BNI buyout by Berkshire

Berkshire acquired BNI earlier in the week for $100 consideration. I will not detail the offer as most media have done it with better detail. However the post is about my view and my future action.

First my view on the transaction. I am really disappointed that BNI is going private, you can read my posts on the company here. I had visions 10 years down the road to see my investment in BNI to have risen by 1000% or more, so to be deprived from such investment, to say the least, is disappointing, albeit my return from holding BNI is 50% plus dividends, so I am always thankful.

The price is low relative to the value of BNI. BNI has tremendous land holdings that are not realized in its balance sheet. Also, BNI is not just a good business with competitive advantage, it is a protection against inflation and oil prices. BNI does well when oil is high or low. When oil is high their rates go up in lock step however if oil prices are declining so is their costs. BNI also is a good hedge against inflation as it rates and assets can compensate investors for rise in prices.

Second, I will opt to take the cash. I do not understand Berkshire and Buffett is not going to last forever. To preempt any comments, I did not say Berkshire is bad business but it is too complicated for me, that is all.

Thrid, I will tender my shares for cash rather than sell due to several factors:

1. I want to postpone my capital gains till next year,
2. in the unlikely event the acquisition fails,
3. I am not leaving $3 on the table, and
4. There is a dividend payout coming up before closing that I want.

Fourth, BNI represented more than 10% of my portfolio so I will have a lot of cash coming back to me to reinvest and that creates some problems. First, the market is at fair value which makes finding ideas a bit difficult. Moreover, the risk in this market is to the downside currently. Second, most railroads have shot up on the acquisition so replacing BNI with another will be difficult as a lot of people are emulating Buffett and bidding their prices. I do not like crowded trades. But I will follow some railroads to take advantage of any weakness. Two of my favorites are Canadian National (CNR) and Union Pacific (UNP). I am also looking at Canadian Pacific, where it could see some improvements in margins with better management. Third, good ideas like BNI are rare.

The other alternative is to invest in Intermodal companies. Those companies use multi modes of transportation on behalf of shippers to get goods to their destination. Intermodals obviously need access to the rail networks through agreements with railroads. Some Intermodal companies own a fleet of trucks to handle what is called last mile transport or the final link from rail to the buyer, or can contract this out to independent truckers.

Pacer International (PACR) is

...asset-light North American logistics provider. The Company provides transportation and logistics services to numerous Fortune 500 and multi-national companies. The Company provides its transportation services from two operating segments, its intermodal segment, which provides intermodal transportation services principally to transportation intermediaries, beneficial cargo owners and international shipping companies who utilize intermodal transportation, and its logistics segment, which provides truck brokerage, truck transport, supply chain management services, freight forwarding, ocean shipping and warehousing and distribution services to a range of end user customers.

Pacer had a bad run lately as its contract extension with Union Pacific, where the majority of its freight revenue come from, was uncertain and weighted on the stock heavily. I liked that situation. I bought at $3.16 last week to take advantage of investors flight due to uncertainty. Although the stock has shot up some 50% since their earnings and contract renewal two days ago, I think the potential to move to $8-10 per share is reasonable.

I admit I did not finish buying to establish my desired position and rather to have bought before the move but the risk/ reward thesis is still valid. The stock should drift higher as investor buy again into it after the uncertainty has been removed.

I will share more thoughts on Pacer some other time.

IFRS implementation in Brookfield Properties

Brookfield Properties (BPO) will adopt IFRS, new accounting standards that most US and Canadian companies will transition into, ahead of schedule according to their press release. You will see most real estate operators opt to adopt IFRS early, particularly those with properties acquired more than 5 years ago. That is because it will decrease their leverage and increase book value.

IFRS allows companies to adopt fair value measures of their assets. It is advantageous for owners with older properties to account under IFRS this way their leverage ratio will be much better. Also I think in this cycle where commercial real estate have been clobbered you will see many years in the future of up revaluation of properties and steady increase in book values.

The accounting changes will move BPO book value from $9 to about $14 making Price/ book value less than 1.

Also they will be compare more favorably now that leverage is reduced. Most analyst do not like BPO because it has higher leverage ratios compared to other office owners.

Practice Investing

Investing is just like any other discipline you need practice to develop the skills to be good at it. For awhile I have been thinking about a framework of skills and how do I practice to improve my game. I have broken it down to three elements that need to be developed and worked at constantly:

1. Knowledge
2. Skills
3. Behaviour

Knowledge:

If you have read Poor Charlie's Almanac, which I recommend highly, you will see that he harps on what he calls "mental models". This is the equivalent to knowledge in my framework. However, I want to further detail these models into two elements:

1. Systems Knowledge: similar to Munger's description, it is your knowledge of the necessary sciences to enable you to decipher your way through events, readings and decisions:
• Accounting
• Mathematics
• Psychology
• Language
2. Domain Knowledge: Munger did not explicitly break out this element as a distinct "mental model" but he emphasized reading a lot. Domain knowledge is the structure of information and data or "insights" about a specific industry. You can't be knowledgeable sufficiently about several domains so you have to keep your efforts focused on few ones, the less the better investor you will be.

How do you practice your knowledge building capacity? By writing down notes about what you read. What you need to write is not a summary of the information but an answer to the questions: so what? What will be the impact of the news item on you, your business and the companies involved?

Skills

To develop the knowledge required, you will need to read and read a lot, this has to be evident by now. Here are the skills that you need to work at as well to be more effective and efficient:

1. Speed reading: you need to read quickly because knowledge has one limitation and that is time. The skill is hard but you need to work at it to continuously improve the yield on your time by acquiring more knowledge for each unit of time spent.
2. Memory: what is the point of reading if you can't remember the information you need to analyze a particular situation or identify a unique opportunity. This is a skill that can be improved by practice as well.
3. Creativity: Munger in his book said to "invert, always invert" well to do so you need imagination. Creativity is needed in order to develop future scenarios and imagine possible risk for business.

Behaviour

I have identified three behaviours or personality characteristics that need to be nurtured as well:

1. Passion: your passion should be about the process not the outcome. If you are passionate about the process you will think and have perspective on how to improve it rather than use it in a mechanical fashion.
2. Adaptation: one of the most valuable traits of humans is their ability to adapt to their circumstances and learn from their mistakes. But this require that you take responsibility and internalize errors and mistakes rather than blaming it on chance or others.
3. Determination: because you will fail but you need a combination of strong will, ambition, and discipline to keep going as what I outlined here is a lot of hard work.

Train hard!!!!

Positions Revisited

I want to revisit some of my stock decisions and see what was the outcome and analyze if there is anything I should have done better. I will try to be intellectually honest with my assessments and recognize my errors. Also i want to look back and see if there are any mental traps that affected my decisions and recognize when i fall for these psychological biases.

Below is all the positions that I have talked about on this blog for over a year or so. All are businesses that I looked to own but did not or I bought and sold.

General Growth (GGPWQ): I have dismissed the value in this name when it was trading at $.35. now the stock is over $4.5 an impressive 600%+ return. Was I wrong? Off course I was. Would I do the same decision again? Probably yes. There is nothing inherently wrong in how I analysed the situation. I came to the conclusion that there is a probability of permanent loss of capital; this probability excluded the equity of GGP right away.

I honestly can live with the consequences of such decisions. I prefer to err on the side of preserving capital than take a speculative position like General Growth.

Coach (COH): I liked the business and its management but I decided I will only buy at $18 or below to give me enough margin of safety. Coach is trading at $33; some 80% return if I have gone ahead and bough at my buy decision.

My inaction cost me here. This one hurts more than General Growth because there was no reason not to buy. I scummed to the fear and paralysis during the market tumble earlier this year. My bias for the status-quo and regret avoidance have cost me.

Hawk Drilling (HAWK): I did not like this spin-off for various reasons. However, the stock has gone from $22 to $35 in the span of several weeks. The business has a lot of ugly factors in it, which is what you want to buy in a spin-off. But again this one I can live with. The price has gone up not to the specifics of the company but because of movement in natural gas as evident of a similar move by its competitor Hero Drilling as seen in the chart; Natural Gas has also moved from $2.7 mcf to $3.7 during the same period. I concluded that this was a leveraged play on Natural Gas and I did not want to call its direction.

Switch of Bank of America to American Express: After BofA bought Merill Lynch I decided to get out and switch to AMEX. My analysis were right that BofA would have tough time with Merill and I am better with a company that have a great brand name and much more easily understood and analysed than a bank. AMEX return 65% from the switch to BofA -14%.

In this instance I did not have any status-quo bias I acted and I did not have a loss aversion bias. I hope I can have the same capacity to perform the same decision in similar situations.

Preferreds (Brookfield and Bombardier) and Senior Loans Positions: I have bought several positions with the credit theme to be a better proposition than equity. All worked very well with most of them 70% gains plus their yield.

However, equity performed very well since its March lows. All my buying from late 2008 to early 2009 has been tilted toward credit instruments rather than equities. There were several companies that I liked that could have provided me with handsome returns over the last six months. Again, some paralysis on my part to pull the trigger on stocks with attractive prices, similar to Coach above.

Teck Resources (TCK): This position has worked as I expected. The assets were too valuable. When it was trading at $4, I did not think there was any chance of loss of capital. Now that the stock is trading at $30 it still has some room to high 30s.

However I made a silly mental error. I sold too early and left a lot of profit on the table by halving my position. The business did not hit my value estimate and I reacted to the price run and I fell to regret avoidance mode. I should have asked what is the value?

FirstService (FSV): I sold at 8% loss when I realized I made several errors in valuation and business model assessment. My mistake here is that those assessment should have been made before hand not afterwards. I rushed to take advantage of price decline before the opportunity escapes me. Little I know the price declined further. Here it was a process violation; the position should have never been established and because of the error I am 8% poorer.

NorthStar Realty (NRF): I am down some 50% on this one. I can be wrong on this one but I followed my process and my thesis still good. I am willing to hang onto it until I see another opportunity with better return profile.

Sears Holding (SHLD): I am down 30% on this position. Again so far I am wrong and the intrinsic value has declined with the name as its real estate assets have went down in value. Moreover, I realize now that valuation discount alone is not enough it has to be coupled with good business model and economics.

Cardinal Health, Peyto Energy, and Burlington Northern: All of these positions are recent and any analysis is not worth its trouble.

I just wonder how this post would have been different if the market have not rallied. I come to remember the quote " rising tide lifts all boats". So I am thankful that I did well but I always think that there is an element of luck in my decisions.

Value idea: Peyto Energy Trust

Natural gas is at extreme lows as it should; there is tremendous supply in the system. Storage is almost full. There will be no where to put extra production. The reason is the vast discoveries of shale gas. North America is abundant with natural gas contrary to what was believed of North America peak gas. Even with a harsh winter I do not think the supply picture will improve.

However I believe that goods or assets can't sustain prices below its average production cost over the long term. Sure there will be some divergence in some periods but it should return to equilibrium eventually. The question is when. I am not going to speculate on that as it is going to be a crap chute at best.

However a good position if I can find a way to participate in the price recovery of natural gas, while I get some downside protection and a margin of safety. I think Peyto Energy Trust (Pey.un) gives me this proposition. Peyto is :

Canada-based energy trust. The Trust’s principal business activity is the exploration for, development and production of petroleum and natural gas in Western Canada. As of December 31, 2008, the total proved plus probable reserves were 998.3 billion cubic feet equivalent (166.4 million barrels of oil equivalent) with a reserve life of 23 years. Production is weighted approximately 85% natural gas and 15% natural gas liquids and oil.

I like Peyto for the following:

• hedge book for half of their production of the next 12 months at an average price of $7.5 per mcf
• low debt to capitalization and good coverage of debt service and dividends
• low cost producer of natural gas. currently their operating costs per BOE is $2.56 as of their latest quarter
• long life reserves
• the cost structure for the most part is variable and gets reduced with lower revenues.
• cheap valuation where its Entp. Value to NPV is .57, a measure to value the company to its discounted cash flow from reserves in the ground.
• The current dividend yield is Distribution is 15.5%. The coverage of the distribution is good but if gas prices continue its decline it will be halved.
• I get good odds betting on natural gas plays. The upside is potentially large while the downside is limited. We are already at a decade low of natural gas price. Most Natural gas producer did not participate fully in the recent rally and lag the indices by a wide margin.
• And a very good management, extremely good management.
• My catalyst will be the revision to mean in natural gas prices as most likely it can't keep going down. We are in a period of supply and demand imbalance and there should be an equilibrium found in the next 12 months.

What can go wrong:

• Payout ratio is trending higher, which is understandable given the weak revenue figure. Peyto has already cut its distribution and it could a further cut is probable.
• Natural gas is the "widow maker" and can be very volatile. There is no reason it can't go to low $2s per mcf.
• Their operating lines can be shut or reduced if credit environment deteriorates further. Producers rely on operating lines to fund operations and exploration.
• Royalties are influx in the government of Alberta and can be very fickle to factor in analysing operations. Couple years ago royalties has been hiked on gas producers but once the bust has set in it was reconsidered.
• The conversion to corporate entity issue. Trusts will be subject to regular corporate taxes in 2011 so this is issue is hanging on Peyto and all trusts alike.

A note: This is a Canadian trust equivalent to master limited partnership in the US so it will have personal tax consequences that will have to be taken into consideration when purchasing

Changes to portfolio

Reducing EEM stake by more than half. I have been holder of Emerging Market index for a while in an effort to diversify internationally. The call was to hold the index for the long term but as my style of investing changes, more focus on event driven investing, I find my emotions rule how I view this position. I get swayed by economic analysis from various sources. I do not have any insight or edge.

Also, I have bought in the EEM when all were selling in Sep of last year. Valuation then made sense. Now emerging market funds are loaded with capital as money flow into them like crazy. Valuation has increased from 10 x earning to 20 time earnings now. People have high expectation of emerging market due to growth potential. I think it is a likely scenario that economic dominance will shift to some emerging economies like China and India but the odds that the market gives me for returns are not favorable. So I am taking my profits here and I will set tight.

I am also selling out of FirstService(FSV). I am existing this position with a small loss of 7%. I have made this call based on valuation alone. the value of the sum of the parts were higher than the market cap of the company. However as I started to look at the business details, a step I should have done before buying, I started to change my mind and cheap valuation does not cut it alone. I sold because:

• high compensation to CEO and management compared to peers and level of earnings growth.
• rollup strategy that is empirically destroys value
• ROIC is on par with the cost of capital
• bulk of the growth is attributed to acquisitions. what will happen if they can't acquire anymore?

Another sell decision TSX index: too much concentration in Natural resources and financials. Actually between the two sectors it makes up to 75% of the index. And those two areas where I do not have a lot of insight. Another small loss of 4%.