Berkshire Hathaway Annual Meeting/ Yellow BRK'ER Party

This will be my fifth year at the Berkshire Hathaway Annual Meeting. If your planning to attend feel free to send me an email so we can meet in person.

Besides the annual meeting itself, the highlight of my experience in Omaha is always the Yellow BRK'ER gathering.

Here are the details:

Berkshire Hathaway shareholders from all online communities are welcome to an unofficial gathering on Friday, April 30, 2010.

You are invited to join as fellow shareholders unofficially gather on Friday, April 30, 2010 at the DoubleTree Hotel in Omaha to meet and have fun, starting at 4:00 pm and you can linger until 7:00 pm (or longer). There will be a short program at approximately 5:00 or 5:30.

This is a casual atmosphere, with light snacks available. It's a "happy hour" type of gathering - not a formal dinner or anything of that sort.

The DoubleTree is located on 16th and Dodge. There may be some street parking, otherwise, one can use the parking garage with an entrance from the South at 16th & Dodge street, just east of the First National Bank.

Click here to Register

Space is limited; if planning to attend please be sure to register in advance. To help cover the costs we are asking for a $5 suggested donation at the door.

Interview Of Alex Bossert By Classic Value Investors

Mariusz Skonieczny of Classic Value Investors recently interview me.

He runs Classic Value Investors, LLC, an investment firm based in Schaumburg, IL. He wrote a book called "Why Are Investors So Clueless About The Stock Market," which I plan to review soon for this site. He also has a very good blog over at http://www.classicvalueinvestors.com.

The interview was published on Mariusz's site here.

Here is the interview:

Alex Bossert is a young investor who was recently featured in the book, Of Permanent Value by Andrew Kilpatrick. He writes a blog, Alex Bossert’s Thoughts on Value Investing, which I recently added to my resources page.

Mariusz Skonieczny, Classic Value Investors: I learned about you because Sandesh Trivedi, who is my friend and a subscriber of my blog told me that he likes your website. I checked it out and I agree with him. You became interested in the stock market when you were 10. Did you buy your first investment at that age? If so, you have a one-full year advantage over Warren Buffett who bought his first stock at the age of 11.

Alex Bossert: I began learning about the stock market when I was 10 and I purchased my first stock right after my 11^th birthday. My first investment was in shares of Wal Mart. What first got me interested in the stock market was a book touting the money to be made in internet stocks. Luckily, I didn’t take this book too seriously. The second book I read was How To Pick Stocks Like Warren Buffett by Timothy Vick. This is the book that got me hooked on investing and started me down the path of learning everything I can from Warren Buffett. The book started with stories of Buffett’s childhood businesses such as his idea of putting pin ball machines in barber shops. He also paid friends to go retrieve golf balls from local courses and then he would resell them. I got my first money to buy stocks from a similar business idea. So right off the bat I could relate to him.

Warren Buffett’s teachings on investing just plain make sense. Value investing rests on two very simple rules: buy businesses that you understand and only buy when they are trading for less than intrinsic value. It just made so much sense to me to think in this common sense fashion. As Benjamin Graham once said, “Investing makes the most sense when it’s most business like.” But for many reasons, only 5% or so of investors are value investors and the short term mentality of most investors provides a huge opportunity for value investors. I felt that I had discovered the holy grail of investing. Warren Buffett once wrote that the concept of value investing is like an inoculation – it either takes or it doesn’t – and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don’t.

Mariusz Skonieczny, Classic Value Investors: You tend to look at smaller companies versus big giants. Why?

Alex Bossert: I don’t limit myself to small companies but I do focus my attention there. One of my largest holdings is actually a $23 billion market capitalization Chinese company called BYD. Warren Buffett recently invested in the company and it has been one of my most profitable investments.

I’ve always had a fascination for small companies because oftentimes they are overlooked. Many of these companies get no analyst coverage and the many hedge fund managers are too big to look at them. I focus on where I can find the greatest discrepancy between price and value and that is in small and nano caps. I’ve invested in companies that are smaller than $10 million in market capitalization.

Warren Buffett made his 30%-40% partnership returns investing in micro cap companies and that is what I’m trying to recreate. The Buffett partnership letters are a fascinating read. Particularly Buffett’s investment in Sanborn Maps found in the 1960 letter to partners: http://www.gurufocus.com/news.php?id=7227

One year ago was the time of a lifetime for value investors looking at small caps. In many instances a company would experience no impairment of intrinsic value but the stock might be down 60%. One example is Clear Choice Health Plans. In September of last year this company was trading for $11 per share. The stock declined about 60% in a year because of fears of what health care reform would bring. However, 50% of Clear Choice’s business is Medicaid which is Obama’s platform for covering the uninsured. It was unclear how healthcare reform would affect profit margins but revenue would definitely increase under Obama’s plan. The company was trading for just over 5 times earnings and for 40% of book value. The company had $28 per share of cash and investments, $11 of which could have been distributed to shareholders while still maintaining statutory minimums. Management appeared at the time to be willing to put this money to good use and was buying back a significant amount of stock. Factoring in the cash and investments, the business was being given away for free. In late December of last year the company announced it was being acquired for $26 per share.

Mariusz Skonieczny, Classic Value Investors: You call the management of the companies that you research. Do you also meet with them face-to-face? What do you ask them? How do you evaluate them?

Alex Bossert: I don’t go and meet with management face-to-face but I sometimes call with questions. Evaluating management is extremely important and I think the proxy statement is just as important as the annual report. When I call the management of a company I’m researching, it’s not to evaluate management. Instead I usually have questions about the business, financial statements or the industry.

Meeting with management usually isn’t productive because CEO’s are good salesmen and that’s why they are the CEO. Executives understand their industry better than anyone else and they are always friendly. They are very good at selling their point of view. It’s really hard to come away not feeling really good about what they said and this could cloud my judgment of the company or management.

I have an investing checklist with 70 or so risks to look for in an investment. I have 8 or so things to look for in evaluating management. To evaluate management, I look at what they’ve accomplished. I also listen carefully to what they say on conference calls and in the annual reports. I want honest management with a long term view. I look at how they measure performance and if they freely admit mistakes. One way to judge honesty is to look at how aggressive the accounting is. In addition, I look carefully at how they pay themselves. I want to know if they love the money or love the business. Do they have skin in the game and own a big ownership stake in the company relative to their salary? I favor executives who purchased the shares with their own money rather than with granted options. Are they buying shares or selling? These are the questions I ask myself when evaluating management and they are answered by reading the proxy and annual report, not by talking with management.

Mariusz Skonieczny, Classic Value Investors: Congratulations on being featured in Andy Kilpatrick’s book Of Permanent Value: the Story of Warren Buffett. How did you get to be featured in it?

Alex Bossert: Of Permanent Value is one of the first books I read on Warren Buffett. It is by far the most in depth of all the books written on him. My favorite aspect of the book is that Andy Kilpatrick has chapters on all of Berkshire’s acquisitions and explains Berkshire’s subsidiaries in depth. I’ve researched nearly all of Buffett’s acquisitions and why he invested so this was extremely useful. It’s a big honor that Andy asked me to be included in the book and I highly recommend people read the book.

Mariusz Skonieczny, Classic Value Investors: Where can people read your story from the book? Is the edition in which you are featured published yet?

Alex Bossert: I was published in last year’s edition. I was in chapter 205, pages 1169-70 for those who want to look it up. The 2010 edition is now out on Amazon for pre order and is due to be shipped in late April. The book can be pre ordered here. I’ve posted the chapter on me on my web site. The chapter can be read here: http://alexbossert.blogspot.com/2009/10/blog-post.html

Mariusz Skonieczny, Classic Value Investors: What is it like to be a high school student interested in the stock market? What do your peers think about your passion for investing?

Alex Bossert: I feel that success in investing is based on how much time and effort is put into it. The more investors read and the longer they invest, the greater the chances they will become successful. That’s why many successful investors started young or had a lot of practice before they became successful. I spend a lot of my free time reading about companies and studying the most successful investors. I’m fascinated by and enjoy the whole process. Because I’m so passionate about investing, all my friends respect my interest in the stock market. A few are somewhat interested in what I’m doing but none of them invest on their own. I’ve met a few people my age that are value investors mainly through my site and at the Berkshire Hathaway annual meetings.

Mariusz Skonieczny, Classic Value Investors: Can you tell us about a company that you invested in recently and why you think it was a good investment?

Alex Bossert: My favorite company right now is Nicholas Financial. I have an extremely detailed analysis on my site. Nicholas Financial is a very uniquely managed auto lender. Auto lending is a business that has been given a very bad name recently. Nicholas is a great company trading at a very cheap price. They have very high quality underwriting unlike many of their competitors that focus mainly on the FICO score. They go further in researching the creditworthiness of their customers than their competitors do and employees are paid directly based on the quality of loans they originate. They also hold all of the loans on their books with no securitizations.

In boom times Nicholas is unwilling to make bad loans and pulls back on credit availability. However, when the credit cycle turns down and their competitors suffer or go out of business, Nicholas remains solidly profitable and takes market shares away from competitors. While their competitors were going bankrupt last year, Nicholas’s profits declined from 20% return on equity to 10%. At the same time management was buying a lot of stock. The company also over reserves for losses every year and is constantly accreting unrealized losses back into earnings. The company was incredibly cheap last year and is still a good buy today.

Last year the stock declined from $8 to $2. I’ve read everything I can on Nicholas as well as researched their competitors. Because I understood the business so well, I was buying a lot of stock at less than $5 per share when other investors were selling based on fear. I knew it was extremely unlikely the company would have a margin call unless the economy got significantly worse than it was in March of last year. Currently, book value is $8 a share and I think the company is worth around $15 per share. The company should be able to earn around $2 a share in a few years and earnings are growing 10-15% per year. In the last ten years, shareholders equity has grown from $11 million to $88 million today. Here is a quote from a CEO I’m very happy to partner with: "When yields on loans look temptingly high, we always try to remember that the return of your money is more important than the return on your money."

Mariusz Skonieczny, Classic Value Investors: Thank you very much for the interview and I wish you good luck with your investment endeavors

Alex Bossert: Thanks for the questions.

Update On Convera

I’ve had a few comments about my lack of posts on this blog recently. I’m having a very busy senior year in high school and I feel that with my more limited free time, I have for investing, I’d rather spend it reading and researching than posting more frequently. I feel no need to fill your email with useless posts and I will post once every two or three weeks on what I feel is most important. I think it makes sense to post few but very high quality posts.

I’m honored that my site has over 210 subscribers and over 33,000 page views. If you would like to subscribe and receive email updates when I post, please subscribe by clicking here. I’ve also enjoyed getting to know many of you. I’ve received emails from readers from all around the world. I really enjoy your feedback or questions at Alexbossert[at]Gmail[dot]com.

Update on Convera:

I sold CNVR two months ago because I no longer thought the transaction would play out as I originally wrote in my write up. The transaction was likely to take longer than expected and the cash burn was more than I expected in the 10Q filled in December. The 10Q in December also had different language as it relates to the distributions than the proxy statements. The most recent 10Q troubled me because it didn’t mention the two $2M distributions, which account for about $0.07 of value in the liquidation. They were still included in the original plan of liquidation and therefore by reference in latest 10Q. The distributions were likely to be less and stock was still trading at the same price as I bought at, so I sold.

As it turns out, the company distributed 10 cents per share February 8^th. Convera is trading for 8 cents right now and in the original proxy, management estimated that the company would pay out an additional 7.4 cents from here. So if you pay 8 cents now you might get 7.4 cents back and some shares in a potentially worthless company. So it’s not near buying range right now.

Companies in liquidation has been an area of the investment world that really interests me. A good example of of a liquidation play is my investment in Footstar. You can read everything I've written on the company here. Footstar worked out really well and with Convera, I just broke even on my investment. I would also say that it’s much less appealing to own liquidation plays after the first few major liquidating dividends. That is when it starts to take a really long time and management has the incentive to sit and collect their salaries.

Portfolio Update and Results for 2009

Here is where my portfolio stood at year end:

Boss Holdings 9%
BYD Co 25%
Clear Choice Health Plans 6%
Cogo 10%
Nicholas Financial 25%
Convera 9%
Cash 16%

For the year 2009 my portfolio had a 160% return. Obviously this year was incredible and it’s unlikely to be repeated. My portfolio’s results over a 3 to 5 year span will be more reflective of how good of an investor I am and I shouldn’t be judged on one year alone. I had a nice surprise at the end of the year when Clear Choice Health Plans announced it was being acquired for a 167% premium. My portfolio did well because of the investments made around a year ago. Investments I made such as Nicholas Financial, Horsehead Holdings, Footstar, BYD and Clear Choice Health Plans were made when other investors were pricing many of these companies as if they were going out of business. In all of the names I mentioned above, the intrinsic values of these companies wasn’t impaired in the recession but were trading for 50-90% less than they were trading for only one year earlier.

A quick update of what I’ve been up to. I’m currently a senior in High School. I haven’t figured out where I want to go to college yet but I will be hearing back from schools I’ve applied to soon. This past summer I interned at a hedge fund in New York City. I was also featured in the book Of Permanent Value: The Story of Warren Buffett by Andy Kilpatrick.

I hope my blog is both interesting and profitable to readers. As always if anyone has any comments feel free to email me. I’d love to hear your feedback.

Convera Corp.

Convera is a liquidation play. Convera is trading for $.22 and the company estimates investors will receive $.26 per share in cash in the next 12 months and an additional $.11- $.19 after intellectual property is sold. The trading volume on Convera shares is small with around 150,000 shares traded a day.

According to Yahoo Finance, Convera’s business consists of “vertical search services to trade publishers in the United States and the United Kingdom. The company provides hosted white-label search technology and services, which enable publishers to generate Web traffic and online revenues by creating customized search applications. Its search platform helps publishers to combine site search, their proprietary content and an editorially vetted best of the Web into a vertical search application that provides an authoritative and comprehensive search experience for specialist audiences. Convera Corporation’s vertical search service comprises a suite of various components, including Web Search Platform that incorporates multimedia search of Adobe Systems Portable Document Format, image files, and other data formats; Convera Ad Service that allows publishers to manage and pursue search-based advertising revenues for their vertical search Web sites; and Publisher Control Panel, a self-service application that provides the publisher with the ability to control and tailor the Convera Web Search Platform and the Convera Ad Service for each vertical search site from a single interface. It also offers Converanet, an online search directory portal that contains various search engines in a single Web site. In addition, the company provides various professional services consisting of Web site customization; search engine optimization, marketing services, and training; and advertising sales kit development and training.”

Liquidation Time table:

Majority shareholders have already approved the liquidation:

According to the proxy statement: “Holders of our Class A Common Stock which represented a majority of the voting power of our outstanding capital stock as of the Record Date, have executed a written consent in favor of the actions described above and have delivered it to us on September 22, 2009, the Consent Date. Therefore, no other consents will be solicited in connection with this Information Statement.”

The Certificate of Dissolution hasn’t yet been filled:

“We anticipate that we will first take corporate action with respect to the Plan of Dissolution in accordance with our stockholder approval by filing the Certificate of Dissolution with the Secretary of State of the State of Delaware not less than twenty (20) days after the mailing of this Information Statement to our stockholders.”

The first cash distribution will take place shortly after the certificate of dissolution is filled with the state of Delaware.

Distributions:

The liquidating distributions consist of two parts. First, Convera will distribute a cash component worth $.26 per share. Second, after the certificate of dissolution is filled, Convera will merge its remaining intellectual property with VSW recieving a 33% ownership stake in VSW. Convera will sell its 33% interest in VSW or distribute it to shareholders. The company says the value of its ownership interest in VSW will be $.11 - $.19 per share.

Cash Component:

According to the proxy statement:

“In connection with the Merger, our stockholders will receive cash, plus a pro-rata share of an aggregate of one-third of the common stock of VSW. Our management estimates that our residual cash, after transfer of all of the operating assets and $3,000,000 in cash at closing of the Merger, drawn-down portion of the $1,000,000 line of credit, and various wind-down activities, will be approximately $14,000,000. We plan to distribute $10,000,000 shortly after the closing of the Merger, with the remaining $4,000,000 to be distributed in $2,000,000 increments at six months and 12 months after the closing of the Merger, subject to possible holdbacks for potential liabilities and on-going expenses deemed necessary by our board of directors in its sole discretion.”

The present value of this cash distribution, assuming a discount rate of 10%, is estimated at $0.26 per share. The calculation was performed as follows:

Value of intellectual property:

“Following the filing of our Certificate of Dissolution, we expect to consummate the merger of B2BNetSearch, Inc. and Convera Technologies, LLC, each a wholly-owned Delaware subsidiary of Convera, with VSW 2, Inc., the Delaware parent company of Firstlight Online Limited, a company in the business of online advertising sales and marketing incorporated as a company limited by shares in the United Kingdom (“Firstlight”), pursuant to, and subject to the terms and conditions of, an Agreement and Plan of Merger dated May 29, 2009, as amended and restated on September 22, 2009 (the “Merger Agreement”). As a result of the Merger, Convera will own 33.3% of the total outstanding capital stock of Vertical Search Works, Inc., a Delaware corporation and the indirect parent company of VSW 2 (“VSW”)."

“Both our CEO, Patrick Condo, and CFO, Matthew Jones, will join VSW after the effectiveness of the Merger. Mr. Condo has entered into a transition agreement with us and we intend to enter into a transition agreement with Mr. Jones. Additionally, it is the intention of the parties that Messrs. Condo and Jones enter into employment agreements with VSW.”

“In accordance with such agreement, we will pay Mr. Condo, among other benefits, an aggregate amount of $480,000 in cash in a lump sum on the 30th day after the closing of the Merger, provided that Mr. Condo has signed and delivered a general release in favor of us and the release has become effective.”


“Hempstead assessed the value indication associated with a one-third equity interest in VSW based upon the discounted cash flows methodology. Specifically, under a discounted cash flows methodology, the value of a company’s stock is determined by discounting to present value the expected returns that accrue to holders of such equity. Projected cash flows for VSW were based upon projected financial data prepared by our management. Estimated cash flows to equity holders were discounted to present value based upon a range of discount rates, from 25% to 35%. This range of discount rates is reflective of the required rates of return on later-stage venture capital investments."

The resultant value indications for the VSW component of the transaction, on a per-Convera share basis, are as follows:

The valuation placed on the 33% interest in VSW is $.11 - $.19 per share. Convera’s estimate of the value for the cash and valuation of VSW stock to be received in liquidation are within a range of $0.37 to $0.45 per share.

Herb Allen:

Herbert A. Allen has been a director of the Company since the effective date of the Combination on December 21, 2000 and was a director of Excalibur since June 2000. He has been President, Chief Executive Officer, Managing Director and a director of Allen & Company Incorporated, a privately-held investment firm, for more than the past five years. He is a member of the Board of Directors of The Coca-Cola Company. He is the father of Herbert A. Allen III.

The Allen family and Allen and Co. control over 61% of the company. Since Herb Allen is friends with Warren Buffett, I’d assume he is honest and trustworthy. He is also a very well connected person, knows a lot of power players, and with his own money on the line its good that the person in control has an interest in making sure the liquidation is completed quickly and efficiently. Both Herb Allen and his son are on the board of directors of Convera.


Conclusion:

Convera shareholders will receive the following as part of the liquidation:

1) $10m or $.187 per share upon closing of the merger
2) $2m or $.037 per share 6 months after the closing
3) another $2m 12 months after the closing plus 33% of VSW, estimated to be worth $.11- .19 per share.


At a purchase price of $.22, I’m being paid an 18% return to hold a free option on the value of VSW. The value of VSW is unknown but all the upside is free. One of the major risks in a liquidation play is executives have an incentive to delay the liquidation process and continue collecting their salaries. In this case, the executives are being hired by VSW so they don’t have to worry about losing their jobs. In addition the CEO, Patrick Condo will receive $480,000 30 days after the closing of the merger. Executives, especially the CEO have an incentive to move the liquidation process along quickly. Also, Herb Allen controls over 61% of Convera and he and his son are on the board. I like the fact that he’s friends with Warren Buffett and he will insure that the liquidation process moves along quickly because $8 million of his money is on the line.

The author owns shares in Convera.

Sold Horsehead Holdings

I purchased shares in Horsehead Holdings back in March at $4.23 per share and I recently sold my investment at $11. I made at 160% return on my money in 6 months. I invested in Horsehead because it was trading for $150 million with $123 million in cash and a net current asset value of $150 million. I was buying at 40% of book value and the replacement value of the facilities is over one billion dollars. Not only was Horsehead incredibly cheap but it was a great company to. It’s the lowest cost producer of zinc in the world and the only company that can use 100% recycled feedstocks in its facilities. Horsehead’s competitive advantage in the zinc market is further benefited because its facilities are next to steal mini mills with long term contracts for the delivery of feedstocks. It would be extremely hard for a competitor to come in and hurt the company’s supply of low cost EAF dust. No other company has been able to develop recycling techniques comparable to those of Horsehead. Horsehead has a large moat in the zinc market. I also recognized the potential for higher economical uses of the iron by product that could be worth up to $13 million per year. In addition, the company continues to increase the percentage of feedstocks derived from EAF dust. 66% of the company’s feedtsocks are EAF dust and for every percent increase, margins expand.


Revenue decreased 64% in the first half of 09 because of lower realized prices for zinc and a decrease in shipments. Net income was negative $24 million vs. a profit of $24 million in the same period last year. The decrease was due to lower prices of zinc and less production. The company idled some capacity but fixed costs are still high. EAF dust fees were also substantially lower. A $22 million charge occurred due to hedging activities.

The company resumed operations at its Rockwood, Tenn., recycling facility in August. The company said it expects to restart one of two kilns at the Rockwood plant in mid-September. It had idled the facility as a result of the economic downturn.

In September Horsehead issued 9.1 million shares in a secondary offering at $10.50 per share less discounts and commissions of $0.525 per share and received $80 million in cash. “The Company intends to use the net proceeds from the offering for general corporate purposes, which may include capital expenditures, acquisitions, working capital, investments and the repayment of indebtedness.” After the offering there are 44.364 million diluted shares outstanding. Horsehead currently has $160 million in cash when the proceeds are factored in and a market capitalization of $500 million.


The secondary offering changes the dynamics for my investment in Horsehead. The market cap of the company is now around $500 million. The price of zinc has averaged about 90% of the cost of production. Unlike oil or many other commodities, zinc is so plentiful in the world that the price of zinc is based on the cost of production and has averaged around 90% of production. Predicting the price of zinc is impossible but looking at historical prices and the cost to produce zinc it doesn’t look like their will be any large upside from here. I have no competency in zinc prices and the price of zinc meant little to my investment in Horsehead. I invested because it was the lowest cost producer of zinc and it was trading below net current asset value. Horsehaed is no longer cheap and based on historical earnings it appears fairly valued.

Alex Bossert Featured in "Of Permanent Value: The Story Of Warren Buffett" By Andy Kilpatrick

Last year I was lucky enough to be featured in a chapter of the 2009 edition of Andy Kilpatrick’s book “Of Permanent Value: The Story of Warren Buffett.” I was in chapter 205, page 1169-70. The chapter was titled “The Story Of Alex Bossert, Age 17.” Andy Kilpatrick is good friends with Warren Buffett and has been updating the book every year. The book is sold directly at the annual meeting every year.

Next year’s edition will be out in April and has a chapter on me and my friend Eric Schleien. Chapter 215 is titled: “The Alex Bossert Story, Age 18.” The chapter is on page 1215.

“Of Permanent Value” is considered by many to be the most extensive book about Warren Buffett and value investing.

View Andy Kilpatrick's web site

Purchase his book on Amazon

Read the chapter that will appear in the 2010 edition of the book

Pabrai Funds Annual Meeting Notes 2009: Huntington Beach California

I attended Mohnish Pabrai’s annual meeting in Huntington Beach California last Saturday. I thought Mohnish did an awesome job as usual. I’ve been lucky enough to get to know Mohnish over the past few years and I grateful that he is so willing to share his ideas with others. Mohnish is both a friend and mentor. I admire his investing abilities and I also find him to be a very genuine person who like Buffett, is always having a good time and cracking jokes.

Here are my notes on the Pabrai Funds 2009 Annual Meeting in Huntington Beach California:

Presentation:

The formal presentation began with Mohnish discussing his checklist. He came up with the idea after reading an article in the New Yorker by Atul Gawande about checklists in medicine. He mentioned a few of the items on the checklist. Is the business simple to understand? Does the investment have a margin of Safety? Does the business have a moat? Mohnish went on to say that he has analyzed many of Buffett’s and other value investor’s mistakes as well as his own and added the mistakes to his checklist.

Mohnish cleaned house in the fourth quarter of last year. He sold many of the poor performers and weaker names and invested in natural resource companies and banks. He added 10 new positions in the 4th quarter of last year. The portfolio is now much stronger as a result. Mohnish's funds are up around 110% since the begining of the year.

He has also learned a lot from Seth Klarman about diversification. The old structure was geared towards 10 names with 10% of the fund allocated to each. Now, Mohnish has adopted a 3, 5 or 10 method whereby most positions will be 3 or 5% or the portfolio and if the seven moons line up he will allocate 10% to the investment. Mohnish said this should lead to better results.

Mohnish then discussed a few mistakes he has made. Compucredit is a subprime lender that was trading at 5x earnings and growing rapidly. The investment was sold at a 72% loss. The company has a win lose dynamic where is the company does well it is because they are preying on lower income customers.

Sears Holdings is another mistake. The funds lost 60% in Sears. Retailers are tough businesses. Mohnish is unhappy with himself for investing in this particularly because he wrote a chapter in his book Mosaic about why retailers are tough businesses. The thesis was that Lampert was very smart and would redeploy assets in better things. Sears also has below market leases and some very valuable brands. If it didn’t work out the real estate would be sold. But the problem is that 324,000 employees are between the investors and the assets. Sears cannot compete with Wal Mart.

An investment that worked out late last year was Level 3 bonds. Mohnish purchased the 3.5% 2012 convertible notes around November 4th for an average price of $432. The bonds have a $1,000 face value. He sold for $680. The bond markets were tremendously depressed during the crisis.

Questions:

Q: One of the first questions came from someone who wasn’t happy with Mohnish’s performance last year. From peak to trough the funds were down 70%. This person said that was inexcusable. He also wanted to know why Mohnish doesn’t pay attention to the macro view? To avoid the huge losses last year Mohnish could have raised a large cash position?

A: Mohnish said that for the most part investors were blindsided. Also, he can’t go short and can’t take on leverage. Even if he focused on the macro view, it would have been very difficult to have forecasted what happened last year. He does have some appreciation for the macro view though. But, its much easier to focus on situations where the probabilities are easier to handicap. Mohnish will benefit from inflation because of the natural resource investments he has. Going forward the changes for the funds will be more diversification, a little more emphasis on the macro view and higher cash positions. He is currently a net seller of stocks.

Q: Due to the events last year do you still wait for 3 years for your investments to reach intrinsic value?

A: Mohnish said he is still patient with investments and will wait 3 years for a particular investment to reach intrinsic value. The majority of the gains in the portfolio are long term gains. He will try to minimize taxes. He would never place a stop loss order.

Q: Would you invest in Chinese companies?

A: He said most lay outside his circle of competence. But he has made investments for the partnership in India. He also has one Chinese investment. When making foreign investments he would focus on the ethos of management. There are many great companies but its hard to make investments from foreign companies while being based in the US.

Q: Would you invest in Gold?

A: No. Gold is too hard to value. It has luster value but the intrinsic value is unclear. He has investments in gold through some of the companies he owns. He wants to invest in productive commodities and then find the lowest cost producer. Then he would be interested.

Q: Would you invest in warrants, options or short stocks?

A: Won’t look at anything except possibly covered calls. He has experimented in his personal portfolio and so far only lost money. To invest he would have to go through an amendment process with investors.

Q: How does the Kelly criteria fit with the 3, 5, 10, portfolio allocation method?

A: Pabrai told Munger about his diversification ideas and Munger interrupted him and said that he is going in the opposite direction then him. Pabrai said that since he’s running other people’s money he has to be risk averse. Berkshire has had way more than 20 holdings for a long period of time and done very well. Some large bets have gone wrong. The Kelly Criteria works if the inputs are correct. In some instances he placed the wrong inputs in the formula. Some of his large bets went wrong. He did the formula wrong. He’s moving to a greater cash position like Klarman. When stocks are cheap such as earlier this year he puts the cash to work and now he is a net seller. So over time the cash position will build up as ideas become less plentiful and then cash will decrease when investment opportunities become more plentiful.

Q: Do you use the checklist for portfolio strategy? For example, is there an item on the list that says that you won’t invest a lot in just one industry?

A: The checklist is company specific. The portfolio structure comes before the checklist comes into play. He wouldn’t put a large portion of the partnership in one industry. There will always be at least one issue on the checklist for even a good idea. If you exclude leverage 80% of investments are ruled out. There is always at least one issue. 10 of the questions on the checklist are on leverage, 5 on management. Such as; does management have a large stake in the company? The checklist puts the tradeoffs in front of you. Another checklist item is; does the company have union issues?

Q: An entrepreneur asked Mohnish for some advice on running a business.

A: Focus on what you’re passionate about. Find what you’re interested in and good at. Then hopefully people you know well will give you money.

Q: Did Mohnish had any confidence issues in the 4th quarter of last year?

A: Mohnish said he had no confidence issues but he was watching redemptions closely. He saw the most incredible opportunities he’s ever seen. He was very excited about the investments that were being made. He said that he looked for investments in businesses that had moats and products that were essential.

Q: Why is Mohnish closing the fund to new investors at one billion in assets?

A: He wants to focus on smaller companies. If he had a billion dollars, with 5% allocation he would put $50 million into each investment. To stay under the 5% threshold he would need under a billion in capital.

Q: Someone asked if he could explain his Pinnacle Airlines mistake?

A: Based on value metrics it was very cheap. It totally fails the checklist. There is no win/win dynamic in the business ecosystem. Pinnacle would rake in money as the carriers lose a lot of money.

Q: Could you discuss the lunch with Warren and Charlie?

A: The lunch was worth every penny. 54 different topics were addressed. Buffett said that if he could have lunch with anyone it would be Isaac Newton and then he stopped and said no it would be Sophia Loren. Mohnish told Warren that Harina really enjoyed the lunch but her real love in life is Charlie. Buffett then arranged a meeting with Charlie. He found Charlie to be gracious, like having lunch with your grandfather. Mohnish asked Charlie how he handled his fund’s poor performance in 73 and 74. Most of it is family confidential. Warren told his kids that the most important decision they make is who they decide to marry.

Q: Any book recommendations?

A: The Black Swan was good but could have been written in only ten pages. Atul Gawande’s article in the New Yorker about checklists is a must read. That’s the article that sparked Mohnish’s idea to create his checklist. Also, Atul has written two books, Better and Complications. Mohnish highly recommends both. Mohnish also mentioned the book, The Miracle: The Epic Story of Asia's Quest for Wealth by business journalist Michael Schuman.

Q: Why were there so many redemptions?

A: Last year 15% of the fund’s assets left. Mohnish feels bad because these people were not able to let the investments play out and lost out on a lot of upside. The reason was partly hardship redemptions and fear of equities. Some investors went completely to cash. Some sold everything and went completely into cash. Investors like to do the opposite of what they should. They invest after stocks have done well and sell after they have done poorly. Mohnish received the most new money in 05-07) and the most was taken out just before the best gains in the history of the fund.

Q: Was he forced to change his methods and ideas or was it voluntary?

A: It wasn’t a change rather it was an evolution. Munger says to be a continuous learning machine. But, underlying principles always stand.



Link to Pabrai Funds 2009 Annual Meeting notes from Chicago

Nicholas Financial Update

Nicholas Financial had a good first quarter because of a drop in loan losses. Nicholas is able to make highly profitable loans as a lot of competition is hurt. The company has only a fraction of the debt to equity ratio of its peers but because of its unique lending strategy and its able to make an ROE of 20%+ in a normalized environment. I believe the company is worth at least $12 per share.


For more background information on Nicholas and my original write up click here


All my posts related to Nicholas click here


Nicholas Financial reported net income of $2.3 million for the three months ended June 30, compared to net income of $2.1 million last quarter and $1.6 million in the first quarter of 2008. Revenue for the just-ended quarter was $13.7 million, compared to $13.1 million a year earlier. Things are beginning to improve for Nicholas as loan losses, operating expenses and the cost of borrowed funds fell in the quarter. Net income rose 34%.

The biggest issue I see is the company needing to increase its credit line and renewing it in November of next year. This shouldn’t be an issue because they extended their credit line last year without a problem. The credit line is for $115 million and they have $104 million drawn down. The line of credit has one key covenant, which is that the pre-interest-expense, pre-tax income must be 1.25x interest expense at the end of each month. They're at 3.8x as of this quarter. The company should have no problem there.

The economic indicator that best correlates to Nicholas’s charge off rate is the unemployment rate. The pre-tax margin for the quarter was 6.34% and the provision for credit losses was 6.16%. Credit losses would have to double from here to bring Nicholas into the red, a very unlikely scenario, given that the provision for credit losses fell from 6.26% of average credit receivables to 6.16% in the current quarter. Net charge offs fell from 8.94% in the fourth quarter to 7.72% in the 1st quarter. Management anticipates losses absorbed as a percentage of liquidation will be in the 11%-16% range during the remainder of the current fiscal year. Losses as a percent of liquidation were 11% in the 1st quarter.

The loans the company is making are getting more profitable as their competition has diminished during the credit crisis. The average discount of new loans purchased has risen to 9.29% from 8.87% a year ago. At the same time the new loans are becoming more profitable they are also being made with more stringent credit standards:

The primary changes include; raising the minimum income required by the debtor to qualify for loan approval, reducing the maximum dollar amount that can be advanced for certain loan applications, and the maximum dollar amount that can be approved by a branch manager on certain approvals.

- First quarter 10Q

The average pre-tax yield over the course of the company’s history is around 9%. So when that level is reached again and it is likely that it will be at 9% or higher given that the loans being made now are of higher quality, due to lack of competition. With $216 million in net finance receivables at a 9% pre-tax margin, net income would be $12.5 million. At the same time the company is growing at more than 10% per year. With a multiple of 10x earnings Nicholas is worth $125 million or $12 per share.

Each of the 50 branches is budgeted (size of branch, number of employees and location) to handle up to 1,000 accounts and up to $7.5 million in outstanding finance receivables, net of unearned interest. To date ten of the branches have reached this capacity. The goal is to get all the branches to this level. If all the branches were operating at this optimum level the company would have $375 million in net finance receivables verses $216 currently. One issue for the company has been attracting qualified branch managers who are able to run a small business and at the same time be street smart and tough enough to collect from non paying customers. In the CEO’s letter to shareholders he said:

As a result of the spike in the unemployment rate, especially within financial services, we are now attracting a much higher number of quality job candidates than we have in the past. In many instances their company has either gone out of business or made considerable cut backs leaving them out of work or fearful of future layoffs. This recent change in the recruiting environment has allowed us to staff our company with several well-qualified people, making us stronger than ever. We believe this opportunity will help us to expand our Company, while our competitors pull back or in some cases, abandon our markets.

- Chairman’s Letter to shareholders 2009

During the recession management stopped all expansion to keep the balance sheet strong. Management is more confident with their current results so they have two more branches scheduled to open in the near future. This expansion will include new branch locations in Akron, Ohio and in Gastonia, North Carolina, which will bring the number of branch locations to 50 in 12 states. Also, the company mentioned, for the second time, that it is interested in an acquisition: The company “remains open to acquisitions should an opportunity present itself.” In ten years net worth has grown from $11 million to $88 million. Clearly the company has room to grow.
Nicholas is currently trading for $70 million with $88 million in shareholders equity. I believe the company is worth $125 million and I added to my position a few months ago at $5. Company insiders also thought the company was cheap and have been adding to their already large holdings.