Whitney Tilson Comments on Long Ideas: BRK.A, MSFT, BP; and Shorts: IOC, NFLX

Forbes: Can you give us some specific investment recommendations to take advantage of these circumstances?


Tilson: Sure, let me give you three examples of stocks we've been buying recently and that are large positions in our portfolio. If you want the safest blue chip in the world that's moderately undervalued, try Berkshire Hathaway (BRK). It's trading at $120,000 per a share. We think it's worth $150,000, so it's trading at a 20% discount to our estimate of intrinsic value. There's no immediate catalyst, and it's not rapidly growing, but it has one of the strongest balance sheets in the world and Warren Buffett managing it conservatively and safely. The underlying business is going quite well. The company reports earnings on Friday ,and we think it's going to be another very solid quarter. So Berkshire Hathaway is the safest thing we own, but is not screaming cheap. It's moderately undervalued. [Editor's note: After Berkshire's earnings announcement Friday, Nov. 5, we checked back in with Tilson, who said he's upped his estimate of intrinsic value to $165,000.]


If you go a little bit further out the risk curve, but still in the blue chip category, there's Microsoft (MSFT, Financial), which we've been buying this week. They reported spectacular earnings last Thursday, crushing analysts estimates, but the stock has barely budged. It's trading net of cash at less than 10 times trailing earnings for a company that's growing its revenue in every segment of its business at north of 10%, that grew its operating earnings at 19% last quarter, and that's buying back stock by the truck load. If they continue to buy back stock at the rate they bought it back last quarter, they could retire 7% to 8% of their shares in the next 12 months. That's something for a company of this size. They're also paying a 2.5% dividend. And most importantly, they're riding a new product cycle that's driven by Windows 7, the new version of Microsoft Office and new server software. Those are the three main product areas where Microsoft earns more than 100% of its profits, and they have hot, new successful products in all three areas. So we think there's a nice growth story here.


Equally importantly, Microsoft has one of the world's strongest balance sheets, probably tied with Berkshire Hathaway. And, so it's safe, cheap and has strong growth. However, it's a technology company, so the business model is not as safe as Berkshire Hathaway. Berkshire Hathaway you can tuck away and forget about it for five years and sleep well at night. In contrast, Microsoft is more, in our opinion, a one-year investment with the thesis that analysts' estimates are way too low and the multiple is way too low. With a technology company, you can't make a five- or 10-year bet and forget about it.


Lastly, for investors with a little bit more stomach for a tainted company, consider BP (BP, Financial). They just reported fabulous earnings, and the stock is up about 2% to around $42. We think it's easily a $50 stock by early next year. It trades at less than seven times this year's earnings, excluding the Gulf clean-up costs. They continue to sell assets at exceptional prices, cash flows are robust and the stock is way too cheap. The main catalyst here, other than the passage of time, is that they said they will revisit reinstating the dividend when they report earnings early next year. If BP were to reinstate the old dividend, the stock would be yielding around 8%, but it looks like the company will reinstate half of the dividend, which it can easily afford.


Forbes: Well, Whitney, you had mentioned you're on the short side too. Are there any particular standouts there that you think people should get rid of them if they own them or go short them if they were into that approach?


Tilson: Sure. Let me give you a couple of very different types of shorts. Our largest short position is a company called InterOil ( IOC). It's a company that claims to have discovered one of the largest natural gas fields in the world in Papua New Guinea. This is a company that has been drilling in New Guinea for over a decade, has consistently announced incredible finds and then in every case to date it's turned out that there was nothing that was commercially exploitable. Over and over and over again, for more than 10 years, this has been a company that has produced well over 200 press releases, but not much else. The company has a market cap in the $3 billion range and we think it will go down in history as one of the great promotions of all time.


To be clear, this is not Bre-X, one of the famous frauds of yesteryear that claimed to have found gold and there was nothing there. There is natural gas in Papua New Guinea, and there is natural gas in the fields where InterOil is drilling. We simply question whether there's as much as they say there is. To this day, the company has no proven, probable, or even possible reserves. It just has an estimate from a consulting company about what might be there, called a "contingent resource estimate," of which we are quite skeptical.


Even if there is a lot of natural gas there, that might not mean much. There's lots of natural gas all over the world, but most of it is stranded, which means that for whatever reason--it's deep underwater or in a remote area, for example--it's not commercially exploitable. It would be hard to find a more remote area than the jungles of Papua New Guinea, plus it's one of the world's most corrupt and least-developed countries. Finally, even if there is enough gas to be commercially exploitable, this is a company that has very little cash left--and it would cost billions of dollars to develop the infrastructure, to build a pipeline and an LNG facility, etc. We think that the people who would put up that money will end up owning most of the company if there is a big field there. So we question how much would be leftover for InterOil's current common shareholders.


Another very different example of a stock we're short is Netflix( NFLX). This is a well-run company with 17 million subscribers, and it's growing very rapidly by providing streaming video. This is almost the opposite extreme from InterOil in terms of our respect for the management team, and Netflix is providing a real service. But in this case, the valuation is just too extreme. The stock is trading at 63 times trailing earnings.


As Netflix transitions from a company that sends DVDs through the mail to one that streams video via the Internet or through Apple (AAPL, Financial) TV to your television, or to any number of devices, we think their margins are going to be compressed, because they have to pay for the content every time they stream it to a customer. Under Netflix's old model, it simply bought a DVD and could rent it out over and over again to its customers without paying the studio that owns the content each time. They just had to buy the DVD once. But for streaming content, Netflix must have a contract in place on an ongoing basis.


One of their big contracts is with STARZ, which is a cable TV channel like HBO. Netflix's contract for STARZ content that is coming up for renewal next year. Right now they're paying the bargain price of $30 million a year for that content, but we think they could end up paying eight to 10 times that much for STARZ's content under a new contract. So although we think Netflix is a wonderful company, the margins are going to be compressed fairly dramatically as they shift to a streaming video company. And when a company is trading at this kind of valuation, there is absolutely no margin for error.


I should say, by the way, that we have lost money on both of these short positions. But our loss is your readers' gain in that we thought these were attractive shorts at substantially lower prices than they're at today. That said, shorting is a very dangerous business, and I do not recommend it for anyone except seasoned professionals.