(We discuss Motorola not because we think it is more attractive than the other 83 holdings in the Fund, but because it illustrates our investment approach and incorporates two of the assumptions discussed above: continued demand for telecommunications products and services, and increased purchasing power for people in the developing world.)
At the end of the third quarter of 2006, the Fund owned a relatively small position in Motorola (1.2% of the Fund). Unfortunately, the company’s earnings tumbled over the next six months, and the stock’s valuation followed, falling to approximately one times Motorola’s sales (from a high of about 3.5 times sales in 2000). Motorola’s risks include increased competition from other handset manufacturers, dependence on its ability to continue to innovate and lack of market share in next-generation wireless network infrastructure. However, we believe Motorola enjoys a durable position in the extremely competitive global telecommunications market. Further, management appears to be taking meaningful steps towards improving internal operations and profitability in its handset business. Additionally, Motorola has a leading position in broadband network equipment and is a key supplier to operators of cable, cellular and private two-way radio systems. With strong intellectual property and a solid balance sheet, we believe Motorola has the necessary foundation to execute a turnaround over the long term. Because of the stock’s lower valuation and our analysis of Motorola’s opportunities and risks, we increased the Fund’s position in Motorola to 2.6% as of June 30.
May 24, 2007
() - $ others
Nikko Cordial, Japan's third largest brokerage firm, contributed most to the quarter's performance. The market's overreaction to penalties imposed by the Japanese regulator, the FSA, upon Nikko Cordial in the fourth quarter of last year allowed us to rapidly accumulate a sizeable position in a company with a tarnished reputation, but with a pristine balance sheet and a valuable franchise. In March Citigroup made a bid for all of Nikko Cordial's outstanding shares, and raised the bid after the announcement that the company's shares would not be delisted. The revised offer of 1,700 yen per share remains below our appraisal, but represents a substantial premium to the Fund's cost. Citigroup's bid was outstanding at the end of the quarter.
The Nikko Cordial experience validates components that underpin all of our Japanese investments. First, the tide of large-scale, cross-border mergers and acquisitions that has swept most of the developed world has touched Japan's shores. The tide may not move as fast as we would like, but we believe it is irreversible. Second, courts and regulators increasingly uphold and protect shareholder rights. Third, despite a multi-year malaise, the Japanese financial markets provide substantial opportunities to managements who provide innovative solutions to Japan's savers, as Nikko Asset Management's success has proven. Fourth, despite recent increased attention from investors, the Japanese market remains surprisingly inefficient given its size and maturity. Finally, executives of undervalued companies increasingly are being held accountable, and in some cases, are being replaced by managers, whether inside or outside of Japan, who think they can do a better job.
DIRECTV Group Inc. The (DTV) - $26.48 Broadcasting & Entertainment
DIRECTV, one of the Fund's best performers in 2006, gave back some gains in the first quarter. DIRECTV continued to add high-quality subscribers and realize excellent pricing. Our appraisal of the company grew, and we watched Chase Carey exhibit his commitment to building value by repurchasing a large number of shares as they became cheaper.
The Fund's largest position, Dell, declined during the quarter. Kevin Rollins resigned and Michael Dell has taken the reins as CEO. Dell has brought in several new senior managers, is improving customer support, and is focused on restoring margins and sales growth to previous levels. While the outcome of the SEC's investigation of Dell's accounting is uncertain, we believe that the company's competitive advantages remain in place, i.e. being the low cost provider via the direct sale model and having an entrenched distribution network with unique access to small and mid-sized customers. Even in what was arguably a bleak year, the company earned $3.7 billion in free cash flow and had margins, albeit depressed, that were higher than its competitors (in the case of HP, this excludes the printer cartridge business.) Our appraisal is significantly higher than the current price, and as the business improves and the company repurchases shares, Dell's intrinsic value should grow meaningfully.
Mitsubishi Estate Co., Ltd. is a broadly based real estate empire. Its key assets include 31 office buildings in the Marunouchi District of downtown Tokyo, and two Class A office buildings in midtown Manhattan. In particular, the prospects for good-sized rent increases in the Marunouchi District in the years ahead seem favorable. It appears as if the Fund has acquired its position in Mitsubishi Common at a meaningful discount from NAV.
Henderson Land (“Land”) and Henderson Investment (“Investment”) are both actively developing real estate assets in the People’s Republic of China (“PRC”). In addition, the Henderson entities control a substantial amount of earnings assets – both real estate and non-real estate – in Hong Kong and the PRC. Investment Common, which is 67.94% owned by Henderson Land, seems to be an attractive pre-arbitrage opportunity in that there may be possibilities that Henderson Land, for the third time since 2002, will try to privatize Investment by making it a wholly owned subsidiary of Land.
Meanwhile, both Land Common and Investment Common appear to be issues of very high quality companies, which the Fund seems to be acquiring at meaningful discounts from readily ascertainable Net Asset Values (“NAVs”).
HANG LUNG GRP SP ADR (HNLGY.PK) - $0 Real Estate Holding & Development
Hang Lung Group Common was acquired by the Fund at a price that values 100% of the outstanding Hang Lung Group Common at US $4,113,800,000. Around 97% of Hang Lung Group’s net assets are represented by its ownership of 50.6% of the outstanding common stock of Hang Lung Properties Limited. That 50.6% interest in Hang Lung Properties Common had a market value of US $5,733,000,000 at January 31, 2007. Put simply, the Hang Lung Group Common was acquired at a 28% discount from the market price of Hang Lung Properties Common at January 31, without attributing any value to the small amount of other assets, net of all debt, owned by Hang Lung Group. The Hang Lung entities seem to be a very interesting growth play, as the companies over the next five years or so embark on developing 12 major multi-use projects in various secondary cities in the People’s Republic of China.
The TJX Companies Inc. (TJX) - $34.12 Apparel Retailers
TJX reported a fine year that highlighted the inherent strength of its off-price business model. The company saw its earnings per share, absent one-time charges, grow by more than 20%. In recent years, TJX had committed a succession of gaffes, including the failed launch of a dot com business and the rapid expansion of several unproven start-up concepts. Finally, in late 2005 the board of directors tapped chairman of the board and founder Ben Cammarata to return as interim CEO. Cammarata achieved almost immediate results by re-focusing TJX on its core businesses, TJ Maxx, Marshall's and Winners, the TJ Maxx of Canada. He replaced a number of senior managers and closed stores that had little potential for earning a satisfactory return. Perhaps most importantly he lured long-time executive Carol Meyrowitz, who had left the business earlier in 2005, back to the company.
Meyrowitz, a respected apparel merchant, was instrumental in the turnaround and recently was appointed CEO. She should have a stronger supporting cast of senior managers than existed 18 months ago. We trimmed TJX in 2006 after the stock rose during the year, but it remains a large position and we are encouraged by the changes made over the past five quarters.
Berkshire Hathaway Inc. (BRK-A) - $117900 Property & Casualty Insurance
Berkshire Hathaway Inc. (BRK-B) - $3936.9 Property & Casualty Insurance
Berkshire Hathaway enjoyed a terrific year, though it received more than a little help from Mother Nature. After two years which saw multiple hurricanes wreak havoc on the Gulf Coast, writers of "supercat" reinsurance raised premiums significantly, then saw no major storms hit the U.S. mainland in 2006. This fortuitous circumstance helped Berkshire more than double its reported earnings per share through the first nine months of the year. As a major writer of "supercat" reinsurance, there will be years when Berkshire gets lucky, like 2006, and years when it pays out billions of dollars in claims, like 2004 and 2005. A prudent forecast for 2007 would include a more normalized level of catastrophe claims, and thus a lower level of earnings in the reinsurance business.
Berkshire's good performance was not simply a matter of good weather. GEICO is knocking the cover off the ball. The company's fantastic advertising, together with its very aggressive entry into New Jersey, are driving very satisfactory growth. Gen Re posted its best results in many years in 2006. NetJets showed improved results. Most pleasingly, through the first three quarters of the year Berkshire invested $14 billion in stock investments and acquisitions of private companies. The favorable economics of these investments gives us confidence that they will produce a very satisfactory return.
Based on Berkshire's 2006 performance, our decision to reduce our ownership position during the year could be second-guessed. It remains our single largest investment but, given Mr. Buffett's age and our level of concentration, we felt it prudent to reduce our exposure. We expect Mr. Buffett will continue to do a masterful job deploying Berkshire's vast capital and we intend to benefit from that performance over many years.
Mohawk Industries' stock price fell 14% in 2006. Reported earnings rose 17% for the year, reflecting earnings accretion from the purchase of Unilin, a large European-based laminate flooring manufacturer, in late 2005. Absent the acquisition of Unilin, net income would have been flattish as lower interest expense from debt pay-down would have offset a modest decline in operating profits at Mohawk's business units. The decline in operating income reflected high oil prices, which increased the cost of the raw materials used to make flooring products, and a slump in both new home construction and home remodeling, which reduced demand for residential flooring. In this difficult environment, Mohawk successfully managed operating costs and the acquisition of Unilin. It also dramatically reduced the debt taken on to make the acquisition.
We do not know how long the housing slump will last, or how long raw materials prices will remain high. We do know Mohawk has been passing on raw materials price increases for some time, which speaks to its position in the marketplace. At the end of 2006, Mohawk sold for less than 12 times forward earnings estimates, which strikes us as an attractive price for a business that has grown its earnings at a 17% compound average annual rate the last five years.
The Progressive Corp. (PGR) - $19.05 Property & Casualty Insurance
For most of its history, Progressive's aim has been to earn at least a 4% operating margin and grow as fast as possible. In 2006, it earned a 14% margin. This windfall occurred largely because of a number of structural changes that cumulatively have significantly reduced the frequency of automobile accidents.
When Progressive tested lower rates in recent years, it found little elasticity of demand. Therefore, at the risk of holding a pricing umbrella over less efficient competitors, the company opted to preserve higher margins. Although it anticipated that such pricing would reduce growth, it did not contemplate that the growth would cease altogether.
Looking ahead, Progressive may be forced to cut rates more aggressively to attract policyholders, as more surgical price cuts have not worked. This almost certainly will lead to lower profits for shareholders.
Progressive is an outstanding company that currently faces two great challenges: 1) increasing retention or policy lives through a number of measures; and 2) improving both its brand proposition and its marketing and advertising. Fortunately, management embraces change and the company could not have a better change agent than CEO Glenn Renwick.
ABM Industries Inc. (ABM) - $22 Business Support Services
We recently invested in ABM Industries, a leader in the fragmented janitorial services industry with related services such as parking, security, engineering and lighting. ABM suffered earnings declines due to fewer high margin lighting projects, some cost escalation on fixed price contracts and the underperformance of its SSA security acquisition. The lighting division is now rebounding with new business tied to energy tax credits and efforts to fix the security division are yielding results.With the majority of revenues tied to the office market, ABM should benefit from higher occupancy rates as white collar employment continues to strengthen.We believe that earnings should grow to more than $1.50 per share in 2 to 3 years, up from $0.94 in 2006. ABM is reasonably valued at less than 16.5 times normalized earnings, has a strong balance sheet with $2.70 per share in net cash and pays an attractive 2% dividend yield.
Cerner Corp, a recent purchase, is the largest supplier of healthcare information technology (HCIT) for physician offices, hospitals, clinics, labs and pharmacies. The company offers the broadest solution set in the industry resulting in 30% market share. The HCIT market is forecasted to grow 8% over the next several years. The healthcare industry is compelled to continue investing in information technology systems to improve efficacy and efficiency. Approximately 25% of hospitals currently have a fully implemented electronic medical record (EMR) system, indicating how under penetrated the market is. Cerner is well positioned to benefit from this trend and, in our opinion, will grow profits at double-digit rates over the next several years. The stock sells at a reasonable valuation given its earnings growth potential, experienced management team and positive long-term investment outlook.
RPM International Inc. (RPM) - $20.87 Specialty Chemicals
RPM International, a current holding, manufactures, markets and sells specialty paints, protective coatings, sealants, adhesives and roofing systems for the consumer and industrial markets. Products are sold in 151 countries and territories. RPM has a good long-term track record in growing earnings and dividends, and has solid financial characteristics. The company is expected to grow earnings at 12% during the next 5 years and has a return on equity of 17%. The shares are attractively valued, selling at 13.5 times estimated earnings and yielding over 3%.
Medtronic, Inc (MDT - $53)
Medtronic is the world’s largest manufacturer of implantable biomedical devices. In their largest business, cardiac rhythm management (pacemakers and implantable defibrillators), Medtronic has higher sales than all its competitors combined. Both investors and acquirers typically pay very high prices for businesses with dominant share that sell proprietary products into growing markets. In fact, back in 2000, Medtronic traded at $62 per share, over 50 times projected earnings. As expected, earnings have more than doubled since 2000, but despite that, the stock price has declined. Medtronic stock now trades at less than 20 times projected earnings, only a small premium to inferior businesses. Like many of our more recent purchases, we believe Medtronic will continue to achieve superior growth and expect it to again be accorded a superior multiple.
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