USAA love

Joy and I are starting to be serious about buying a house(!), which has added to stress lately. We probably aren't going to get a great deal, but I think we are close to finding a fair deal on a townhouse. Now, most of our liquid assets are tied up in retirement accounts, including the IRA that I use for investing in individual stocks mentioned here. So I called USAA to see what the rules are for withdrawing money for buying a house. The representative cleared up the questions I had, but also suggested several other products in the softest possible way. It was like having a conversation with a very knowledgeable friend. I didn't actually buy anything at that point, but I will in the very near future. I'd like to see another bank steal my business from USAA. Good luck!

Price/Value ratio

Reading the latest Longleaf Partners Funds report, I was inspired to calculate the Price/Value ratio for my holdings:

Company          P/V
-------          ---
Canon            86¢ 
Select Comfort   36¢ 
Berkshire        82¢ 
Sally Beauty     59¢ 
First Marblehead 23¢ 

I recently sold Oracle for somewhere between 90¢ and $1 to the dollar. Cash is always worth $1 to the dollar and I used the same rate for Alberto-Culver, since I haven't put a value on that company. My composite P/V for the portfolio is roughly 66¢ to the dollar.

Select Comfort and First Marblehead still seem insanely cheap to me even after slashing my value estimate. I expect these will be truly outstanding investments for those who purchase today, but both have been classic value traps for me. (A value trap is an investment that looks cheap, but whose value falls as fast or faster than the price.) First Marblehead in particular has been a head-scratcher, since it operates in a great business that has been abandoned by other companies due to short-term problems. Both companies now include a free option on any future growth.

Of course, the value portion of the ratio is my conservative estimate of the present value of all future earnings. Further, there's no way to know when or if the price will converge on the value, assuming I estimated it correctly.

First Marblehead's good day

So the analyst who has been talking down First Marblehead for months has upgraded the company because the negative news is now baked into the stock price. As a result, the stock price has jumped 30+% today.

Of course, nothing has really changed except that one influential analyst has become a little less negative on some deeply discounted shares.

Luxury Goods

So here are three things I read today:

• The Rich Drink Better Beer, Not More
• There's a new thing called coolspotters that tracks what products celebrities endorse.
• Consumers are incredibly stingy, except when it comes to luxury items.

Of my investments, I'd say three and a half of them less luxury goods to consumers. Canon sells top of the line cameras (as well as high-quality point-and-shoots), Sally Beauty sells salon-quality supplies, and Select Comfort sells premium mattresses. Alberto-Culver has mass market products that are more upscale than average in drug stores and Wal-Mart. The advantage these companies share is pricing power. Basically in hard times, like now, they can decide to drop prices a bit to keep up sales volume, or they can wait around until times get better and raise prices. I have to be honest: I'll probably pay 10% more to get a Canon product over any of the competitors. It might seem irrational, but I think it's justifiable because I know what I'm going to get and I know I'll be happy. I'm sure the same is true of women who buy certain brands of shampoo or soap.

Biggest losers

I'm constantly amazed by the irrationality of the stock market. (Of course, the market seems irrational when my stocks are going down and I'm a genius when they go up!) My two biggest losers are priced far below what my DCF models predict they are worth. First Marblehead is fairly easy to figure, since the company publishes projected cash flows from its residuals. If you discount those residuals at 15%, which is greater than the rate management uses to value any of the residual tiers, the stock ought to be trading no less than $6 a share. That would imply no future business, which is a safe assumption at the moment. The current price ($3.62) implies a discount rate of 23%, which is what you might be charged for credit card debt if you had a really bad credit score. Remember, these loans can not be discharged in bankruptcy and were originally made to people with relatively good credit scores. First Marblehead will almost certainly double in price when the cash from residuals begins rolling in during 2009. Also, the shares have a built in call option on the possibility business will resume in the future.

Select Comfort, as a consumer products company that is currently out of favor with consumers, represents a tougher challenge to value. There's no way to know if the Sleep Number concept has run its course and sales will whither and die. But if we assume that the company will earn 22¢ in the next 12 months as it did the last 12 months and that earnings will increase a modest 3% forever, you get the current market value. But there are reasons to expect these assumptions are too modest. First, the company has finally stopped building new stores and buying back shares, and has cut advertising, staff and other expenses. Earnings in the future figure to be higher even if sales remain flat. Second, if the market ever turns Select Comfort would seem poised to capture quite a bit of market share. It's severely cut back advertising, which has hurt the wholesale and online portions of the business. When people start buying mattresses again, it should face fewer competitors with less capacity.

Now these companies have very little risk of becoming worthless and if things go right ought to do very well. At these prices, simply returning to profitability will provide new investors with great returns. I've already lost most of my investment in these companies and I can't afford to put more cash into them. But I will continue to hold them, which is functionally the same as considering them good buys, because the upside remains more likely and more profitable than the downside. As Mohnish Pabrai says, "Heads, I win; tails, I don’t lose that much."

Why I sold off my Oracle position

For the first time since I began buying individual stocks, I do not own Oracle outright. The call option I sold last month was exercised at expiry and was worth 80¢ since Oracle ended the week at $21.80. Although I lost a little bit on this option, my combined ratio stands at 68.04% for all options written.

The position I sold over the weekend was purchased a little over a year ago for $16.50, which works out to a 29.32% annualized gain. The S&P 500 has lost about 1% over the same time. So that particular trade has been very profitable, as has my Oracle trades in general. I still believe Oracle is misunderstood, but I believe it is trading near its fair value and I don't think its prospects look particularly good in the next few months. Eventually, companies will respond to slowing consumer demand by cutting capital spending. And we have not yet seen the end of bankruptcies even within the financial sector. Perhaps I will be able to buy back into the company if it misses earnings in the next year or two. I hope so, because I'm already starting to miss it.

More good news and bad news

This week, my portfolio had good news and bad news. The good news is that Canon paid their year end dividend. Since the exchange rate has fallen to about ¥100 to the dollar, the ¥60 dividend worked out to be 60¢ a share. Canon's dividend yield is about 2%, but based on my original cost basis, I'm earning closer to 3%. As long as Canon continues to raise its dividend, I will be happy to hold my shares.

The bad news was that TERI, the non-profit that First Marblehead uses to insure its loans, declared bankruptcy. Now I believe the bankruptcy is for technical, not fundamental reasons, and I think the effect on First Marblehead will be very little in the long run. But my position has been battered to a considerable degree and perhaps permanently. At the very least, the news makes an immediate recovery very difficult.

At no time have a felt that First Marblehead was a bad risk/reward proposition at the current price, so in one sense I don't feel I made a mistake. But I did ignore one of my fundamental sell signals: to get out when a dividend is cut or lowered. If I'd done that, I would have saved myself a lot of money and aggravation. Further, there will often be an opportunity to buy the shares back at a later date when I've had a chance to analyze the company independent of the dividend.

At the moment, this sell signal only applies to Canon and my token position in Alberto-Culver. Which reminds me: selling Alberto has easily been my most costly decision to date since it freed up cash to buy First Marblehead.

Good and bad news for Oracle

Oracle had a pretty good third quarter, but not good enough for Wall Street's standards. Earnings came in at 26¢, which was 6¢ better than the previous year, but 4¢ less than the average analyst prediction. I don't see anything too surprising about the numbers on first inspection—there aren't as many companies buying new licenses, but current customers still seem to be paying. But Oracle's shares fell $1.50 or so this morning.

Meanwhile, my short call position gained about 75¢ over the same time period, which effectively cushioned half of the loss for me. Further, the news does not substantially lower my long-term opinion of Oracle's value, though it did reduce the odds I'd get $21 for my shares. So selling the call option has served my purpose. Interestingly, the call ought to have served the purpose of whoever bought it as well. Rather than buying shares and losing $1.50 overnight, the buyer would have lost only 75¢. And the insurance would have required less cash be tied up than if the shares were bought outright. Altogether, it was a fair exchange.

With 22 days remaining before expiration, there the odds the option will be exercised are less than 30%

Why I sold another call option on Oracle

I sold a call option on Oracle with a strike price of $21 that expires in April. I think $21 is near the bottom of Oracle's fair value range and I'm willing to be paid 75¢ for the risk it will be worth more than $21 in a month. Oracle took a little dive today after I sold the call and the odds that it will be exercised are about 2 in 5 as of right now. I'll also be happy to get the cash if I need to sell—Oracle is most nearly fully valued of my positions.

Here comes the activist

Last night on 60 Minutes, there was a story on Carl Icahn, activist shareholder/corporate raider. I caught myself wondering if he would be interested in a small, unconventional mattress company based in Minneapolis. Of course, the entire company is far too small for him to bother with, but as luck would have it, the George Hall (another activist shareholder) has targeted Select Comfort.

The letter to Select Comfort lists a number of proposals, which are not terribly radical, but do highlight several management failures. Most troubling to me are comments about CEO William R. McLaughlin's recent announcement about his salary:

Further, the Chief Executive Officer's agreement to forgo his base salary until same store sales increase by at least 1% for four consecutive weeks, while good for public relations, is inconsistent with shareholder interests, since improvement of the Company's financial performance requires a greater length of same store sales improvement than four weeks. Further, this limited, short test allows for alteration of marketing spending in order for the Chief Executive Officer to achieve his limited performance goals, which may have nothing to do with appropriate marketing spending for the Company and inconsistent with the Company improving its annual financial performance.

Looking at the text of Mr. McLaughlin's letter, I'm forced to agree with his critics—he seems to be an untrustworthy manager. At this point, he has set the bar so low that practically anyone with some business experience can clear it. I'm afraid I now agree with those who have called for him to resign.

Reading between lines, implementing SAP seems to have become a death march. More money will not solve the problem, so shareholders ought to consider the cost so far to be sunk. Also, as the letter spells out, the SAP installation is probably overly ambitious for a company like Select Comfort, which may never recoup the savings needed to pay for the system.

I don't know if I agree with the idea that the company should close low performing stores. The letter suggests returning to the company's direct marketing roots and eliminating the wholesale business. I think the key to the problem is understanding why some stores are failing. For instance, it does not seem like stores are getting the advertising coverage they need. If that's the case, closing the stores might not be the most productive idea.

Overall, I welcome Mr. Hall's investment and I hope management will open up their operation to his input. An outside pair of eyes can only help.

Portfolio volatility

Thanks in part to abysmal performances by First Marblehead and Select Comfort, my portfolio is sinking like a rock. It has now dropped decisively below two of my favorite benchmarks: Berkshire Hathaway and inflation + 10%. Worse, I think the official measure of inflation I use is understated and Berkshire is undervalued. Meanwhile, the S&P 500 index is "gaining" ground (by dropping less quickly than my IRA), so the recent past has been harsh.

Nobody likes to be wrong and the standard response to a situation like this would be to say that luck turned against me. Owning two companies that have been particularly hard hit by the housing and securitization busts might seem like unfortunate timing except that I've bought both companies on the way down knowing the strikes against them. It's ugly and I can't blame luck.

The good news would be that I haven't actually lost money on these shares. Both companies will see their fortunes reverse in a few years. I expect current prices will seem unimaginable. Further, there is no particular reason for me to sell these companies until their fair value is reached. So I need to ignore the stock charts wiggling up and down for the moment.

2007 Look-through earnings

As usual, I have to wait for Warren Buffett to release Berkshire's earnings before I can tabulate mine:

EPS              2008* 2007  2006  2005  2004  2003  2002
Oracle           0.15  0.27  0.13  0.21  0.30  0.44  0.34
Canon            0.37  0.31  0.28  0.49  0.34  0.08 
Select Comfort   0.18  0.19  0.19  0.27   
Berkshire        0.22  0.30  0.25    
Alberto-Culver   0.02  0.02  0.08    
Sally Beauty     0.05  0.04  0.00    
First Marblehead 0.41  0.14     
Look-through     1.00  1.13  0.93  0.97  0.64  0.52  0.34

* 2008 numbers are consensus analyst estimates.

I keep track of my IRA like an open-ended mutual fund and this is the look-through earnings per "share" of my IRA "fund". As I buy and sell stocks, my portion of their earnings fluctuates and when I add cash, it alters the percentage of portfolio's total value comes from look-through earnings. So when I sold Oracle shares over the year, I reduced the earnings I give myself credit for and when I bought Select Comfort, I increased my share of earnings.

Thanks in very large part to Oracle, my look-through results actually improved. When you add in call option premiums and capital gains on selling shares, my results are even better. But my relative share of the company has been reduced and I won't get anywhere near those returns in 2008.

My two troubled positions look ok in this table, but that is mostly an illusion because I've increased my holdings to a large degree. In his just released letter, Mr. Buffett lays out four criteria he looks for in buying a business: "a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag." The CEOs First Marblehead and Select Comfort have earned my respect anew by taking voluntary pay cuts for poor results that are largely out of their control. Also, the stock market has cut share price of these companies from cheap to practically free, in my opinion. The reason in both cases is largely a result of worsening economic conditions. In both cases, there are internal changes that need to be made if the companies are going to thrive, but they continue to have advantages compared to competitors that are not likely to disappear. If I weren't already up to my ears in these companies, I'd be buying at these prices.

Canon and Berkshire continue to earn about what is to be expected. They are both too large to grow quickly, but have very wide and clear moats that ought to preserve the businesses for decades to come. Unlike Oracle, the market has not come close to recognizing these company's intrinsic values, so I have not been tempted to sell.

Sally Beauty earned very little this year because it has needed to pay so much in interest expenses since splitting with Alberto-Culver. This year and next ought to be pivotal for the company, so it's very encouraging that directors have bought $3 million of shares to the $1 million worth they purchased with their own money last year. When the restrictions on selling agreed to by the principals of the spin-off transaction expire at the end of the year, I expect management will begin to trumpet business growth instead of underplaying it. I've noticed there are plenty of mom-and-pop beauty supply shops here in Southern California, and I expect there will be plenty of opportunities to consolidate the industry while paying down the debt.

Interestingly, 2007 looks similar to what analysts predicted last year, but that result is misleading because I'm more invested in these stocks than I was at that time. Looking at operating earnings, which includes various cash returns and costs, shows a fuller picture of my results:

Interest    0.01    0.03    0.16    0.01    0.03    0.02    0.00
Dividends   0.00    0.08    0.06    0.08    0.03  
Costs      (0.01)  (0.14)  (0.19)  (0.04)  (0.06)  (0.22)  (0.12)
Arbitrage   0.00    0.50    0.41    
Options     0.07    0.14     
Operating   1.07    1.79    1.37    1.01    0.65    0.32    0.23
Gain      -38.18%  25.76%  35.66%  56.70% 100.59%  41.50% 

I'm fairly pleased with these results, but I can't expect them to continue into the future. In particular, I likely will not have any arbitrage earnings this year, since I've invested most of my cash into businesses that I feel are too cheap to pass up and which might not pan out for a few years. Finally, here are my net results juiced by large realized gains that will not be repeated this year:

Realized Gain           2.88                            1.79 
Special dividend                2.99    
Net              1.07   4.60    4.37    1.01    0.65    2.11  0.23
Gain           -76.79%  5.41% 331.08%  56.70% -69.39% 827.21% 

Portfolio news

First, Footnoted.org has some details on the Oracle/BEA merger and gave First Marblehead a gold star.

In worse news, Select Comfort has again disappointed shareholders, though it seems the market is overreacting a bit. Now that it's clear air beds are not immune from recession the way Tempur-Pedic memory foam beds seem to be, no one should be surprised by slowing sales in the quarters ahead. There is no reason the company can't survive and come back much stronger. At these prices the risk is minimal and I suspect that recent price drops have more to do with institutions dropping losers and "penny stocks" than real analysis of the business.

That said, there are some huge opportunities that the company has missed. Having established their brand and product as legitimate, they should have addressed the question of why buy from them. The competition, in my opinion, is regional mattress stores and traditional mattresses, not other premium mattresses like Tempur-Pedic. Now that Select Comfort has established stores all over the country, the network needs to be leveraged.

Here's my idea for a new ad campaign:

A sleazy looking salesman in a wrinkled suit is standing in front of a mile of mattresses next to a guy in a bear costume.

Salesman: Come on down to Miles of Mattresses! If we can't get you the cheapest bed, I'll wrassle this bear!

The picture jumps and slows down as if it were on a film projector that is starting to die. The scene fades to a clean Select Comfort store with three beds or so and a clean-cut salesman in a polo shirt and slacks. There might be another salesman helping a couple try out the bed in the background, but the store should not look cluttered.

Spokesman: Why buy an outdated spring mattress that needs to be flipped every year? Springs start to sag after a while in cheap mattresses and become uncomfortable. Select Comfort sells only modern Sleep Number beds that support sleepers with their exclusive adjustable air chambers. And unlike foam or water beds that are difficult to move, the a Sleep Number bed can be emptied and packed in a matter of minutes. Why buy from this guy, when you can sleep on a layer of air for a lot less than you might think. Come to one of our X locations in Y.

As the spokesman talks, cut to the standard "pressure point and support" image or, if there are customers in the store, show them adjusting the bed to minimize pressure. When the spokesman says, "this guy", cut to the salesman and bear wrestling or cycling each other. Finally cut to a map of the Y region with X stores clearly marked.

These ads should be short, well produced and run constantly. They need to be shown in the cheaper time-slots at night, during the day, and on weekends so that they get seen by people who are ready to buy a new bed. Hopefully everyone who has a TV will see them at least occasionally. I think retail partners are a mistake unless Select Comfort has no locations in a region, and even then, they should make sure the retailer's ads put Sleep Number beds in a good light.

I don't think the financials are nearly as bad as they appear, especially if you allow for a recession. I also don't think it will be too hard to turn this ship around. In fact, I think they are one good TV spot away from returning to high growth, since they have cultivated a number of advantages over regular beds.

Why I bought yet more First Marblehead

After the most recent First Marblehead release, the market gave me an offer I couldn't refuse. According to my calculations, the current liquidation or run-off value of the company is $9.80 a share. That number assumes shares will be diluted 20% according to the Goldman Sachs deal. Then I calculated a conservative guess of the company's value assuming it is able to return to some sort of stable business. I'm guessing the company is worth $38 or more if they are able to convert some of their loans on the balance sheet into earnings. Note that I'm not assuming they will get the same sort of securitization deals they received a year ago—just that they find buyers or financing to turn their loans into earnings at some point.

Personally, I think this whole crisis will blow over in a year or two and Marblehead and Sallie Mae will survive as a bunch of competitors will disappear. As survivors, their earnings power will dramatically increase and $38 will seem laughably cheap. But for the sake of argument, let's use that number. I also expect survival has a better than 90% chance, since Goldman Sachs has a stake in the company. But to prove the point, I'll assume the survival odds are 50%. My expected price, therefor, is $24 and my Kelly ratio is 39%. So I bought more shares at $14.95 to boost my First Marblehead position and reduce it's cost basis.

In my opinion, First Marblehead will be able to continue as a going concern whether or not it is able to securitize loans. Those loans will provide consistent, high-return cash flow to someone over the next few decades, so someone will buy them or finance Marblehead to keep them. It's not dissimilar from Microsoft shifting from selling shrink-wrap software to collecting service reviews. Either way they are selling something valuable and it's just a matter of how to collect profits. So this purchase is not a bet on the securitization market, but a bet on First Marblehead's business.

Four types of moats

Recently on the Motley Fool, there was an article highlighting four different moat types:

1. Economies of scale
2. The network effect
3. Intellectual-property rights
4. High switching costs

Personally, I'd divide IP rights into: patents/secrets and brands, which is to say: what you know and what your customers know. Also, economies of scale and network effect are really two sides of the same coin. Size can give a company advantages or it can give customers advantages or both. I think high switching cost has an analogue as well: monopoly. Regulated monopolies are especially impervious to assault.

1. Size
   1. Economies of scale
   2. The network effect
2. Knowledge
   1. Intellectual-property rights
   2. Brand
3. Stickiness
   1. Monopoly
   2. High switching costs

In each case, the moat is developed by created an advantage that other companies can't steal. Bigger companies, like bigger ancient cities, are more likely to have established moats. For instance Oracle, Canon and Berkshire Hathaway have multiple and deep moats in nearly every category. First Marblehead mostly fends off competition with intellectual property. I'm worried that Select Comfort might have lost their primary moat—their brand. Those are much smaller companies that have not completely staked out their territory.

So for smaller, fast-growing companies, the question is what moats can they develop?

Yield curve strategy nears turning point

When the Federal Reserve knocked short-term rates down 3/4%, I took at look at the current yield curve to see if it has become attractive. It still looks flat to me, so I'll stick to the PIMCO Total Return fund for now.

The Total Return fund returned 9.07% last year compared to 5.49% for the S&P 500 with dividends invested. That's pretty good, but I made the call about a year too early. The S&P 500 was up 15.80% in 2006 compared to just 4.0% for PIMCO. So far this year, the index is down 9.67% and the bond fund is up 2.66%, so I'm not complaining about being early. In fact, I think the nature of the yield curve signal requires an early switch when the curve becomes inverted.

As we saw today, the Federal Reserve controls the short end of the yield curve. When it wants to stimulate the economy, it pushes down rates and tries to raise them when the economy seems to be functioning well. Market forces controls the long end of the curve. Since there is little default risk in US bonds, the market mostly concerns itself with beating inflation over the life of the bond. In general, the longer the bond the more yield investors demand to compensate for inflation risk over the life of the bond. Since inflation and economic activity are closely related, you could rephrase those goals so that the Federal Reserve is fighting inflation and the bond market is predicting future economic activity, but I think that's overly complicated.

Under normal circumstances, the curve slopes up as the term of the bond increases. When the short-term rates go up because the economy is functioning well, the long-term rates go up too because of an increased expectation of inflation. On the other hand, when the economy is in trouble, there isn't as much inflation to fear in the future. So there is something strange going on when the curve is inverted. Specifically, the Federal Reserve thinks the economy is doing fine and the bond market isn't worried about inflation, which seems like the best of all worlds—the so-called Goldilocks economy.

And for a while, it is the best of all worlds as the economy hums along with no sign of rising prices. But it also means that most people let down their guard against "bad things". There is also an inherent risk that people will borrow long and loan short to profit off of the inversion. When the curve snaps back to normal, the profit vanishes and the position becomes an expensive liability. Leverage will increases the pain. You might think this only happens to hedge funds and Wall Street types, but how many stories have you heard recently about people taking money out of their home's equity to buy cars or go on vacation? One of the reasons people were willing to do that sort of thing was that borrowing against home equity was so cheap and easy.

So an inverted yield curve marks the moment when everything is working about as well as can be expected and conventional wisdom says there is nothing to be worried about. And there isn't until suddenly, there is a lot to worry about. The Federal Reserve responds to economic trouble by pushing down the short end while the market responds to future inflation by demanding more yield on the long end. When we see a normal to steep curve, the fear permeates the economy and it's time to switch from bonds to stocks.

Long-term results

I go to the mound in the 1st inning planning to pitch a perfect game. If they get a hit, then I am throwing a one-hitter. If they get a walk, it's my last walk. I deal with perfection to the point that it's logical to conceive it. History is history, the future is perfect. — Orel Hershiser

Having become throughly depressed by my IRA's 2007 results, I thought it would be a good idea to look at the long-term results again:

Date      S&P 500   Delta     IRA   Delta   BRK A
06/23/02     
12/31/02  -11.37%  42.32%  30.95%  30.18%   0.76%
12/31/03   26.38%  -1.49%  24.89%   9.08%  15.81%
12/31/04    8.99%  -2.16%   6.84%   2.49%   4.34%
12/31/05    3.00%   3.23%   6.23%   5.42%   0.81%
12/31/06   13.62%  14.88%  28.50%   4.39%  24.11%
12/31/07    3.53% -16.83% -13.30% -42.04%  28.74%
01/11/08   -4.59%  -0.66%  -5.24%   1.47%  -6.71%
Total Gain 41.13%  54.81%  95.94%  12.98%  82.96%
Annualized  6.40%   6.47%  12.87%   1.38%  11.49%

While 2007 was a very rough year and 2008 is not looking much better so far, my 5 1/2 year performance is still 6%+ better than the S&P 500 and 1%+ better than if I'd just bought Berkshire Hathaway shares. Big years early on have saved my IRA from under-performance. The current bear market will be a test on my portfolio and my willingness to deal with loss.

To tie in the Oral Hershiser quote: mistakes (and successes) in the past are no longer important to what must be done in the future. Rather than beat myself up over past mistakes, I need to focus on what I can do to maximize my future success. If that means selling some investments at a loss to buy another investment with better potential returns, so be it. As it happens, I still believe in my current investments, so I don't plan on doing anything drastic. Over the long run, I hope my decisions to be shown correct.

I think I understand the Goldman deal

After listening to the conference call and reading the press release and SEC documents, I think I understand the logic of First Marblehead's deal with Goldman Sachs. Recall that when I bought the company, it needed to securitize the loans it helped originate in order to make money. The banks that originally fund the loans only paid the cost of the loan processing in exchange for agreeing to securitize through First Marblehead. As a result, the business model was heavily backloaded and dependent on investors to buy asset-backed securities.

By the end of 2007, the market for all sorts of asset-backed securities had dried up to the point where First Marblehead was not able to sell the loans it helped originate. As a consequence, the banks originating the loans were able to start charging a penalty to Marblehead (a risk I did not fully understand). This left the company in a bind. It could stop originating loans until the market for them cleared up, losing ground to better capitalized companies. Or it could keep making loans hoping they could be sold before running out of capital. Neither choice was very palatable, though curtailing originations was clearly less risky.

Apparently, GS Capital Partners VI Fund, L.P. and First Marblehead "executed a confidentiality agreement, dated as of July 13, 2007", which means they had been considering some sort of deal for half a year. We can't know what the deal would have looked like at that point, but since the confidentiality agreement was signed by a "global, diversified fund dedicated to making privately negotiated equity investments" (according to its press release), we can be pretty sure it would have been a privately negotiated equity investments similar to the one that was finally agreed upon. Of course the terms would have been more favorable in July than they were in December.

It's possible First Marblehead saw the writing on the wall last summer and was ready to sell an equity share in order to get access to a warehouse facility like it got in December. That would open up options in the event secuitization stalled for a quarter or two. Alternatively, it might have facilitated keeping a portion of loans on the books for one reason or another. But there can be no doubt that what First Marblehead wanted, and what the Goldman Sachs fund could provide, was access to capital. So the plan was to begin shifting from the nearly capital-free business model to one that was more capital intensive.

I think the reason the Goldman deal did not go through during the summer is that it wouldn't have looked good to investors or to clients. Low capital requirements made the company a very attractive investment since cash flows could be diverted to dividends and buybacks. It also created an opportunities for First Marblehead's banking clients, who provided capital to originate the loans. So it would have been difficult to sell this deal in July when business looked pretty good.

By December, when it was clear the business was in trouble, the deal could be seen as a baleout, not a sellout. Whether or not it would have been better to just do the deal over the summer is water under the bridge—the real question is was it worth doing in the winter. And given the choice between stepping out of the student loan business or selling an equity share of the company to keep going, there is a strong case to be made for the later, especially if the plan was in the works already.

To make the case, let's look at First Marblehead's growth history:

Fiscal     2007    2006    2005    2004    2003    2002    2001    2000
Revenues  54.61%  34.83% 109.76% 118.11% 121.42% 511.06%  70.08%  72.38%
Earnings  57.37%  47.78% 112.12% 138.96% 157.58% 487.37%  

Now for the sake of argument, assume that without the deal, First Marblehead will lose money for a quarter or two (their Q2 and Q3), and then make enough in the final quarter to be flat on the year. Q1 revenue, which traditionally accounts for a third of the annual total, was up 24% and earnings were up almost 20% from the previous year, so this scenario seems possible. In 2009, we'll assume growth jumps back to 35%, so that earnings are up a total of 35% over two years. I made this scenario as aggressive as seemed reasonable, since it's the one I'm arguing against.

With the deal, we can assume loan volume growth will be close to the 35% we saw in 2006 because there's no evidence student borrowing is slowing down. Q2 will still be a losing quarter and depending on how the accounting works Q3 might be too. But when the market for ABS opens, First Marblehead will have a lot of inventory saved up. We don't know exactly when securitization might start up again, but let's suppose it takes through the end of 2009 to work through the backlog. Two years of 35% growth works out to about 82% total growth compared to 35% without the deal.

Presumably, the securitizations will be less profitable with the deal, because warehousing the loans racks up interest charges. And of course, you have to factor in the 20% share of the company First Marblehead needed to give up. Obviously, there are risks added as well. But its hard to argue against diluting shares 20% over two years to get 47% better growth over the same period.

2007 Year in review

On the last day of 2007, my IRA ended the year down 13.3%, which was the first down year I've had and substantially worse than my benchmarks, the S&P 500 and Berkshire Hathaway. These things happen and especially with an ultra-concentrated portfolio. Here are my core positions:

Stock               2007 Return
-----               -----------
Alberto-Culver      20.83%
Berkshire Hathaway  29.19%
Canon              -17.74%
First Marblehead   -87.43%
Oracle              34.23%
Sally Beauty        16.03%
Select Comfort     -57.70%

Select Comfort has been the biggest disappointment of my short investment career. I certainly misjudged the business though I still think my initial purchase was a good decision. I now believe my follow-on purchase last year was a mistake, because I did not recognize the danger of air mattresses becoming a commodity. Select Comfort is built from the ground up to be a specialty bedding company, so if it ever needs to compete on price, quality and service alone, it must be revalued. That said, I think the current price is actually less than what the company would be worth as a commodity manufacturer. So any future turn-around comes as a free option at prices less than about $7 a share. As I mentioned when I made my third purchase, I plan to aggressively sell covered call options until the future becomes more clear.

First Marblehead has always looked stunningly cheap to me. Incredibly, the price has dropped to just over book value because of worsening conditions in the student loan paper market. Basically the market assumed for a while that the company would just close up shop. Since the supply (or from the perspective of students, the demand) of private student loans is growing at breakneck speed, walking away from the business would be crazy. Instead, First Marblehead has entered into an agreement with Goldman Sachs that will allow it to hold the loans it currently sells off in exchange for nearly 17% of the company's equity. I haven't had time to dig into the details of the deal yet, but it does seem like First Marblehead simultaneously removed short-term risk, reshaped its business model, and bought a powerful ally with a vested interest in its success. Buying more shares is a definite possibility, though I don't like the message sent by the dividend cut.

Canon became cheaper in part because of a delayed entry into the TV business due to patent problems. In the meantime, the company's core camera and printer products have sold well and profitably, and it is working on other entries into the display business. The dividend for 2007 was raised another 10% without seriously eating into cash flows. Canon's dividend is important because it is a signal from management that the business is doing well and it provides me with another reason to keep holding. Based solely on the dividend, Canon is trading below its fair value.

Outside of these three stocks, my investments performed quite well. Unfortunately, my losers made up a larger portion of the portfolio than the winners did. Options and arbitrage transactions worked extremely well for me on the whole, but I'd have to dramatically increase my trading activity to come close to making up for any one of the losing positions. On the other hand, my returns would undeniably be worse without these small, short-term, trading successes. Along the same lines, Alberto-Culver helped, but is a portion of my portfolio too tiny to profitably sell. Its performance barely matters.

Sally Beauty meets my current expectations. Everything seems quiet at the moment, but that will change as the company pays down debt and the restrictions on insider sales expire over the next year or so. I'm contemplating increasing my exposure in what amounts to a publicly-traded, private-equity investment (if you can imagine).

I'm in the process of wishing Oracle, my first and most successful investment, a fond farewell. On an annualized basis, my return on shares sold in 2007 has been over 20%. I've decided to end this investment because I believe the company is trading at a fair value. For the last few months it seems that Larry Ellison agrees with me as he has been exercising options for and selling a million shares a day. He has plenty of shares left to keep his financial future firmly tied to the company he founded, but I'm guessing he is more excited about other investments such as NetSuite. I'll keep my eye on the price in case it falls below its fair value again, however.

Berkshire Hathaway remains the anchor of my portfolio for the foreseeable future. This year will almost certainly be the moment when the company can finally use its dry powder. There are certainly plenty of quality assets available for pennies on the dollar due to "lack of liquidity" (i.e., over-leveraged entities that can no longer refinance). No doubt we will see some buys in the months to come.

Perhaps I'm foolish, but I feel fairly optimistic about 2008. Besides Select Comfort, the portfolio has improved financially and the businesses are stronger than ever. I have no urgency to sell until the future becomes clear, so the market price isn't all that important in the short run. Further, lower prices for stocks in general ought to present me with better opportunities for future purchases.

Why I bought yet more Select Comfort

This might be a mistake. Yesterday, when I wrote the post on Select Comfort's problems, I got angry. The market is completely hammering this company and it has gotten out of hand. Every DCF model I use suggests the market is pricing in zero growth—forever! Now if we were talking about First Marblehead, I suppose I could see how that might happen. The student loan business depends on a complex web of legal, political, financial, and societal conditions. If any one of these change, the business could cease to be profitable. But Select Comfort sells mattresses. People will always need them.

Right at this moment, people aren't buying mattresses. Or to be more accurate, people aren't buying mattresses unless they are really cheap or have Tempur-Pedic on the label. I think that's for exactly the same reason that houses in Bel-Aire are selling at record prices, but aren't selling at all in other parts of Los Angeles unless the price is rock bottom. Rich people haven't been hurt by inflation, housing prices, and risky loans the way the rest of us have, so they can buy premium products. I blame Select Comfort's management for not adjusting to the current reality, but I don't think they can screw this up so badly that sales won't come back in a year or two.

While we are on the topic, management has screwed up lately, but the results of the past year ought to shake them up and get them focused on the right things. From the business update this week, I think it has. To me, it was outstanding news that they refused to give guidance for the rest of this year or next. Wall Street hates that, but if management can't be sure what is going to happen, they really ought to stay quiet. Hopefully they have permanently stepped off of the beat-the-numbers game.

My purchase at $6.50 today increased my share count by a third, but only increased my cost basis by a sixth. I intend to aggressively sell call options on my shares in order to create a synthetic dividend. Maybe this isn't rational, but I think the market is mis-valuing Select Comfort and I want to capture some of that difference. I guess another way to put it is that the market is pricing Select Comfort as if it will screw everything up from now on and I think the odds are low that will happen. So I'm adding to my position. But I'm not so sure the market is wrong that I'm willing to take on more downside risk without getting paid.