The Island Investing Blog

  • How I Voted Our Shares

    An update for Tarpon Fund investors.

    During the sign-up process for investing in the Tarpon Fund you may remember that you chose to either vote the shares in the companies you owned or allow me to vote those shares on your behalf. This is proxy season for most of corporate America, so I’ve been doing a fair bit of voting lately.

    A proxy is a statement that a company is required to file every year with the SEC that discloses among other things the bios of company officers, compensation for executives and directors and the number of company shares that each executive owns. Proxies are also used to solicit votes prior to a company’s annual meeting.

    Here’s how I’ve voted our shares so far in 2009:

    For almost all of the companies we own that have recently issued proxy statements, I have voted as management recommended. It’s not that I have a rubber stamp, though. Most votes have just dealt with routine issues such as ratifying the appointment of new auditors, re-electing board members and approving amendments to compensation plans.

    In one case, however, I voted our shares against management’s recommendations.

    Google

    Google shareholders floated a proposal in this year’s proxy that would effectively require the company to resist censoring its web searches in foreign countries. You may recall the company’s 2006 agreement with the government of China to censor its search results as a condition of gaining access to that market. In the proxy, management acknowledged that free expression on the internet was important but opposed the proposal.

    I’m not too strident about the issue one way or the other in terms of political policy. As a businessman, however, I do think it probably damages Google’s brand both here and abroad to agree to censor searches.

    Marketers often try to define “brand” as some sort of mysterious collection of mass impressions. I think the better way for investors to define a brand is as a long-term asset, no different than a building, despite not being found on a balance sheet. The value of a brand is, like any other asset, whatever it costs to reproduce it.

    In Google’s case, the company’s brand is hard to reproduce here in the U.S. because the company has amazing user loyalty despite the ease with which searchers could switch to another service. They’d likely come back, because Google’s search results are superior, but I’d prefer to not give anyone an excuse to think about switching loyalties in the first place.

    Censored search results by definition won’t be superior, however, and in the dark of the night I fear that could make Google searches in foreign countries appear no different than those of inferior search engines. I’d rather not see the asset that is Google’s brand being impaired in any countries.

    Back to the proxy. Rather than acknowledge the potential impact of censorship on its brand, management argued against the proposal by disputing the role Google has played in developing industry censorship standards. As I read it, however, the proposal wasn’t asking the company to develop better standards – it was asking the company to take a stand.

    It was an artful dodge of a tough question, and though I still have tremendous respect for Google’s business and its management team, I voted against management’s recommendation on this particular issue because they need to get some clarity on censorship policy. They’ve been waffling for years now.

    I don’t pretend to know the true impact foreign censorship could have on Google’s brand or business. It’s probably minimal. But I don’t think anyone at Google truly knows, either, and as a shareholder, I’d like some assurance that management is leaving no chinks in the armor. I think it’s probably worth spending a few bucks to assess the perceived value of Google searches by foreign users and advertisers who are aware that results are censored before committing capital to expand in other countries.

    So our votes were cast in favor of the shareholder proposal regarding Internet censorship. Here is the proxy statement if you’d care to read it. See page 33 for details on the censorship proposal.

    Again, I am less concerned with the specifics of Google’s policy than I am with making sure that management has thought out all the possible negative business consequences of a formal position either way. I don’t think they have, so I publicly pinged them as best we could. I suspect most shareholders will vote as management recommended, but I thought it important to send a message to protect the company’s brand.

    Target

    The other proxy worth mentioning was that of our company Target. On the surface the issues up for vote seemed pretty innocuous. Voting to formalize the number of directors at Target at 12 and not 13 seems an issue more suited to a party planner than a shareholder. Behind the scenes, though, there has been considerable drama.

    For several years the activist hedge fund Pershing Square has been discussing various initiatives with Target’s management. A few years prior Pershing had seen high returns by agitating at the hamburger chain Wendy’s. Pershing’s interest in Target was similar.

    Pershing’s founder Bill Ackman is by all accounts sharp. Last October he published a 164 slide presentation on his latest plans for Target. In a nutshell, Ackman wants to place a few friendly faces on the board to push the company to about this plan:

    To have Target form a REIT (real estate investment trust) that owns the land under all of its stores. Then the company will spin off a 20% stake of that REIT through an initial public offering to Target shareholders. The REIT would then lease the land back to Target for 75 years. Target would retain 80% ownership of the REIT and use the capital raised from a $5.0 billion IPO to pay down its debt.

    If you’re asking yourself, “Why should Target go to all this trouble?”, you’re not alone. I slogged through the Ackman slideshow last fall and did again prior to voting. Both times I couldn’t help but think it seemed a bit myopic.

    While no one should question Ackman’s financial engineering abilities, it’s not clear what business problems he is attempting to solve at Target. I don’t believe the company has a dilemma when it comes to its real estate. I’m comfortable with their debt levels, as is management, who even Ackman concedes is the best team in the retail industry.

    There is certainly a gap between the value of Target’s real estate and what the market believes it to be worth, but, hey, we’re in the middle of the worst real estate bust in the modern era. Gaps are everywhere. Trying to accelerate the market’s recognition of one particular discrepancy above all others these days is like paddling a canoe to Cuba with a baseball bat. You may get there eventually, but you’ll be exhausted.

    The second time through the presentation I also found myself nitpicking at certain assumptions. For instance, I wouldn’t want to acquire any commercial real estate or land leases with an 8.5% cap rate these days, as the opportunity cost is too high. And even if the company’s new leases qualified as operating (versus capital) leases for accounting purposes, those new payments would in the analytical sense be just as much a commitment as interest payments on debt. So I’d treat them as debt, anyways.

    By my estimate Target would also be paying at least $2.1 billion a year in lease expense under Ackman’s plan. Spinning off the land under Target stores to pay off $5 billion in debt now, only to be left with $3 billion owed to JP Morgan and still have $2.1 billion in debt-like lease payments every year for 75 years doesn’t sound too appealing. As a standalone entity, Target’s financials will look better, but I fail to see how the plan will improve the economics of the business. Perhaps I just don’t get it.

    In the end, it became hard not to think of the plan as a Wall Street straw man propped up to help reverse the disastrous bet Ackman made on Target at a much higher share price. To each his own. But for the record, I voted our shares with Target management to formalize the number of directors at 12. Pershing is a good firm, but Target’s management has earned the benefit of the doubt.

    Please email me with any questions. And someone please send Bill Ackman this book.

    Disclaimer: Cale Smith owns shares of Google and Target. Clients advised by Mr. Smith also hold long positions in both companies. This post in no way constitutes investment advice. Commentary on this blog should never be relied on in making an investment decision. Not now, not ever.

    Posted by: Cale Smith , Commentary
  • The Superior Math of Value Investing

    I believe value investing is the only rational way to invest. It’s two scoops of common sense, a healthy dollop of skepticism and a commitment to ordering off-menu entrees. While a certain level of analytical ability is required, investing intelligently is not nearly as difficult as Wall Street would like you to believe – if you can keep in mind the other ingredients.

    There’s a central concept behind value investing that seems to either resonate immediately with people or pass by them completely. The concept is this: a publicly traded company has two values – its ‘intrinsic’ value, and the value the stock market puts on the business.

    Intrinsic value changes infrequently, while stock market value changes every few seconds. By determining the intrinsic value of a company, we can compare it to the stock market’s assessment and buy small pieces of those businesses which are the most underappreciated by the market. Through a value investing lens, the stock market is seen as a tool to be either used or ignored, however you see fit.

    The discipline to purchase shares only at prices far less than what they are truly worth is critical for two reasons.

    First, it protects you from significant and permanent loss. This “margin of safety” concept is unique to value investing.

    Second, buying well below intrinsic value presents the potential for substantial appreciation once the market recognizes the company’s true long-term value. And it never fails to do so, though rarely as quickly as most people would like.

    Value investing is a simple concept with surprisingly few devotees. It is also in stark contrast to what Wall Street and academia typically preach.

    Where’s the proof ? In at least two places.

    First is at the very top of Forbes’ 2008 list of the world’s richest people. There you’ll find Warren Buffett, the most famous practitioner of value investing.

    There is a simple math proof, too.

    Say Corley buys shares in a company for 50% of their intrinsic value. The intrinsic value of the company then grows 12% per year by doing nothing more than retaining its own earnings. Even if it takes four years for the market price to reflect the company’s true worth, her investment will still have compounded at 30% per year.

    Mathematically, two thirds of that return comes from the gap between market price and intrinsic value
    closing. Only one third comes from the business value growing.

    There are three key points here:

    1 – Growth is essential, but its less important than buying at a low price.
    2 – Value investing effectively provides leverage with less risk.
    3 – The quicker the gap closes between intrinsic value and market price, the higher the returns.

    Here’s Warren Buffett on value investing:

    “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the
    temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

    The above article was originally featured in our first Letter to Investors. To subscribe, email me.

    Posted by: Cale Smith , For Investors
  • Create Your Own Convertible

    I don’t mean building a car – see this guy to do that. I’m referring to a bond that can be converted into stock.

    Convertibles are hybrid securities with the features of both stocks and bonds. They usually have lower yields than regular bonds, but an owner receives the right to convert the bond to common stock at an agreed upon price. So, convert owners can receive guaranteed interest payments and still benefit from growth in a company’s stock.

    While the market for converts in the U.S. is very liquid, not all companies issue them. Fortunately, you can create your own. You can also think of building your own convertible as a way to create a dividend from a stock that doesn’t pay one. So if building an annuity is not your thing, but you’d like to dip a defensive toe into the stock market, here’s another low fee option.

    You can create a “synthetic convertible” by combining interest bearing securities and call options. LEAPS in particular can enable you to benefit handsomely from mispriced assets – if you have a long-enough time horizon.

    “90/10” is one way to build a synthetic convert. That means 10% of the cash you want to invest goes into call options and 90% goes into an interest bearing security, such as a CD, that is held until the options expire.

    The options provide built-in leverage and give you the right to buy shares in the company – just like a real convert. The CD limits your downside risk, meaning your loss exposure is limited to the amount of the call premium less the interest you earn on the CD.

    That’s all there is to it. A guaranteed return plus the chance for an equity kicker. Now you can impress folks down at the dock. Plus, with an attitude and $20,000 you can go start your own hedge fund.

    Morningstar has a good free guide to options for beginners here. There’s more on converts here, too.

    Posted by: Cale Smith , For Investors