Politics & Policy

Bubbles & Squeaks

A tech curmudgeon does well for himself.

A merciful sort, Whitney Tilson suggests we have our dinner at a modest place called Hanratty’s, way uptown on Madison Avenue. “It’s inexpensive,” he says. This is good since I am paying. Against all odds, I lost the bet.

On July 13 of last year, I wrote a column that began, “Is high tech really back, or are we headed for Dubble Bubble?” In the next paragraph, I quoted Tilson, whom I called the “venerable and circumspect columnist for the Motley Fool,” the personal finance website. Tilson was firmly in the Dubble Bubble camp. On June 6, he had written, “Times like these make me sigh, hold my head in my hands, and groan, ‘How is it possible that, in less than three months, investors have forgotten all of the painful lessons of the previous three years?’”

I pointed out in my column that tech stocks that he had called “ridiculous” had, in the five weeks following his words, zoomed upward even more. EBay (EBAY) went from $96.97 to $113.07; Yahoo (YHOO), from $27.95 to $32.19. E-Trade Group (ET), which Tilson told readers on May 23 he was selling (after a purchase in September 2002 at $4.30), went from $6.49 to $9.50.

On Feb. 13, eBay closed at $68.60, after a two-for-one split, so it’s up an additional 21 percent in the past seven months. Yahoo is up 44 percent over the same period; E-Trade, up 55 percent.

And, if you hadn’t noticed, there’s been no Dubble Bubble. But, somehow, I lost the bet.

In an e-mail after my article appeared, Tilson proposed that, by the end of 2003, his deep value stock, Berkshire Hathaway Inc. (BRK), would beat my tech stock, Nasdaq 100 Trust Shares (QQQ), an exchange-traded fund (ETF) that mimics the value of the 100 largest stocks on the Nasdaq Stock Market. Given that I own both securities, I figured I was well hedged.

In the event, Berkshire rose 14.62 percent while QQQ rose 14.51 percent. Those 11 one-hundredths of a point cost me a dinner in New York.

I lost the battle but won the war. The thrust of my column was right: “The message is to get into technology and stay there.” Still, I am not bitter. I had a decent dinner, and I learned a lot from Whitney Tilson, who, as it turns out, is less venerable than I am by 20 years and a smart and interesting guy. He was a Baker Scholar at the Harvard Business School, worked at the Boston Consulting Group, and helped start Teach for America and another organization that brings private equity to inner-city businesses. Tilson, nevertheless, is a curmudgeon — a young curmudgeon.

He is part of an informal gang that’s often called Graham-and-Doddsville, after the two financial geniuses Benjamin Graham and David Dodd, who in 1934 wrote the classic book Security Analysis, which urged investors to “look for a margin of safety” when they bought stocks.

Graham, who taught at Columbia and managed money very successfully, was mentor to Warren Buffett, chairman of Berkshire and now the unofficial mayor of Graham-and-Doddsville, whose population also includes Buffett’s partner Charlie Munger and such mutual fund managers as Mason Hawkins of Longleaf Partners Fund (LLPFX), William Ruane of Sequoia Fund (SEQUX), and Christopher H. Browne of Tweedy, Browne American Value Fund (TWEBX).

Like these other inhabitants, Whitney Tilson is a value geek. He’s a parsimonious sort who insists on buying stocks with “50-cent dollars,” continually whines and harrumphs about equities being too expensive and about Americans and their government being profligate borrowers and how this will all end badly, etc., etc.

Curmudgeon or not, Tilson has done very well for himself — and for investors in the hedge fund he runs, Tilson Growth Fund, L.P. In the four years since it was launched (on Jan. 1, 1999), the fund has returned 68 percent (53 percent after fees), compared with minus 3 percent for the benchmark Standard & Poor’s 500-stock index. Of course, value has beaten growth over much of that period, but even in a go-go year like 2003, Tilson whipped the S&P, 37 percent to 29 percent.

Tilson combines skepticism with optimism. For example, his year-end report reveals that his “cash position is near its highest level ever,” mainly because he can’t find enough “really cheap stocks.”

Skepticism is also evident in his ownership of puts on the Nasdaq 100 and on Semiconductor HOLDRS Trust (SMH), an ETF that owns a basket of chipmaker stocks. A “put” is an option that gives you the right to force someone to buy your shares at a specific price over a specific time period. Like short-selling, a put lets an investor profit when a stock’s price falls.

Tilson notes that the price-to-earnings ratio of the stocks of the Nasdaq 100 is 59 and, as he wrote in his Motley Fool column in October (and still believes today), “It is a virtual mathematical certainty that the companies of the Nasdaq 100 cannot possibly grow into the enormous expectations built into their extreme valuations.”

So much for the skeptical side. I find Tilson’s optimistic side much more enlightening.

First, Tilson loves McDonald’s (MCD). He calls Jim Cantalupo, the chairman, his “CEO of the Year for turning around a fast-food giant.” Last spring, Tilson bought long-term call options (termed “LEAPS”) that expire next January on McDonald’s stock. The calls give him the right to buy shares at a specific price until that date. For example, he purchased, for an average of $6, a call to buy McDonald’s for $10. The stock closed Feb. 13 at $26.63, and the value of the LEAPS has tripled.

Don’t try this at home. For most small investors, the best way to own a company you love is simply to buy shares of its stock with cash. When you purchase LEAPS, you get leverage: You make more if the stock rises but lose more if it falls. For instance, if McDonald’s shares fall below $10 on the date they expire, then Tilson loses his entire investment.

Why did Tilson buy McDonald’s? He liked Cantalupo’s strategy — scaling back growth, ending a price war with its competitors, selling off non-core-concept restaurants, emphasizing the basics. But strategy alone is not enough. He liked the execution, the fact that the new chief executive “acted urgently” to carry out his plan.

In addition, McDonald’s, despite its troubles, “was consistently pounding out nearly $3 billion [a year] of operating cash flow.” It was a classic case of what I call “faith-based investing.” When a great franchise falters (International Business Machines before Lou Gerstner is a good example), it’s a good bet (an act of faith) that a talented manager will come in to get it galloping again.

Tilson also holds stock in two other restaurant chains: CKE Restaurants (CKR), which owns Carl’s Jr., Hardee’s, La Salsa Fresh Mexican Grill and Green Burrito; and Yum Brands (YUM), which owns Pizza Hut, Taco Bell, KFC, Long John Silver’s and A&W. Yum, which is up about 50 percent in the past year, is a smaller holding, and Tilson is especially high on CKE, despite the fact that it has more than doubled in 12 months.

“I believe the company is just hitting its stride,” he wrote to his investors earlier this month, “and free cash flow is just starting to grow. If current trends continue, the stock could at least double from here.” Tilson, who also teaches accounting, focuses on free cash flow (FCF), the money a company has left after it makes necessary capital investments out of its yearly profits. FCF is the figure Buffett uses to derive the “intrinsic value” of a company — what it is truly worth today, a figure derived by estimating FCF over the future life of the firm and applying a discount based on interest rates and risk. Tilson figures that the ratio of CKE’s price to its FCF is just 7, an attractively low number.

Other reasons he likes CKE: Carl’s Jr. is a phenomenally successful chain, with profit margins of 21 percent, and Hardee’s has revamped its menu and operations. Also, “Hardee’s new Thickburger menu appears to be a hit.” (Personal preference: Change the name of this dish!) As part of his research, Tilson called more than 30 Hardee’s in six markets and visited two in Omaha and Daytona Beach.

Finally, Tilson is practically rhapsodic about his big bargain stock, Cutter & Buck (CBUK), the No. 2 brand of golf clothing. C&B, like other golf-related companies, got clobbered in the recession that followed the go-go 1990s, when new courses were springing up all over. During those boom years, C&B sales were growing at more than 30 percent a year.

The stock had dropped from more than $20 a share in mid-1999 to $6.66 when Tilson bought it in 2002. This is a company that had earned $1.10 a share in its heyday, and Tilson thought it could get back to that level as the economy recovered. Instead, C&B was caught by its auditors in some hanky-panky to boost reported sales, and the stock crashed to $3.44 after the Securities and Exchange Commission announced a probe.

“With much of my investment thesis in tatters,” wrote Tilson, “I was sorely tempted to sell, but didn’t.” He liked the turnaround specialist who came in to run the company; C&B’s brand remained strong; the scandal was relatively benign; and, dear to the heart of any deep-value investor, “the stock had become preposterously cheap.” It was trading at a discount of 45 percent to what it would be worth if it were liquidated in a fire sale. On Feb. 13, Cutter & Buck closed at $9.50 — up 43 percent in the two years since Tilson bought it. He still owns it, but it was quite a wild ride.

Tilson also owns Office Depot (ODP) and, of course, Berkshire Hathaway, which is a holding company for a couple of dozen companies, including private ones such as GEICO and public ones like Coca-Cola (KO). You can’t live in Graham-and-Doddsville unless you own Berkshire.

For the year ahead, Tilson is decidedly curmudgeonly. He doesn’t like the economy and the stock market as a whole (“little upside and substantial downside”), but he also quotes Buffett’s comments at a 1992 Berkshire annual meeting: “If we find a company we like, the level of the market will not really impact our decisions. . . . We spend essentially no time thinking about macroeconomic factors. . . . We simply try to focus on businesses we think we understand and where we like the price and the management.”

Buffett has also said, however, that he is “not finding anything” in the market — though that may be a smart poker player’s ploy.

Unless you’re awfully rich, you can’t invest in Tilson’s hedge fund. You can read his columns — which are excellent, if a little grumpy for my taste — online for free. To invest Tilson-style in a mutual fund, your best bet is probably Longleaf. It’s highly concentrated (just 23 stocks) with very low turnover (the average stock is kept for five years) and modest annual expenses (0.91 percent, with no load). Top holdings include FedEx (FDX), Hilton Hotels (HLT) and Yum.

Sneak a peak at Sequoia’s holdings on the Morningstar website and you find that, at last report, 33 percent of the assets are in Berkshire, 12 percent in Fifth Third Bancorp (FITB), and 11 percent in Progressive Corp. (PGR), an insurance company. Talk about concentration!

Which reminds me: A third alternative to having Tilson manage your money is simply to own Berkshire itself, which closed last week at $3,064 for each popularly priced B share and $91,900 for the premium brand.

– James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com . Of the stocks mentioned in this article, he owns Nasdaq 100 Trust and Berkshire Hathaway, and McDonald’s advertises on TechCentralStation. This article originally appeared in the Washington Post.

Members of the National Review editorial and operational teams are included under the umbrella “NR Staff.”

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