ) mold then I will be racing to buy Gap shares (for more on Radioshack, visit Chad Brand's blog The Peridot Capitalist ). Can you imagine what somebody like them could do with the Gap? What do I mean? Sears Holdings shares are up over 1000% since Lampert took over almost 3 years ago when both Sears and Kmart were left for dead by everybody. Radioshack has gone from one foot in the grave to seeing its shares up almost 80% since Day took over last summer. How did they do it? They have this novel approach that the most important thing they can do is grow profits, not just sell merchandise. Somewhere along the way, retailers got the "bigger at all cost is better" mantra ingrained in them and began to chase sales over profits. Lampert and Day have said, profits matter most, not just sales. This has lead them to close under performing locations, sell off unnecessary assets, keep closer tabs on inventory and not just discount merchandise to drive unprofitable revenue growth. They then take this extra money and begin massive share buybacks, pay off debt and to re-invest in the current locations that are performing satisfactorily. The potential here for a CEO like this to make shareholders very wealthy is just waiting to be had as Gap has $2 billion in the bank, produces another $1.5 billion of operating cash flow per year and is virtually debt free. If they would stop investing in trying to just get bigger and got smart, they could return a ton to investors via buybacks (I estimate 15%-20% in year one at current prices). Currently Gap (GPS) shares are trading over 10% below their early year buyout rumor highs.

If they new guy (gal) has more store growth aspirations or a "new product mix" goal, I will be watching from the sidelines. Gap has a lot to like about it and I think there is a ton of hidden value there, it just remains to be seen what the new CEO will do with it. Think of it this way, if both you and Emeril Lagasse have the same ingredients in your kitchens, my guess is his final results cooking dinner with them will be far superior. Thus is the dilemma with a CEO-less Gap, are we going to get Emeril or Norm Peterson's dinner from the "Hungry Heifer"? Please don't tell me you do not know who he is.......

McBux?

From the "timing is everything" department:

1/17 - SBUX shares stand at the high price for 2007 at $36.29 a share
1/22 - ValuePlays first post hits claiming SBUX is overpriced - Why Price Matters. A Case Study
2/8 - Did SBUX CEO Donald Really Say That? Is posted questioning the direction the company is going. It is widely distributed inThe Wall St. Journal, The Stockmasters.com, Seeking Alpha, ValueInvesting News and others
2/8 - SBUX shares close at $33.42 down 9.2% from their highs
2/14 - Founder and Chairman Howard Schultz pens memo to CEO Donald echoing sentiment in ValuePlays post of 2/8
2/23 - Memo becomes public and is reported on CNBC
2/26 - SBUX follow up piece Vindication Thy Name Is Howard Schultz runs in ValuePlays
2/26 - SBUX shares close at $30.75 down 15.2% from high level
2/27 - StarbucksGossip. com picks up 2/26 ValuePlays post
2/28 - Boston TV Show "Chronicle" does a segment comparing coffee chains called "BreakfastWars" featuring McDonald's improved coffee offerings
3/1 - Prudential analyst Howard Penney cuts his price target SBUX shares
3/2 - SBUX shares close at $29.88 down 17.6% from their high

"Ok, so what is the point Todd"? The point is that SBUX shares are falling fast and now that the mainstream media is piggybacking on the ValuePlays sentiment, there is nothing happening on the immediate horizon to stop it. If anything, things are due to get worse, much worse. Why?

*McDonald's (MCD) announced it will serve specialty coffee beverages like vanilla lattes and caramel cappuccinos at outlets across the U.S. The drinks are already available at McDonald's restaurants in Michigan, New York and New Jersey. McDonald's is pricing espresso-based drinks between $2 and $3, undercutting Starbucks, many of whose similar offerings are over $3. The high-end coffee drinks are consistent with an overall strategic shift away from its traditional burger-and-fries offerings and toward more "upscale" food, like chicken and salad. McDonald's specialty coffee drinks will be served from push-button machines, which are faster than Starbucks' labor-intensive hand-made approach.
*Starbucks announced plans to start selling hot breakfast sandwiches in its stores to compete with the Egg McMuffin.
*The past five years, Starbucks sent a gift card for $3.50, enough money to buy a latte. Previously, it was a coupon for a free drink of their choice.This year, shareholders are opening the envelope to find a coupon good for two coffee-drip drinks. Starbucks says it wants people to bring a friend or family member along and then write about their experience at www.mystarbucksstory.com. According to shareholders, "We expect better next year, Howard."

When your competition is encroaching on your main product and even those who invest in you are unhappy, you've got problems. In a nutshell here is the core of the issue... SBUX has no identity anymore.

Starbucks used to stand for superior quality in a relaxed atmosphere (almost lounge like). For that, people were willing to pay a premium for their product. What happened? Whether they will admit it or not not, management is trying to "out McDonald", McDonalds. Meaning? This whole new breakfast menu thing is a catastrophe in the making. Just give me my muffin and let me sit down or go on my way. When you begin to serve McDonald's breakfast items, the only way you can be considered successful at it is if you do it better than them and nobody, nobody executes better than McDonalds. Yeah, I know what you are saying "SBUX egg sandwiches have imported feta cheese, all organic no growth hormone eggs, hydroponic rain forest lettuce and hand milled flour buns". Right, so when I order I'll ask for the "egg and cheese"? "But what about McDonalds" you ask. Aren't they trying to "out Starbucks" , Starbucks with the improved coffee and premium offerings like latte's and cappucinos? Yes they are, and they are doing it. Here is the reason, for most people coffee is coffee and and egg and cheese is an egg and cheese. Of course there are the "coffee connoisseurs," they will never go to McDonald's and I am not talking about them, I am speaking of the great ambivalent masses in the middle. When all things are equal, price and convenience always win. McDonald's has both. What about the atmosphere you say? Check out the new McCafe' concept. What has happened is McDonald's has raising its image and Starbucks has come become more ordinary.

Starbucks needs to take what they did best and do it better. What they did was try to do what McDonald's does better and in the process lost what made them great. McDonald's on the other hand is taking their concept and improving it to meet the needs of their consumer, without, and here is the key, sacrificing what has made them great, convenience and price. You also cannot underestimate the goodwill McDonalds enjoys with consumers being associated with the Newman's Own brand coffee. When Starbucks started they created a niche, by then doing what McDonald's does they opened the door for McDonald's to be compared to them and are losing the battle. If they want to win, they must take the concept more upscale... not less. Here is a freebie, instead of making me stand in line for 15 minutes, could somebody come over and take my order and bring it to me? If I am going to pay premium prices, I ought to get premium service, no? Sounds simple but think about it. If I am ordering at McDonald's and they do not have my order ready, they ask me to go sit down and relax and they will bring it to me, even if it is only a .99 cent hamburger. Why can't I get my $12 latte' and muffin brought over?

Mr. Schultz, really, this is starting to get away from you guys... email me..

The Berkshire Letter: A Value Investors Instruction Manual

Here is Warren's annual missive. This is the value investing instruction manual. A word of warning: Be careful about relying on the media to frame his comments for you. Quite often in the past they have taken snip-its that sound good on TV but when you read them again in the context they were written, do not necessarily convey the same sentiment.

Berkshire Hathaway Annual Letter (you need Adobe Reader to view it)

Some commentary that is relative to recent news events:

Real Estate:

"The slowdown in residential real estate activity stems in part from the weakened lending practices of recent years. The “optional” contracts and “teaser” rates that have been popular have allowed borrowers to make payments in the early years of their mortgages that fall far short of covering normal interest costs.

Naturally, there are few defaults when virtually nothing is required of a borrower. As a cynic has said, “A rolling loan gathers no loss.” But payments not made add to principal, and borrowers who can’t afford normal monthly payments early on are hit later with above-normal monthly obligations. This is the Scarlett O’Hara scenario: “I’ll think about that tomorrow.” For many home owners, “tomorrow” has now arrived. Consequently there is a huge overhang of offerings in several of HomeServices’ markets. Nevertheless, we will be seeking to purchase additional brokerage operations. A decade from now, HomeServices will almost certainly be much larger."

On A Replacement:

" I have told you that Berkshire has three outstanding candidates to replace me as CEO and that the Board knows exactly who should take over if I should die tonight. Each of the three is much younger than I. The directors believe it’s important that my successor have the prospect of a long tenure. Frankly, we are not as well-prepared on the investment side of our business. There’s a history here: At one time, Charlie was my potential replacement for investing, and more recently Lou Simpson has filled that slot. Lou is a top-notch investor with an outstanding long-term record of managing GEICO’s equity portfolio. But he is only six years younger than I. If I were to die soon, he would fill in magnificently for a short period. For the long-term, though, we need a different answer. At our October board meeting, we discussed that subject fully. And we emerged with a plan, which I will carry out with the help of Charlie and Lou.

Under this plan, I intend to hire a younger man or woman with the potential to manage a very large portfolio, who we hope will succeed me as Berkshire’s chief investment officer when the need for someone to do that arises. As part of the selection process, we may in fact take on several candidates. Picking the right person(s) will not be an easy task. It’s not hard, of course, to find smart people, among them individuals who have impressive investment records. But there is far more to successful longterm investing than brains and performance that has recently been good.

Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.

Finally, we have a special problem to consider: our ability to keep the person we hire. Being able to list Berkshire on a resume would materially enhance the marketability of an investment manager. We will need, therefore, to be sure we can retain our choice, even though he or she could leave and make much more money elsewhere.

There are surely people who fit what we need, but they may be hard to identify. In 1979, Jack Byrne and I felt we had found such a person in Lou Simpson. We then made an arrangement with him whereby he would be paid well for sustained overperformance. Under this deal, he has earned large amounts. Lou, however, could have left us long ago to manage far greater sums on more advantageous terms. If money alone had been the object, that’s exactly what he would have done. But Lou never considered such a move. We need to find a younger person or two made of the same stuff.

* * * * * * * * * * * *
The good news: At 76, I feel terrific and, according to all measurable indicators, am in excellent health. It’s amazing what Cherry Coke and hamburgers will do for a fellow.

Some Changes on Berkshire’s Board

The composition of our board will change in two ways this spring. One change will involve the Chace family, which has been connected to Berkshire and its predecessor companies for more than a century. In 1929, the first Malcolm G. Chace played an important role in merging four New England textile operations into Berkshire Fine Spinning Associates. That company merged with Hathaway Manufacturing in 1955 to form Berkshire Hathaway, and Malcolm G. Chace, Jr. became its chairman.

Early in 1965, Malcolm arranged for Buffett Partnership Ltd. to buy a key block of Berkshire shares and welcomed us as the new controlling shareholder of the company. Malcolm continued as non executive chairman until 1969. He was both a wonderful gentleman and helpful partner.

That description also fits his son, Malcolm “Kim” Chace, who succeeded his father on Berkshire’s board in 1992. But last year Kim, now actively and successfully running a community bank that he founded in 1996, suggested that we find a younger person to replace him on our board. We have done so, and Kim will step down as a director at the annual meeting. I owe much to the Chaces and wish to thank

Kim for his many years of service to Berkshire. In selecting a new director, we were guided by our long-standing criteria, which are that board members be owner-oriented, business-savvy, interested and truly independent. I say “truly” because many directors who are now deemed independent by various authorities and observers are far from that, relying heavily as they do on directors’ fees to maintain their standard of living. These payments, which come in many forms, often range between $150,000 and $250,000 annually, compensation that may approach or even exceed all other income of the “independent” director. And – surprise, surprise – director compensation has soared in recent years, pushed up by recommendations from corporate America’s favorite consultant, Ratchet, Ratchet and Bingo. (The name may be phony, but the action it conveys is not.). Charlie and I believe our four criteria are essential if directors are to do their job – which, by law, is to faithfully represent owners. Yet these criteria are usually ignored. Instead, consultants and CEOs seeking board candidates will often say, “We’re looking for a woman,” or “a Hispanic,” or “someone from abroad,” or what have you. It sometimes sounds as if the mission is to stock Noah’s ark. Over the years I’ve been queried many times about potential directors and have yet to hear anyone ask, “Does he think like an intelligent owner?”

The questions I instead get would sound ridiculous to someone seeking candidates for, say, football team, or an arbitration panel or a military command. In those cases, the selectors would look for people who had the specific talents and attitudes that were required for a specialized job. At Berkshire, we are in the specialized activity of running a business well, and therefore we seek business judgment.

That’s exactly what we’ve found in Susan Decker, CFO of Yahoo!, who will join our board at the annual meeting. We are lucky to have her: She scores very high on our four criteria and additionally, at 44, is young – an attribute, as you may have noticed, that your Chairman has long lacked. We will seek more young directors in the future, but never by slighting the four qualities that we insist upon."

Misc.

"Berkshire will pay about $4.4 billion in federal income tax on its 2006 earnings. In its last fiscal year the U.S. Government spent $2.6 trillion, or about $7 billion per day. Thus, for more than half of on day, Berkshire picked up the tab for all federal expenditures, ranging from Social Security and Medicare payments to the cost of our armed services. Had there been only 600 taxpayers like Berkshire, no one else in America would have needed to pay any federal income or payroll taxes."

"Our federal return last year, we should add, ran to 9,386 pages. To handle this filing, state and foreign tax returns, a myriad of SEC requirements, and all of the other matters involved in running Berkshire, we have gone all the way up to 19 employees at World Headquarters. This crew occupies 9,708 square feet of space, and Charlie – at World Headquarters West in Los Angeles – uses another 655 square feet. Our home-office payroll, including benefits and counting both locations, totaled $3,531,978 last year. We’re careful when spending your money.

Corporate bigwigs often complain about government spending, criticizing bureaucrats who they say spend taxpayers’ money differently from how they would if it were their own. But sometimes the financial behavior of executives will also vary based on whose wallet is getting depleted. Here’s an illustrative tale from my days at Salomon. In the 1980s the company had a barber, Jimmy by name, who came in weekly to give free haircuts to the top brass. A manicurist was also on tap. Then, because of a cost-cutting drive, patrons were told to pay their own way. One top executive (not the CEO) who had previously visited Jimmy weekly went immediately to a once-every-three-weeks schedule."

"Every now and then Charlie and I catch on early to a tide-like trend, one brimming over with commercial promise. For example, though American Airlines (with its “miles”) and American Express (with credit card points) are credited as being trailblazers in granting customers “rewards,” Charlie and I were far ahead of them in spotting the appeal of this powerful idea. Excited by our insight, the two of us jumped into the reward business way back in 1970 by buying control of a trading stamp operation, Blue Chip Stamps. In that year, Blue Chip had sales of $126 million, and its stamps papered California. In 1970, indeed, about 60 billion of our stamps were licked by savers, pasted into books, and taken to Blue Chip redemption stores. Our catalog of rewards was 116 pages thick and chock full of tantalizing items. When I was told that even certain brothels and mortuaries gave stamps to their patrons, I felt I had finally found a sure thing

Well, not quite. From the day Charlie and I stepped into the Blue Chip picture, the business went straight downhill. By 1980, sales had fallen to $19.4 million. And, by 1990, sales were bumping along at $1.5 million. No quitter, I redoubled my managerial efforts.

Sales then fell another 98%. Last year, in Berkshire’s $98 billion of revenues, all of $25,920 (no zeros omitted) came from Blue Chip. Ever hopeful, Charlie and I soldier on."

CEO Comp.

"At Berkshire, after all, I am a one-man compensation committee who determines the salaries and incentives for the CEOs of around 40 significant operating businesses. How much time does this aspect of my job take? Virtually none. How many CEOs have voluntarily left us for other jobs in our 42-year history? Precisely none.

Berkshire employs many different incentive arrangements, with their terms depending on such elements as the economic potential or capital intensity of a CEO’s business. Whatever the compensation arrangement, though, I try to keep it both simple and fair. When we use incentives – and these can be large – they are always tied to the operating results for which a given CEO has authority. We issue no lottery tickets that carry payoffs unrelated to business performance. If a CEO bats .300, he gets paid for being a .300 hitter, even if circumstances outside of his control cause Berkshire to perform poorly. And if he bats .150, he doesn’t get a payoff just because the successes of others have enabled Berkshire to prosper mightily. An example: We now own $61 billion of equities at Berkshire, whose value can easily rise or fall by 10% in a given year. Why in the world should the pay of our operating executives be affected by such $6 billion swings, however important the gain or loss may be for shareholders?"

Home Depot (HD) Investors Conference...... Yawn

Talk about anti-climatic. A great number of people (yours truly included) were hoping to have some clarity on the fate of the Supply business during the investors conference on Wednesday. What we got was more of nothing. There wasn't anything said that was already alluded to during their earnings call last month. So, what do we think about the possible fate of HD Supply? The integration of Supply is going forward. HD expects their contribution of sales to go from 13% to 15% next year and unlike the retail operations, actually post earnings increases. This is good news for those of us who do not want it's sale as it increasingly makes the unit more valuable to management. Time is also on our side as the more time and money spent on the ongoing integration, the more unlikely a sale is. This is because the more integrated supply becomes into the overall HD operations, the more expensive it then become to unwind. Well, what should we do then?

Easy..... nothing. We wait until we get answers to our questions and then we act accordingly. Trying to guess what a new CEO is going to do is a bit like guessing what the weather here in New England will be next Wednesday, your guess is just as good and likely as anybody else's. So we wait, and wait and that is ok because we can't lose money waiting, we can and will if we "guess" and "guess" wrong. That, by the way is called gambling, not investing.

To quote Warren Buffet, "there has been many a time where the smartest thing I have done in investing is absolutely nothing..."

ValuePlays Most Read Posts For February

The following were the most read posts on the site in February


1- The ValuePlays Portfolio
2- Total Return Yield- A Measure Of Value
3- Memo To Dow CEO Liveras- Please Do Not Sell Out
4- Vindication: Thy Name Is Howard Schultz
5- ValuePlays Enhanced Features Subscription

We are staring to catch on out there in the "blog sphere". At least I think so? Daily traffic to ValuePlays surged 640% the past 30 days, subscriptions jumped 260% and posts are beginning to pop up in different media. I guess that means that even if we have not officially "caught on", at least we are on the right track? Share the wealth and spread the word, email articles to your friends, encourage them to sign up for the email or Rss feeds to get free daily updates or, if you are getting the Enhanced Features subscription that is only $6.99 a month and like it, write me and tell me why (or suggest how I can make it better).

Other notables:

- I have added an email link on the main page. Feel free to email me thoughts and ideas for stocks or general investing. I cannot promise a time table for a reply but I will try to be prompt. I can generally make a "no buy" decision rather quickly so the longer it takes to hear back, the better.

- Criticism and /or complaints are welcome also just, keep them constructive. I can promise insulting or otherwise inappropriate email will be deleted immediately and the email address blocked. If you are so inclined to send one, make it a good one because it will be the last.

- I am always looking for way to better the site and frequent visitors at times have noticed some odd things as I learn programing code "on the fly" as they say. Feel free to email any ideas to me. I cannot promise I will act on them but they will be considered. Any legitimate suggestion to better your experience on the site will get serious consideration.

- Stock or investing ideas may be used in a future post, your email address will not.











111,89

Bunker Hill - A Lesson For Investors

"Don't fire until you see the whites of their eyes" William Prescott, an American officer, at the Battle of Bunker Hill



The Battle of Bunker Hill took place on June 17, 1775, as part of the Siege of Boston during the American Revolutionary War. By the time the battle had started, 1,400 colonists faced 2,600 British regulars.The result was a Pyrrhic victory for the British, who suffered more than 1000 casualties compared to only about 450 Colonists. It is considered by some to be the bloodiest battle of the war. Being outnumbered almost 2 to 1, William Prescott knew his troops could not afford to miss their targets if they were to have any chance at winning, thus the famous order was given. He knew the closer the British troops came to the colonists, the better his musket troops potential for hitting them was. Their muskets were not very accurate to begin with and as the distance increased from a target what little accuracy they did have decreased. Despite how badly his troops wanted to fire and how difficult it was to wait, they exercised discipline, waited, and inflicted massive casualties on the British troops. Even though they eventually lost the battle, it enabled the Colonists recapture Boston from the British as depleted and exhausted British troops were unable to stop their siege of the city. I can just picture you reading this now thinking "what the hell is he talking about, what does Bunker Hill have to do with investing"? Trust me it does...

The 400 point decline in the Dow Jones on Tuesday and the Wednesday rebound was for investors, our Bunker Hill. There is an almost irresistible need for people to do something, anything, on days like these. When the market is selling off huge, you are driven to sell yourself as you watch profits evaporate, then, on the inevitable bounce the following day, you want to dive right back in and buy everything in sight. You must exercise the same discipline the colonist had at Bunker Hill. Just like their muskets were not accurate at long distances, your decisions are not accurate when you make them based on emotion, not reason. The more emotion, the less accuracy. You should have conditions in place that cause you to either buy or sell the stock of a company and those conditions should have nothing to do with the direction of the market. A decision to sell should be based on business fundamentals, not a temporary drop in price and a buying decision should only be made when a stock hits a predetermined price. You then must exercise discipline on days like these, ignore the market and patiently wait until those conditions are met before acting, or in the words of Prescott, you "see the whites of their eyes".

If you are a value investor, this process becomes easier in times like this. To look for "value" you must be a contrarian by nature. What does that mean? When everyone is buying a stock, we value folk immediately think it is over priced. When nobody wants it, we tend to think there must be something there worth having. Put simply by Warren Buffet, "I buy fear and sell greed". Why does this matter? Instead of panicking and selling on days like Tuesday, I begin to get excited as stocks I am watching like Caterpillar (CAT ) and Harley Davidson (HOG ) crept down to the prices I would be willing to pay for them. They never got there so I did not buy them, but who knows, maybe another down day will give me a chance?

By having the discipline to stick to our parameters we should be able to beat the S&P (remember what we are looking for, down less in down days, up more in up days). Despite the market turmoil the past two days, by sitting, watching and waiting like the colonists did the ValuePlays Portfolio picked up almost a full 1% against the S&P. Like them, we will take our Bunker Hill lumps at times, but by exercising discipline like they were able to, we can put in place the elements to win the war...