2017 Daily Journal Shareholder Meeting Transcript + Q&A with Charlie Munger

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MUNGER: I don't know anything about individual airlines, neither does Warren. We bought a bunch. It was a sector bet, it's not a bet on an individual airlines.

Q: When industries like airlines or railroads rationalize and turn around, how do you and Warren know? I mean...

MUNGER: We don't know. It was easy to—railroad it was all over when we went in. In the airlines it’s not over, but it's a little bit the same story; years of consolidation and bankruptcies. Three, four, five, six big bankruptcies are already in the airlines.

Q: So for 50 years, you've continually read about these industries even though you have disdain for them?

MUNGER: Yes, I talked about patience. I read Barron's for 50 years. In 50 years, I found one investment opportunity in Barron's. Out of which, I made about $80 million with almost no risk. I took the $80 million and gave it to Li Lu who turned it into $400 or $500 million. So, I have made $400 or $500 million on reading Barron's for 50 years and following one idea. 

Now, that doesn't help you very much, does it? I'm sorry but that's the way it really happened. If you can't do it, I didn't have a lot of ideas. I didn't find them that easily, but I did pounce on one. 

Q: Which one was that? Which idea was that? 

MUNGER: It was a little automotive supply company. Anyway, it was a cigar butt.

Q: Is that KMW?

MUNGER: No, I've forgotten the name, but it was a little—it was the Monroe shock absorber and all that stuff. The stock was a dollar and the junk bonds—which paid 11 3/8%—were 35. When I bought the junk bonds, they paid me the 35% and they went right to 107% and they called. And the stock went from 1 to 40, but of course I sold my stock at 15.

Q: What did the article in Barron said?

MUNGER: It said it was a cheap stock.

Q: How long did it take you to make that...

MUNGER: But that's a very funny way to be, to watch for 50 years and act once.

Q: How long did it take you to make that 15-bagger on that stock, from 1 to 15, right?

MUNGER: Maybe a couple of years.

Q: How long did it take you to make the decision to buy it once you read the article?

MUNGER: About an hour and a half.

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Seritage Growth Properties (SRG)

INTRODUCTION

In 2015, Sears Holdings faced the real threat of bankruptcy. In a move to raise much-needed cash, the struggling retailer spun off 266 store locations into a real estate investment trust (REIT), giving birth to a new, separate entity: Seritage Growth Properties (SRG). As part of the spin-off, Sears and SRG entered into a Master Lease Agreement (MLA) which required SRG to lease the stores back to Sears at rates far below market. 

Currently, SRG is unprofitable. But the MLA they entered with Sears contains hidden value for the REIT—and its shareholders—in the form of “recapture rights". These rights allow SRG to reclaim up to 50% of the gross leasable space currently occupied by Sears Holdings, and then re-lease it to new tenants at much higher rates. By reclaiming existing space—along with the adjacent land—from Sears, and then re-leasing it to new tenants, SRG stands to increase their average rent anywhere from 2x to 5x. 

In addition to the rent/sqft charged to new tenants, SRG’s value will also be determined by how quickly stores can be redeveloped, and the success of opportunities outside the core portfolio (i.e., the “adjacent lands”). Because each element can play out a number of ways, any valuation that relies too heavily on specific predictions is unlikely to be accurate. Instead, investors are best off looking a range of possible outcomes—from “worst case” to “best case”—and how they compare to today’s price. 

Even with pessimistic estimates, SRG is undervalued.

BUSINESS OVERVIEW

SRG’s portfolio consists of 266 properties. Of those, 31 are "Class A” (or "prime”) mall properties. The remaining properties are a combination of "Class B” mall anchors, 89 free-standing Sears Auto Centers, and the surrounding parking lots and land. Sears currently occupies 90% of SRG’s leasable space, at an average rent of $4.30/sqft. 

At a cursory glance, SRG might seem an unwise place to invest money: it offers below-market rents across its portfolio; mall attendance is declining; and its primary tenant, Sears, is on the verge of bankruptcy. 

And yet, four famed Buffett disciples—Eddie Lampert, Bruce Berkowitz, Mohnish Pabrai, and Guy Spier—have substantial positions in SRG. Even Buffett himself recently revealed an 8% ownership stake in the company. So what is it they see that the market does not? 

OPPORTUNITY

Today, only 10% of SRG’s space is occupied by non-Sears tenants, but because those tenants pay rents more in line with market averages, these leases bring in $56m (or 27% of SRG’s total revenue). As SRG recaptures additional space from Sears (which, as a reminder, they’re entitled to 50% of, per the MLA), their overall average rent will only increase—and revenue and profit along with it.

SRG’s portfolio is made up of three main property types—Class A mall stores, Class B mall stores, and Sears Auto Centers—all with differing redevelopment costs, prospective tenants, and expected rents. But even when using conservative estimates, the yield on investment across all of SRG’s core portfolio should approximate a very respectable 12%. 

The MLA also gives SRG the right to recapture 100% of the space at 21 high-value properties, which should command rents around $25/sqft (versus the $4.30/sqft that Sears pays). If exercised, average rents will net even higher.

Further, in many cases SRG also owns the adjacent land, which provides other development opportunities such as: adding space to auto centers to attract additional tenants (e.g., restaurants, banks); constructing new buildings on top of parking lots, and/or creating new mixed-use developments such as hotels, office complexes, apartment rentals, and open air “villages”. 

But even if investors were to ignore these other opportunities and solely consider SRG re-leasing 50% of the properties in their core portfolio, the stock still looks undervalued. 

VALUATION

Real Estate Investment Trusts are commonly valued using one of four methods: Net Operating Income (NOI), Funds From Operations (FFO), Adjusted Funds From Operations (AFFO), or Net Asset Value (NAV). While each method differs in how they handle certain accounting conventions, NOI, FFO, and AFFO are essentially just tweaked iterations of profitability; and NAV is a rough estimate of the value of the real estate less any outstanding debt. Importantly, by any of these measures, SRG appears undervalued.

At $44/share, SRG’s current price assumes slower-than-expected redevelopment, lower-than-expected rent, and zero opportunity outside the core portfolio. But the chance of SRG failing on all three counts is low. What’s more likely is that by 2025, SRG will have recaptured 50%+ of the space from Sears, and raised their average rent to somewhere in the $14/sqft range. In that scenario, investors would earn ~12% per year at today’s price. Even if they’re wrong—and SRG can only raise rents to, say, $8/sqft—they’ll still earn a solid (albeit not spectacular) ~6%. This implies a healthy margin of safety built into SRG’s stock price. 

Those estimates could also be over-conservative. If SRG can successfully recapture 100% of the space from Sears, increase rents to $16/share, and maybe have some success outside the existing core portfolio, investors could even stand to gain a remarkable 20%+ annually.

But the most likely outcome is probably somewhere between $8 - $16/sqft rents, 50% - 100% recapture rates, and maybe a few successful projects outside the core property portfolio. Therefore, it doesn’t seem unreasonable to expect a still wonderful ~15% annual return. 

CONCLUSION

It’s hard to pinpoint what SRG's proper valuation is with a high degree of certainty. However—and most importantly—we can be reasonably confident that it’s worth more than what the market thinks. If Sears can stay solvent for another 6-8 quarters and SRG delivers even the low-end estimates of recapture rates and rents, investors will do okay. If SRG delivers any upside, investors will do quite well.

LinkedIn (LNKD)

Since Microsoft’s announced takeover of LinkedIn, LinkedIn’s stock has fallen $6 below the software giant’s $196/share offer over concerns of EU regulatory approval. But the likelihood of the EU blocking the deal—which has already been approved by US, Canadian, and Brazilian regulators and the Board of both companies—is remote. In fact, the only example I could find of the EU blocking a merger between two US companies was in 2001, when GE tried to acquire Honeywell for $42b. Since then, the EU has neither blocked a merger between two US companies, nor have they ruled against a deal already approved by US regulators. And there have been no indications that they intend to block the MSFT-LNKD acquisition. This has created a nice little arb opportunity for investors.

If the deal does close in December as is expected, investors would earn a respectable 12% annualized return ([$6/$190]*4). But there’s also a good chance the deal closes earlier, as the EU is expected to decide between Nov 22 - Dec 6. If they rule in favor of the acquisition early in that range, investor’s would nearly double their return. Using conservative assumptions of a 5% chance of the deal falling through, and that upon such news LinkedIn were to drop by ~$100/share, the expected value is still +.70; thus signaling a buy.

($6 * .95)+(-$100 * .05) = .70

Investors also have downside protection, stemming from Salesforce’s interest in acquiring LNKD. The enterprise software company has made no secret that it covets LinkedIn above all other acquisition targets, lobbying both LinkedIn and regulators in repeated attempts to thwart the deal. Now that they’ve passed on buying Twitter, Salesforce would presumably be waiting in the wings were MSFT’s acquisition to fall through. And even in the worst case scenario, where the MSFT deal is blocked by regulators and then Salesforce chooses not to pursue LinkedIn, investors have yet another layer of protection in the form of LinkedIn’s viable—albeit overvalued—business.

Despite LNKD’s huge stock option expenses, a management team that flouts GAAP accounting, nonexistent profits, and a poor M&A track record, Microsoft is confident that they can harvest enough “mobile enterprise big data social graph cloud synergies” to make their largest ever acquisition pay off. And while it’s hard to argue that LinkedIn was a compelling investment prior to Microsoft’s takeover offer, the merits of the business are of little consequence in this scenario. All that really matters—at least for LNKD shareholders—is if the deal will close by December; and it seems very likely it will. 

No deal is guaranteed until the ink is dry, but there has been no evidence the EU will try to block MSFT’s acquisition of LNKD for $196/share. Investors can now scoop up LNKD for a 3% discount to MSFT’s offer, which is not commensurate to the risk of the deal falling apart, nor the downside protection afforded by Salesforce and LNKD’s operating business. This has created a compelling and straightforward opportunity for investors to earn 12%.  

UPDATE [11/22/16] 

Less than a month later, I sold my position in LinkedIn at $193.90 for a 2.9% gain over my $188.53 entry price—equivalent to ~35% annualized.

Tesla (TSLA)

“I honestly don’t really care about business all that much. It’s not really my first motivation.”

 - Elon Musk

Today, Tesla represents the future of transportation. This is for good reason: the company is led by the brilliant inventor Elon Musk; it creates fantastic products; and it has cheap access to the large amounts of capital necessary to build cars. It’s hard to argue that another company is better positioned to make self-driving electric cars a reality.

This—however—does not make Tesla a good investment. The premise of investing is not betting on whether a company’s product is good or not, or if the founder is right about what the future holds; it’s simply about buying a business for less than it’s worth. And even if Musk does fulfill his loftiest promises, investors wouldn’t stand to gain much, because Tesla’s current value has become wholly detached from economic reality. It trades at 70% of GM’s value, despite selling 187x fewer cars and not generating a cent of profit—a level which is simply unsustainable. Yet most alarming are Tesla’s myriad of red flags: poor corporate governance, quixotic acquisitions, and a financial structure best described as a house of cards—to name a few. I’d argue, therefore, that Tesla is clearly a stronger short candidate than long. But investors have become so enamored of the company’s narrative and promises for the future that they are ignoring these risks with reckless abandon.   

To illustrate, imagine that you have the opportunity to invest in “Tesla Pizzeria”—a local pizza place with the following characteristics:

IT HAS GREAT GROWTH PROSPECTS

…BUT THE BUSINESS BURNS CASH

COMPETITION IS HEATING UP

The pizza market is brutally competitive and dominated by industry giants. For every pizza pie sold by Tesla Pizzeria, the largest competitor sells 200. Companies like Pizza Hut, Dominoes, and Papa Johns have taken notice of Tesla Pizzeria's innovative products, and have signaled their intentions to make similar pizzas. And while Tesla Pizzeria has a similar paper valuation to its competitors, it severely lags behind them in both profit and experience. In fact, every competitor has been selling pizza globally for 50+ years, whereas Tesla Pizzeria has only been selling for eight years, all mostly in one market

Since Tesla Pizzeria publishes all of their recipes and techniques for free, it won't take long for competitors to start making pizzas in the same fashion. To make matters worse, enormous companies in adjacent markets—like McDonalds and Starbucks—think they can make really good pizza too, and are poised to introduce their own products in the next few years. There are even well-capitalized global upstarts gunning for a "slice" of the market. And then there are the companies set on shifting consumer preference to pizza alternatives.

IT SUFFERS FROM POOR CORPORATE GOVERNANCE

AND NOW IT’S BUYING ANOTHER MONEY-LOSING BUSINESS… 

The owners of Tesla Pizzeria have decided buy a tomato farm which lost $192 dollars for every $100 of tomatoes they sold last year. Alarmingly, many of them also happen to own the tomato farm (or are related to someone who does). And it's run by two of the manager's cousins. The sale—which is for a 35% premiumwill net the manager of Tesla Pizzeria and his relatives ~$700m, despite the farm's deteriorating business model. In order to avoid insolvency, the farm recently raised $345m in “tax equity”—whatever that is; and some are even suggesting Tesla Pizzeria is "bailing out" the tomato farm so that its owners don’t lose their shirts. Thank goodness for the synergies!

BUILT ATOP A FINANCIAL HOUSE OF CARDS

The business is financed with a convoluted web of stock sales, private investments, warrants, convertible bonds, and exotic debt. And by taking out personal loans against his ownership stakes in his various companies, the manager is exposing the owners to significant risk

So, is this a pizzeria you would want to own?

CONCLUSION

Investing isn’t about predicting the future or buying the company that will have the greatest impact on society; instead, it’s simply buying a business for less than it’s worth. And with a market value of ~ $35B, Tesla shareholders are almost assuredly paying more than the company is worth—even if Musk is right about the future. But if he’s wrong, the dubious acquisition, poor corporate governance, and risky capital structure ensure the losses be swift and steep. So whether or not Musk is right about what the the future holds, there’s only one smart move for investors to make: hope and pray he pulls it off, but to short Tesla. 

Associated Capital (AC)

"I don't throw darts at a board. I bet on sure things." - Gordon Gekko

In November 2015, GAMCO—an investment management and advisory company owned and managed by famed value investor Mario Gabelli—moved a substantial portion of its cash, investments, and 4.4m of their own shares into a newly created company named Associated Capital. As of this writing, Associated Capital currently has a market value of $770m, which seemingly indicates that the company’s stash of cash and investments is being fairly valued by Wall Street. 

Yet in addition to the spin off of cash and investments, GAMCO also created a five year $250m promissory note (i.e., loan), payable to Associated Capital at 4% interest.

Despite the note representing a very real economic benefit to Associated Capital, its true worth is obfuscated by the GAAP accounting because it’s a “related party loan”—i.e., a loan between two companies controlled by the same person—thus excluding it from the asset side of the balance sheet. But as the note matures, Associated Capital will receive payment from GAMCO, thereby increasing the company’s cash balance by an additional $9.83 on a per share basis.

Additionally, Associated Capital’s downside risk is relatively low because its other assets are highly liquid and thus easy to value: cash can be taken at face value, and many of AC’s investments have market quoted prices. And Mario Gabelli—who owns 75% of both companies—has a proven track record of creating long-term value. Recognizing that Associated Capital is trading at a discount, the Board of Directors has authorized a buyback of 500k shares, which will help to close the gap between value and price. 

With 25% of its value not yet realized by the market, a value-centric owner in Mario Gabelli, and a highly liquid asset base, Associated Capital makes for an attractive opportunity with very limited downside. An investment in the company would be like buying a house worth $500k for $500k, and then a month later discovering that there’s shoebox buried in the yard stuffed with $125k. The GAMCO note—much like the shoebox—represents hidden value not yet appreciated by Wall Street. 

It’s very likely this accounting quirk has created an opportunity for prudent investors to almost literally buy $1 of assets for $.75, which, according to both common sense and Warren Buffett “is a very good thing to do.”