Wednesday, November 3, 2010

What Todd Combs and I have in Common: Leucadia National Corp.

Recently, Todd Combs, a 39 year old hedge fund manager, was named by Berkshire Hathaway to manage a "significant portion" of the company's investment portfolio. Mr. Combs has been managing Castle Point Capital, a Greenwich based hedge fund for the past five years. Today, not much is known about him or his hedge fund, but we can look at Castle Point Capital 13-F SEC reports and learn of his investments. Between March 31, 2010 and June 30, 2010, Mr. Combs purchased 4 new names and added to a few of his existing positions. One of the 4 new positions is in a company called Leucadia National Corp. (NYSE:LUK). He purchased 255,000 shares at an average cost of $23.36. Coincidently, I too purchased Leucadia for my portfolio around the same time at an average cost of $19.97. 

Leucadia, under the leadership of the Chairman Ian Cumming and the President Joseph Steinberg, went from a failing company to a huge success today. Over the last 30 years (1979-2009), it's book value has compounded at 18.5% and its stock price has compounded at 21.4%.

What does Leucadia do? Here is what their 1988 letter to shareholders says:
"We tend to be buyers of companies that are troubled or out of favor and as a result are selling substantially below the value which we believe are there. We then work at improving the acquired operations with a view to increasing cash flow and profitability. From time to time we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long-term track record. We are not income statement driven and do not run your company with an undue emphasis on quarterly or annual earnings. We believe that we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated."
Leucadia has no quarterly calls, no earnings guidance, and no Wall Street analysts that follow it. One of the main reason is that Leucadia has very few operating companies. It is really a hodge-podge of assets that are usually a work in progress. In this article, I would like to highlight a few of the transactions they have done over the years. The main source for this information is their Buffett-like letters to shareholders. Mr. Cumming and Mr. Steinberg are a great example of control investors that have a value investing approach.

In their 1991 letter to shareholders, Leucadia reported that they acquired Colonial Penn Insurance companies, a property & casualty insurer, for $127.9 million in cash. This was a great bargain purchase, since Colonial Penn had $391 million in book value. These companies had been for sale a long time and the selling price had come down to an attractive level. The problem was a portfolio of casualty insurance risks in niche markets that appeared very scary. Leucadia did an exhaustive due diligence and determined that this portfolio was properly reserved and made the purchase. Here is an excerpt about their core operation from Leucadia's 1992 and 1993 letter to shareholders:
"The direct marketing operations of Colonial Penn, prior to our acquisition, were too expensive. During 1992, we adopted a new, lower cost marketing strategy. Although this resulted in lower volume for 1992, we are pleased with the new structure cost structure and with the increasingly profitable premium volume that we hope will result. Our objective on an ongoing basis is a combined ratio of 100%." 
"A combined ratio of 100% means that premiums equal the sum of claims, related expenses, and underwriting expenses. Thus, if the combined ratio is 100% or less the shareholders keep the after tax earnings on the invested reserves and equity, which can be quite substantial."
This is my kind of insurance company - one that strives for profitability not market share or volume. In 1993, they list their guiding principles for managing the insurance companies.
  1. We are driven by a search for profitability, not for volume or market share and, as a result, sometimes the best strategy is to retreat.
  2. We would rather reserve conservatively and be required to release reserves than to under reserve and be required belatedly to report loss.
  3. We search for niches, not dominance, on the theory that the world can tolerate many mice but few elephants.
  4. We invest the portfolios conservatively. We are willing to give up marginal yield for predictability, safety, and a good night's sleep. This general conservatism helped us survive the '80s. There is no such thing as a free lunch - either it isn't lunch or it isn't free.
  5. We face the responsibility of managing so much of other people's money with constant vigilance and trepidation. The insurance reserves do not belong to the shareholders, only the capital does. 
  6. We invest in shorter maturity bonds. In the long run, stocks do better but over shorter periods of time they are not predictable. The obligations to our insureds are predictable. We best fulfill our obligations by investing in bonds.
  7. We are afraid of long-term bonds.
  8. We do not invest the insurance portfolios in uninsured real-estate, junk bonds or exotic securities.
  9. We do not reinsure other insurers risks. Our plate is full with our own risks.
  10. We increase our shareholder's wealth by buying businesses at the right price - not by speculating in portfolio securities.
In 1996, Leucadia reported that they sold Colonial Penn, after successfully turning it around. Their comments in the 1996 letter to shareholders gives an insight into their sell discipline:
"Since we bought Colonial Penn companies in 1991 for $127.9 million, they have been ably managed by ... Together, we have worked hard to make these entities more profitable. The companies have paid to Leucadia tax-sharing payments, management fees, interest and dividends totaling $300 million. This, plus the proceeds from the sales, adds up to approximately $1.77 billion pre-tax. This is a remarkable result and a significant return on investment, approximately, 75% per annum.
In the venture capital business, where we began our careers, we developed the belief that the science is in investing and the art is in selling. Art in the sense of the ineffable human ability to collect and integrate vast amounts of unrelated information and in some mysterious way arrive at an opinion as to whether to hold or sell. Over the years, we have learned to depend upon this process.
In deciding whether or not to sell Colonial Penn companies, we availed ourselves to both science and art. Our personal thinking went something like this. Colonial Penn Property & Casualty sells auto insurance direct to the consumer. Current conventional wisdom is that direct marketing of insurance is the wave of the future. Direct marketing companies are much in demand and lots of money is pouring into the business. GEICO, General Electric, Progressive, and others will become ferocious competitors. When the giants start to rumble, price pressure cannot be far behind. Large marketing expenses in the hope of establishing large market share and profitability is not our forte. Too much capital flowing into market niches makes for a miserable, frustrating experience.
Since auto insurance is not a particularly growing market, the only place to get new customers is from a competitor. We are afraid that in the future making money in the auto insurance business will be like picking pennies in front of a steamroller - dangerous and not significantly rewarding. For a total of over one billion dollars, 2.6 times GAAP book, 3.2 times statutory book, and 24.1 times after-tax earnings, a sale was the better part of valor."
Leucadia conducted its banking and lending activities through its national bank subsidiary, American Investment Bank (AIB). Here is an excerpt about this operation from their 1995 and 1996 letter to shareholders:
"AIB primarily offers auto loans to people with bad credit reports. We have done quite well with the program over the years and offer this service in 14 states throughout the country. In the last couple of years, significant competition began to enter the market. Several large, well financed institutions began to enter the market or bought competitors (at very large premiums) and several initial public offerings were funded. The competition has become increasingly intense, rates have fallen in the market and loan losses are up. From the borrowers point-of-view the choice is simple, go with the lower rate. We have decided not to lower rates but to let business shrink. As a result, our volumes have fallen significantly. We have seen the arrival of inexperienced money before. This is a difficult business. Higher rates are required to make money. Over the next few years we hope that the competition will dwindle and our volumes will slowly return. If not, we will go onto something else. We have no desire to be a slender lender, a lender at inadequate rates."
"[1996] One depressing tangible illustration of the current state of consumer banking is the number of mailers each of us receives offering credit cards, home equity loans, and unsecured lines of credit. In our view, the consumer banking business has become very competitive and the returns do not warrant the risk. Lenders are in a bidding war to convince customers at virtually every income level to borrow more and more. The easy access to credit allows borrowers to control their debt ratios to an unprecedented degree. Not surprisingly, we now read of skyrocketing delinquencies and bankruptcies.
These trends have hit our auto program especially hard. In keeping with the plan we announced last year, we are shrinking our portfolio rather than chase after business with inadequate rates ans excessive losses. Most of our competition securitizes their loans. As capital markets respond to the poor performance of the loans backing these securities, we expect funds available in the market to dwindle and rates to rise. Until then, we intend to approve loans cautiously, make prudent program changes, increase our loan reserves, closely monitor the debt ratios of our borrowers, and pay even more attention to servicing and collecting our existing portfolio. This will reduce earnings in the short run but will position our lending operations to take advantage of opportunities arising from the eventual shakeout in the industry. We don't expect improvement in the auto loan business in 1997. Three large auto competitors have gone out of business, but there is still no shortage of silly money about. Wall Street has yet to feel the pain; when it does, the business will improve. We maintain the perhaps naive hope that this Alice in Wonderland substandard lending market will return to rationality."
By 1998, rationality begins to return to the sub-prime market. In their 1999 letter to shareholders, they report:
"Several players who thought they could defy financial gravity ended up in bankruptcy. The acquisition in late 1998 of a $36.9 million portfolio of sub-prime auto loans, purchased at a discount, jump started AIB's return to the market.
AIB is actively back in the sub-prime business and generating $300 million in loans per annum from 29 states with an anticipated average life of 22 months. While these loans are not as profitable as in the pre-1995 era, the risk/reward relationship makes sense. We will continue to keep in mind the lessons of the past, and should events warrant, AIB will go back into its cave."
By 2001, the dot com bubble had burst and the economy had turned south. In response, AIB exited sub-prime auto lending. It was the right decision given that the potential reward did not justify the high level of risk.

During the Great Recession of 2007-2008, Leucadia got another opportunity to come back to this business through AmeriCredit Corp. Here is an excerpt about their reentry in this business from their 2007 and 2008 letter to shareholders:
"[2008] We have acquired 25% of AmeriCredit Corp ("ACF") for $405.3 million. [2007] We have known of this excellent opportunity for many years, having been in the sub-prime auto business ourselves. ACF has made and financed over $53 billion of these loans and none of its lenders has lost a penny. In this environment, financing for ACF is going to be very difficult and management is taking appropriate actions to downsize the company. We are guardedly optimistic that the financial market will climb out of its bunker next year. People need auto financing to get to work."
[2008] Years ago we owned a similar business and as a result carefully followed ACF. We observed that their large volume and efficient processing and underwriting abilities made them a fierce competitor. We also observed that when a recession hit ACF when through a period of poor results, but when a recovery began they were able to make large profits by being able to select more credit worthy customers and to charge more for loans.
Much of the above remains true; however, we began to buy the stock too soon and paid too much. The recession has been much harder and much deeper than we anticipated, though ACF is succeeding in acquiring credit worthy customers and is able to charge them higher rates. The fly in the ointment has been that is has been almost impossible to secure additional funding to make loans. Securitizations, which were the lifeblood of their funding, has been in rigor mortis. The Federal Reserve has announced a program to restart consumer funding called TALF, but as yet TALF has not been able to access it. Perhaps that will change. ACF has enough funding to operate at a much reduced volume and is committed to preserve its net worth of $15.03 per share. We have a high regard for its management."
In 2009, Leucadia reported its status on the ACF investment:
"In spite of the financial disaster, these investments [ACF and others] performed as expected - beautifully. As in much of life, ACF's secret to success is discipline. Currently, competition has lessoned and ACF can earn a fair return for its risk. Eventually banks and other folks will come rushing back into the market, margins will fall as evaluation of risk becomes, yet again, ignored and volume will become the sole focus of competitors as a means to impress the Stock Market. When that day comes, we hope that ACF will eschew volume, efficiently harvest its portfolio and watch the lemmings as the launch off a cliff. Then the cycle will begin anew. We have a great relationship with, and respect for, the management team. We believe they are the best in the industry."
In July 2010, GM announced its acquisition of ACF for $3.5 billion. Leucadia's share will be $875 million - close to 30% return per annum. Pretty sweet, given that Leucadia thought that they acquired ACF too early and paid too high a price. At one point, Leucadia's investment in ACF was down to $180 million from its investment of $405 million. Value investors don't need to time the market to do well !

Shareholder-Friendly Management
The Chairman and the President together own about 25% of the outstanding shares. Their actions in the past clearly indicate that their interests are aligned with those of the shareholders.

When asset prices were rising in the late nineties, they wrote the following in their 1997 letter to shareholders:
"Higher prices inevitably mean lower returns. The consequence of miscalculation or mistake become more deadly as prices increase. Extreme caution is in order. There is a vast amount of money sloshing around the world. As hard as we run [around the world], the hot money has beat us there. One of us predicts a very unhappy ending to this exuberance; the other doesn't know what to think. This is a conundrum. Several alternatives are available:
  1. Do nothing. Keep our cash short and safe and wait until the old world returns. In the meantime, low returns are guaranteed.
  2. Do the above, but give shareholders back a significant portion of their money. Perhaps individually you can do better than we think we can. At least we will worry less.
  3. Stop the merry-go-round and give all the money back on the theory that a 20 year run is a good one; the old world is unlikely to return soon, but for certain it will not be in the same form. These dogs may be too old for new tricks.
  4. Some combination of the above." 
Finally, in 1998, when they had more money than ideas, Leucadia returned $812 million, or $13.48, to shareholders in the form of a special dividend. The compounding of 18.5% in book value does not include this special dividend. 

In April 2008, Leucadia's stock was north of $50. It was trading at a large premium to its book value. Mr. Cumming and Mr. Steinberg took advantage of this situation and sold 10 million shares at $49.83 to an investment bank Jefferies & Company. In return, Leucadia received 26 million shares of Jefferies and $100 million in cash. Jefferies sold the 10 million shares of Leucadia and fortified its balance sheet. Wow! Not satisfied, Leucadia used $396 million to further increase its position in Jefferies to 48.5 million shares through open market purchases. At the end of it all, Leucadia owned 30% of Jefferies. Here is an excerpt about Jefferies from their 2008 letter to shareholders:
"Jefferies is not in trouble, not a ward of the U.S. Government, not burdened by toxic assets and not over-leveraged. Its employees own a substantial interest in the firm and their pay interests are being managed with the best interests of the firm in mind. Jefferies has successfully hired talented individuals from troubled or failing institutions and recently acquired a muni and underwriting business. Trading volumes have been good, their restructuring business is busy, but their capital markets and acquisition businesses remain lethargic. This will inevitably improve, but timing is uncertain. We have known Jefferies for a long time and are particularly fond of and hold in high regard its long time CEO, Richard B. Handler. We believe that over the long haul Jefferies will survive and grow to enrich our shareholders !"
As of December 2009, the fair market value of their position in Jefferies was worth $1.2 billion dollars.  Taking into account the $100 million cash it received from Jefferies, Leucadia effectively used $296 million in cash  to yield an unrealized gain of $900 million. But remember, in the process, it also diluted its shareholders. The question is whether dilution created value for its shareholders ? Here is a quick back-of-the-envelope calculation. Prior to the dilution, shareholders had a book value of $24. Dilution reduced book value per share by $1.60, but a gain of $900 million equates to $3.77 per share. Its very rare to see management dilute its shareholders but also create value. One way (maybe this is the only way) it can happen is when management uses its overvalued stock as currency to buy an undervalued asset. That is exactly what Leucadia did.

In addition to these transactions, Leucadia has partnered with Berkshire Hathaway on multiple occasions. Also, recently their investment in an iron-ore operation in Australia has also been very successful. Lastly, I will say that Leucadia has not had to pay a single dollar, or hardly any amount of significance, of tax to the U.S. Government ever. An account of these can be very interesting, but I don't intend to make this article a comprehensive coverage of all the interesting deals Leucadia has done over its 30 year history.

1. Todd Comb's Portfolio, June 30, 2010.
2. Rishi Gosalia's Portfolio, Aug 31, 2010.
3. Letter to Shareholders, Leucadia, 1988.
4. Letter to Shareholders, Leucadia, 1991.
5. Letter to Shareholders, Leucadia, 1992.
6. Letter to Shareholders, Leucadia, 1993.
7. Letter to Shareholders, Leucadia, 1995.
8. Letter to Shareholders, Leucadia, 1996.
9. Letter to Shareholders, Leucadia, 1998.
10. Letter to Shareholders, Leucadia, 1999.
11. Letter to Shareholders, Leucadia, 2001.
12. Letter to Shareholders, Leucadia, 2008.
13. Letter to Shareholders, Leucadia, 2009.

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