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Morningstar 2008: Berkowitz: “Study the jeweler”

This morning two stock pickers, Bruce R. Berkowitz of Fairholme Capital Management and Susan M. Byrne of Westwood Holdings Group, discussed their approaches to finding the best values in today’s market in a chat entitled “Let’s talk bargains.” The following is a free-form paraphrase of what was said.

Susan: We’re devotees of growth overseas, but we’re value managers. That has led to buys like MasterCard, which went from $50 to $300 in 18 months because no one understood the the increasing market share of consumer credit in the developing (as opposed to the mature) markets. Likewise, Nike. Two-third of their business is outside the US, the pressures felt by US consumers that would make this stock unattractive are irrelevant. Nike is growing 20 to 30 percent elsewhere.

Bruce: Healthcare is becoming attractive again with low P/Es now (as low as 10) versus 40 to 50 not so long ago. And the tidal wave of aging baby boomers, combined with rising oil prices, means we’re driving less and needing more healthcare.

Susan: The US may make the effort to conserve energy, but if we do, will some other nation take up the slack, keeping prices high? We own energy without overweighting, but we don’t know what the answer as to whether US energy conservation will make a difference in this new world.

Bruce: With oil over $70 a barrel, alternative sources of energy may make economic sense, but they take so long to bring to market (over 10 years for nuclear plants, for example). Energy prices remind me of the Internet bubble — too much media euphoria and crawls on cable news alerting you to the minute-by-minute price of oil.

Susan: Banks, if not the most hated area of investment right now, are maybe the most confusing. They were never the most transparent industry, but it as if they said, “We can’t lose market share to London, so let’s go nuts.” There will be a race to the bottom in the next two to three years among those that are deleveraging. We don’t yet have the answers as to who will be left standing to support the weaker when it all shakes out.

Bruce: [Of the bank crisis] “If you don’t know jewelry, know the jeweler.” In this case, the jeweler is not so hot. A decade of non-cash profits just exploded. That’s why we count the cash, not the clicks, eyeballs, or other non-cash measurements of a business.

Susan: [Of value investing] We’re not patient, so we seek good value and “something happening.” For instance, in drugs, we examine what they are doing, where they are headed, and which aspects of their business strategy are undervalued. Exceeding inflation is the point of owning equities, so that’s why we seek “something happening.”

Bruce: We look for three things: (1) free cash flow yield, (2) a rock solid balance sheet, and (3) a good sense of what management does with that free cash. The current environment is where the seeds of great performance are planted. Sears, for example, generates $6 billion in free cash on 130 million shares, has a strong balance sheet, lots of land, and very strong brands.

Susan: [to Bruce] But you don’t know if management will make the highest and best use of that land that you feel is the value behind the stock.

Bruce: That’s when you study the jeweler. Reading between the lines, we observe how they renegotiate leases, how they buy and sell real estate, and we come to the conclusion that they’re doing it right, but it’s happening under the hood, Buffett-style. Value investing is not rocket science, it’s investigative reporting — do it right, and maybe something good will happen.

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