Why I Sold Apollo Investment Corp., Part lll

| About: Berkshire Hathaway (BRK.B)

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When I first became interested in Business Development Companies, I thought that Apollo Investment Corp.'s (NASDAQ:AINV) debt-based investments would provide a more stable income and a bit of protection in case of adverse market conditions. Bondholders are, after all, paid first. Apollo's investment portfolio did not, however, weather the financial crash or its ensuing recession with any particular grace. Share price doesn't tell the whole story, of course. As described in Part I, Apple's (NASDAQ:AAPL) shares fell about the same as Apollo's over the period of the crash. The difference is that the investments' performance have been quite different in the following period in which the economy has struggled to recover.

Apple - which suffered a near-identical price drop as Apollo Investment - gained share in the PC market and continued to build new stores with outstanding sales per square foot, while selling a cellular telephone the global demand for which promised at least a few more good years of strong global growth. But Apple is an unfair comparison: not only does it seem custom-picked on the basis of perfect hindsight to defeat comparison with any ordinary company, it is a single-business bet on a company whose fortunes rise or fall with that one business. BDCs offer an opportunity to invest with one ticker in a diverse basket of companies that all enjoy independent chance of success, whereas buying one company dramatically improves one's chances of success or failure based on one management team. For example, Apple's management has turned in a post-crash performance that is markedly different than that of most of the companies viewed as its competitors.

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Research in Motion (RIMM), the maker of BlackBerry handsets is also a vendor of presumably high-margin back-office mobile device management software and messaging infrastructure systems. Yet, its management has competed unsuccesfully in a mobile telecommunications market that propelled Apple into the position of the most valuable firm on the planet. It's simply not enough to be in an industry that's exploding: management matters.

A BDC offers an opportunity with one ticker to buy many businesses, each of which may have radically different management. A careful look at a one-ticker diversification scheme like a BDC raises this puzzle: does such an investment diversify risk across the portfolio and its various management teams, or does an investor instead concentrate risk with the one management at the helm of the target ticker? The answer can be both. For example, American Capital (NASDAQ:ACAS) makes a point to advertise that its personnel includes an operations team that seeks to improve the performance metrics of its portfolio companies. Thus, investors aren't getting just the management in which American Capital invested; the investors of American Capital also get the management that results when American Capital supports each acquisition after closing. If American Capital is good at operations improvements, this may be a good thing. It can also be bad. Imagine a portfolio manager effective instead at increasing turnover in portfolio company management and driving up inefficiency. Clearly, a top-level fund manager imposing directives based on systematic errors could impact a fund's entire portfolio. One frequently reads that past performance is no guarantee of future results, but then, one also reads that history repeats itself. A careful look is required when your money is at stake.

Apollo's primarily-debt portfolio has an upside exposure that is limited to the projected return on the firm's (mostly) debt holdings. Apollo thus doesn't offer upside exposure to portfolio companies' potentially outstanding operations. The impact of diversity in its portfolio is limited to the expectation that portfolio companies' performance across multiple industries will be less susceptible to industry-specific threats and thus may pay more reliably on debt than one large borrower willing to pay Apollo's junk-bond interest rates. Apollo's exposure to the operational success at companies whose debt lies in its portfolio is thus primarily to the downside: companies either repay debt as scheduled, or they default. Since the exposure to the benefit of outstanding management at portfolio companies is limited, but the exposure to the potential for error at the portfolio companies still affects the prospects for every investment held, Apollo shareholders in effect get a double-dose of management's downside risk while benefiting from management mostly at a single level: Apollo's manager's skill in selecting appropriate debt investments at the time of origination. Without exposure to the upside of outstanding operations by portfolio companies' managers, all investors seem to have left is Apollo's manager's acumen in evaluating whether a deal provides suitable risk-adjusted returns. In short, Apollo is a BDC without diversification in management risk to the upside, but fraught with downside risk based both at the level of Apollo's manager (in selecting investments) and at the level of the portfolio company (where post-origination performance failures can devalue investments, but where upside opportunity is limited to performance of debt instruments).

Earlier in this series, American Capital's management of American Capital Mortgage Investment (NASDAQ:MTGE) was singled out as a superior opportunity to Apollo. While some mREIT investors saw dividend profits offset by lost asset value as their managers were surprised by prepayment performance or interest-rate changes, the managers at American Capital Mortgage Investment were the same who raised net aset value at American Capital Agency (NASDAQ:AGNC) instead, all the while paying one of the highest dividends in the asset class. As at Apollo, however, the strength of management in an mREIT like American Capital Mortgage Investment lies in picking assets that will pay as projected. American Capital Mortgage Investment, like its sister company American Capital Agency, will likely grow net asset value as a result of undistributed profits and the above-book sale of new equity, but as with Apollo, the underlying investments in each company's portfolio will offer only their projected performance as an investment incentive.

To really capitalize on the benefits outstanding management can yield shareholders over the long run, it is necessary to find an opportunity to participate in the equity upside of well-run companies. As described by Warren Buffett in a recently-published column adapted from his letter to the shareholders of Berkshire Hathaway (NYSE:BRK.B) in its annual report for the calendar year 2011, cash and bonds are subject to value-risk due to inflation, whereas equity ownership of a profit-generating firm will adjust in dollar price as dollar-values move with inflation because all the firm's sales - and profits - are always measured in current dollars. By purchasing equity, one purchases not only an inflation hedge but the right to participate in the increasing profits of outstanding firms. Warren Buffett makes a strong case that a long-term investment portfolio needs equity to succeed.

So, where does one look for a portfolio manager with a track record for buying quality portfolio companies and improving earnings for investors?

Post-Crash Opportunity In Berkshire Hathaway
Berkshire Hathaway's shares fell during the crash of '08 on concerns that were amplified by concerns about the company's derivative risk. A careful read of Warren Buffett's 2008 shareholder's letter makes clear how the unrealized liability associated with Berkshire's custom-crafted decades-long index put options is systematically overstated by the Black-Scholes model so conservatively adopted by Berkshire in its SEC-filed financial reports. One thing to keep in mind when considering the degree to which Black-Scholes properly values Berkshire's risk is that the Black-Scholes formula depends strongly on the daily volatility of the underlying indexes, despite that Berkshire's custom options can be exercised on only one date, their expiration date, which is years and sometimes decades from the contracts' inception. When unrealized losses associated with near-term volatility impact "earnings" at Berkshire to such an extent as to mask the enormous profit being generated there, someone is being fooled. The chart of Berkshire Hathaway's B shares shows the market still hasn't wrapped its head around the value growth created by its solidly-performing portfolio of businesses, and continues to discount the shares severely. Perhaps this results from a conviction that large companies can't really grow profit enough to be worth owning (a message Apple has apparently misunderstood) or that the derivatives exposure proves Berkshire's top management have finally gone soft in the head. The share price performance for B shares (split-adjusted) shows an overall decline from the end of the year before the crash:

The Berkshire graph is particularly interesting in light of the company's solid operating performance while building book value per share. Because Berkshire's overall business characteristics do not change dramatically over time, the ratio of intrinsic value to book value is less volatile than at companies that move in their markets from being a high-cost start up (say, Zipcar (ZIP), which hasn't had a profitable year yet but whose per-vehicle metrics tease promising results) through a growth phase (such as Apple after the adoption of MacOS X following the NeXT acquisition, which enabled the launch of OSX mobile devices such as the iPhone and iPad) and eventually into a steady-state phase of operations (such as Microsoft (NASDAQ:MSFT), which captured operating system markets on the desktop and in servers, and sells high-margin office productivity software that's hard to leave because of proprietary file formats, all of which amount to a virtual guarantee of high-margin software sales into the foreseeable future as software is subjected to ongoing replacement cycles in existing markets long dominated by Microsoft). Berkshire's largest business is a rail line with about 15% of the freight carriage between U.S. cities, and its metrics aren't changing quickly despite its record profits. Since the ratio of intrinsic value to book value does not change quickly, Warren Buffett describes the book value as a proxy (albeit a discounted one) for intrinsic value. While this is not true at every business, it's not unique: Markel Corp. (NYSE:MKL) also uses book value per share as an important internal metric of success. In Berkshire's case, book value per share grew by more than 20% from the end of 2007, despite the overstated negative value of its short index puts. The chart of book value per Berkshire Hathaway A share (A shares' book value wasn't impacted by the 50:1 Class B split associated with the Burlington Northern acquisition; B shares are now 1/1500th the book value of an A share) shows how Berkshire Hathaway's stock price has become disconnected from performance and potentially irrational:

That's right: while the share price has languished, Berkshire's internal valuation has improved - and has done so despite the fact that key aspects of the metrics demonstrably overstate the firm's material liabilities.

A read of Berkshire's chairman's letter to shareholders in the 2011 Annual Report provides a cogent explanation of the growing state of Berkshire's strongest businesses. If you haven't gone through a copy, you'll find it remarkably clear in its explanation of Berkshire's businesses. A few things are of special note to investors concerned about Berkshire's capacity to deliver market-beating growth over the long term.

Berkshire is most famous as an insurer (and reinsurer - that is, an insurer of other insurers' risks). The insurance business creates an interesting investment opportunity: instead of paying strangers to borrow their money in the hope of making a better return than the cost of borrowing (á la Apollo or American Capital), Berkshire Hathaway receives money from strangers without paying interest as part of its temporary assumption of insured risks; more often than not, Berkshire isn't required to give all the money back. Meanwhile, Berkshire is free to invest the money. The impact of this is summed up nicely by Berkshire's chairman in the most recent shareholder's letter, when he said Berkshire's access to float permits "profit just as we would if some party deposited $70.6 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit." Over the last nine years, Berkshire's aggregate "fee" for holding float - not money made by investing the float, just the funds kept from float as a sort of fee for holding it - has amounted to a about $17 billion.

With so many billions to invest, Berkshire has acquired whole non-insurance companies as investments. Berkshire's investments are individually so large that - if not Berkshire portfolio companies - eight would be in theory members of the Fortune 500. The top five of these companies aren't all ancient Berkshire enterprises, but illustrate Berkshire's capacity for growth: seven years ago, Berkshire owned only one of its top five holdings. In 2011, each of the top five produced record profits, to the aggregate tune of over $9 Billion. The one of these businesses that Berkshire did own 7 years ago had pre-tax earnings at that time of $393 million. This year, these five portfolio companies are expected to top $10 billion in earnings.

Berkshire's Huge Cash Hoard
Warren Buffet has never shied from keeping large sums of cash, and has never allowed tens of billions to burn a hole in his pocket; the cash doesn't force any particular conduct. Liquidity has simply presented opportunity: General Electric and Goldman Sachs (NYSE:GS) each accepted multibillion-dollar investments from Berkshire Hathaway during the financial crisis, placing Berkshire in the happy position of holding 10% preferred shares that previously did not exist (and giving Berkshire some additional upside potential in the form of warrants: $3B of GE at $22.25, and $5B of Goldman at $115), and Bank of America Corp. (NYSE:BAC) more recently accepted a similarly-sized investment (the rate paid on the preferred is 6% and the strike price on the 700m shares' warrants is about $7.14; Buffett wanted a long-term investment and Citigroup surely didn't want to look desperate). Who without Berkshire's reputation and cash could enter these deals - especially at Bank of America, which wasn't looking for equity? And try though Berkshire might to keep funds deployed in productive investments, the cash keeps rolling in (for example, Goldman bought back its preferred, followed by General Electric - each paying a 10% redemption premium).
The difficulty of finding good investments for tens of billions of dollars (there are only so many well-run railroads, and there are still antitrust laws, so there's only so much to buy), and the return of capital from successful non-permanent investments, have combined with Berkshire's price-to-book disconnect to drive Berkshire to repurchase its own shares on the open market. Under the new policy, management has the authority to buy shares of Class A or Class B shares when their premium to book is sufficiently slight. Since management believes a correct price-to-book ratio is much higer - a belief the markets until recently also held - the effect of the repurchase is to spend money to get shares that are - in management's opinion - worth more than the purchase price. Since Berkshire's justifiably-trusted management is in a fairly good position to assess the value of the company (and has earned the trust of its shareholders to make such judgments), the plan appears a safe bet to concentrate more value per share than the company spends per share retiring shares.

Berkshire's discipline about repurchase has been so strict that it only bought a couple of trading days in 2011. As described in the 2011 shareholder letter, Berkshire's hesitance to repurchase shares results in part from fiduciary duty to its own shareholders, from whom management is loathe to buy shares below their worth. Where other companies' shares are in question, however, Berkshire has a very different view:

When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: "Talking our book" about a stock we own - were that to be effective - would actually be harmful to Berkshire, not helpful as commentators customarily assume.
Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years.

Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

Just in case this escaped you: Berkshire is willing to warn the world about the prices at which it views its own shares as too irrationally-priced to resist purchase, thus impacting their share price. Why? Berkshire isn't in the business of retiring Berkshire shares from circulation, it's in the business of buying investments that produce a good risk-adjusted return. Berkshire is absolutely willing to allow shareholders of acquisition targets to be picked off cheaply, but willing to telegraph to the world its views about the circumstances under which its own shareholders will find themselves bidding against it itself.

But let's drift back for a moment to Buffett's wish for IBM in the face of IBM's buyback campaign: he wants shares, despite outsized performance of the underlying firm, to languish for years.

Isn't this what we've seen in Berkshire itself? Might we be happy buyers of Berkshire?

Valuing Berkshire's Portfolio
At Berkshire Hathaway, where Warren Buffett's preferred holding period is famously "forever," Berkshire Hathaway's portfolio of businesses isn't held for resale. Thus, the company is not required to use the mark-to-market rule to value such portfolio companies as See's Candies (you've eaten it yourself), Star Furniture (vendor of my media room couch), ISCAR Cutting Tools, Justin Brands (maker of my old steel-toed Chippewa boots), NetJets, The Pampered Chef (didn't realize this was Berkshire's until recently; and yes, I've bought), Fruit of the Loom (you need not admit buying), the Burlington Northern railroad (your goods ride on it), Dairy Queen (love that Blizzard), or its particularly well-known GEICO Insurance (why the move from the Caveman to the Gecko? The Gecko hasn't got an agent!). Thus, unlike a Business Development Company like Apollo Investment Corp. or American Capital Ltd., Berkshire isn't required (or permitted) to provide shareholders a quick metric in the form of a FAS 157 "fair value" that shows what all its diverse businesses are really worth in light of current market multiples.
Nevertheless, Berkshire's "earnings" each quarter are impacted by FAS 157 and the mark-to-market rule, because its derivatives (the multibillion-dollar short index puts mentioned above) are subject to the mark-to-market rule despite that there is no market for the multibillion dollar custom-crafted options. Using the same Black-Scholes valuation formula used on short-term options that can be exercised at any point during the life of the option and readily disposed of in an open market, Berkshire applies as "earnings" the unrealized changes in "value" of the short index options. It's evident from Berkshire's huge profits (record-setting profits, if one adjusts for the "earnings" impact of the derivatives) that Berkshire has been producing outstanding returns in a challenging marketplace, and is fairly valued rather north of its currently-discounted price.

Berkshire Hathaway enjoys a few long-term drivers of unlockable value. First, as the time decays in the illiquid index puts, their "fair value" - a weight on the neck of Berkshire during the crash and the post-crash volatility - will evaporate. As the liability shrinks, this value will by the magic of FAS 157 add to earnings, rather than sap them as it has previously. Since the best case for Berkshire is that they expire worthless, and the downside risk is capped, and the Black-Scholes formula's inclusion of short-term factors such as volatility (largely unrelated to the value of an option that can be exercised only on its expiration date many years into the future) systematically overstate the options' values, there little risk that the mark-to-market valuations associated with the derivative holdings overstate Berkshire's income-producing assets; the rationalization of the options' value over time will work to the advantage of Berkshire's bottom line. The inevitable expiration of the derivatives will thus unlock the value associated with the systematic misstatement of Berkshire's liability.

The New Gold
Berkshire's income-producing assets offer an opportunity to enjoy doubly-inflation-protected returns. The insurance, food, furniture, and everything else sold by Berkshire's portfolio companies will increase in price in accommodation with any inflationary trend. Unlike gold, which produces nothing and is priced based on the fickle demand of short-term speculators who fear to hold cash, productive assets such as utility companies and major fixtures of national transportation infrastructure will not only be priced to accommodate any devaluation in currency, but they are absolute necessities the demand for which - and the real value of which - will increase with demographic trends driven by ordinary population growth and the expansion of every business that operates. Not only can Berkshire transport the industrial output of manufacturers to consumers located all along the Burlington Northern lines, but Berkshire can insure the cargo and supply travelers with Blizzard shakes and Orange Julius drinks while their sweethearts eat See's candies while sitting in a home sold by a Berkshire-owned broker and filled with Berkshire-vended furniture. Berkshire is an opportunity for a bull play on growth in America, and growth in businesses with insurable risks globally.

Best of all, and key to getting a good deal in the market, people easily misunderstand Berkshire's value. Berkshire publishes no market values for any investments other than the portion of its stock holdings that exceed $1 Billion per position. Berkshire is not required by FAS 157 to tell us what it thinks GEICO is worth on the basis of comparisons to other insurers, or what in fact any of its insurance or non-insurance businesses are worth. We know that Berkshire's financials treat its entire $70+billion float as it it were a current liability, and not treat it as an economist would by discounting its distant repayment date into current dollars before assigning a value. We know that Berkshire never plans selling IBM or Wells Fargo or its other substantial holdings, so its deferred tax liability associated with unrealized gains will go undue and unpaid because the tax obligation will not be realized - or, if realized, will be realized in distant-future dollars whose present value is substantially less. We know that the value assigned to Berkshire's custom-crafted index puts is wildly inaccurate. And because we don't hear from the executives at the numerous companies that provide earnings to Berkshire's bottom line, we don't have analysts following any of them - even the ones that would be Fortune 500 companies if not owned by Berkshire. Berkshire is not required to allow analysts to quiz the management teams of its portfolio companies to learn about their growth metrics and internal performance. When Berkshire projects over ten billion in earnings from its top five portfolio companies in 2012, we don't get details to help us understand how much of Berkshire has yet to begin performing at top form following the crash.

What we do know is that Berkshire buys businesses that it thinks are outstanding and leaves their management in place to continue doing outstanding things. When they need capital, they can obtain it from many sources - including from uninvested funds that are part of Berkshire's massive float. Berkshire's portfolio is thus vastly more opaque than one would consider American Capital's , since American Capital at least reports "fair value" on its universe of marketable holdings. Berkshire's opacity increases the extent to which the shares can be misspriced in a market based on available information, and should be enjoyed by the would-be buyer of shares.

Berkshire Differences
Berkshire's leverage doesn't come from high-priced debt to shark lenders, it comes from sources that charge no interest: taxes that won't be due until Berkshire sells IBM or Wells Fargo; insurance float that in most years Berkshire is actually paid to hold. So, it's not fair to say that Berkshire's results aren't a product of leverage. It uses others' money all the time, including multibillion-dollar premiums received when writing custom-made long-term index puts.

By investing in outstanding management teams in so many different industries, Berkshire has amassed a portfolio of businesses that in the aggregate surpass the performance of the broad benchmark of the S&P. Berkshire's S&P-surpassing performance hasn't been the result of good guesswork years ago, or even recently: it's the product of discipline. Berkshire's management believed housing would recover faster. Berkshire invested in oil companies near oil's peak, too. Despite timing mistakes, Berkshire is making money - big money. Why? Its portfolio performance doesn't depend in most cases on being cleverer than others, it depends on being right in the long term about the risk-adjusted returns to be had.

Within each of Berkshire's portfolio companies, add-on acquisitions are conducted, funded by the portfolio companies. Berkshire's businesses are growing and competing as enthusiastically as any publicly-traded companies, just with less analyst oversight. Also, with less executive compensation: Berkshire has serious discipline in establishing appropriate compensation, and isn't bamboozled by executive compensation consultant presentations. If you liked the lower management fees at American Capital Mortgage Investment as compared to Apollo, you will love what you will pay to have Berkshire manage your investment.

Recently, Berkshire added two executives to cooperate on portfolio management. In innovative Berkshire style, the performance portion of their compensation is based 20% on the results of the other manager. Managing "small" $2B portfolios at their inception, these managers aren't suffering from an inability to invest in things that don't cost $10 billion. Berkshire's identification of two managers with the right mentality to invest for the long haul is an extremely bullish development from the standpoint of an investor worried that Berkshire's assets might go under-deployed. Aggressive value investing will be the name of the game in Berkshire's investment portfolio for the foreseeable future.

Berkshire Similarities
Like Apple, which was haunted for a few years by scares related to the health of its rock star CEO, Berkshire is mostly known to the public for its witty and wise but octogenarian Chairman of the Board. Berkshire has made clear that its succession planning is established, and involves executives with which the Board has long experience. Just as onlookers feared Apple would crater without Steve Jobs, similar fears haunt Berkshire's shares when investors consider the age of its top management.

However, the rest of the story is also the same. When Steve died we mourned the passing of an icon, but celebrated that the company he created had a culture that would outlast him and a set of known-quantity proven-effective executives capable of continuing the same outstanding performance as before. So also should we expect with Warren Buffett. Just as Steve Jobs did not write a line of computer code needed to make its products function, Warren Buffett does not sell insurance or build machine tools; his presence is not essential to the operation of the many portfolio companies (much less the investments in marketable securities) that drive earnings at Berkshire Hathaway. The daily drivers of profit are within the expertise of portfolio company management. Berkshire's outstanding managers will carry on in the culture established by their longtime leaders just as they have at Apple.

And a look at the last few annual reports will paint a fairly clear picture just how much better those results are than as reflected in GAAP-compliant balance sheets. These managers are lauded by Buffett in each shareholder's letter, but they are undervalued by analysts who continue to be distracted by the opportunity to write sexy headlines about derivative "losses" in Omaha. When their value becomes more obvious on Buffett's passing - because Berkshire's success can no longer be attributed to one man or his cult of personality - so too will become the value of the firm.

Berkshire Hathaway - a quintessential widows-and-orphans stock - is exactly the kind of medicine needed to wash the unhappy taste of Apollo from an investor's lips. Instead of crashing with the crash, Berkshire built per-share assets. The stock price slumped, but profits churned on and are hitting records even as the shares languish unloved amidst so many issues that aren't in the news enough to notice. Buffett said it best: The markets are in the short term a popularity contest, but in the long run a weighing machine. Berkshire's business model provides consistent and market-beating returns to investors, and has become so undervalued that Berkshire is willing to buy out its own partners. Buy in now, and cash in as Berkshire soaks up extra shares while their price lies unmoving on the stock chart for a few years, until subsequent management proves it can produce the same results as those who first set the high standard.

Disclosure: I am long AAPL, ACAS, AGNC, BRK.B, MTGE, ZIP.