Leucadia: A Smart Hedge To Protect Your Stock Portfolio

During the 3rd quarter 2006 the S&P 500 companies will enjoy their 18th consecutive quarter of double digit profit increase and analysts expect another double digit profit increase during the whole year 2007. Since the S&P 500 profits already reached an eye popping 49 years record level of 8.6% of GDP (total of product and services created by U.S. residents) there is some room for disappointment.

Since it's better worry about the storm when the sun is still shining, it's now the right time to wonder on how to hedge your stock portfolio against possible mediocre stock market returns.

The two major alternatives are:
- purchase of put options (or other options strategies): I tend to exclude this solution since protection is limited and cost (including commission and bid/ask spread) is expensive.
- diversifying in bonds or cash: short term investment grades bonds, U.S. Treasuries or cash do offer a limited reward (though about 2% over current inflation rate is historically a good level for cash equivalent investments), long term bonds at 4.8/5.5% do not offer an attractive reward and inflation protection. Spread of junk bonds over corporates are close to an historical low.

And what about an attractive third alternative: buying shares of a company which is thriving when the economy go bad but offers at the same time a long term track record of superior returns ?
This company exists: it's called Leucadia.


PROFILE

Key numbers (source: Yahoo)
Leucadia (LUK)
last quote (closing 10/24/06): $26.15
outstanding shares: $216 mil.
market cap: $5.66 bil.
P/E: 12.20
P/B: 1.49
dividend yield: 0.50%

Leucadia is often referred as a mini-Berkshire, the holding company of famed value investor Warren Buffett.
Though the company is described by S&P as a "Multi-Sector Holding" company, Leucadia looks more like a private equity firm.
Contrary to Warren Buffett favourite investment strategy, they are not chasing great companies available at acceptable valuations and hold them for a very long period.
They concentrate on deep value investments in distressed or out of favor assets often, but not always, involving bankrupt companies.
They usually prefer to move within their circle of competence which includes, among others, telecommunications, lending/banking, real-estate and mining industry.
Once they control the company they turn it around and sell it for what have been historically excess returns.

period 1979-2005	S&P 500	Leucadia
CAGR (1) index/share prices change (2)	+ 9.9%	+ 25.1%
CAGR Shareholders equity	N/A	+ 21.5%

(1) CAGR: compound annual growth rate
(2) includes dividends for S&P 500, excludes dividends for Leucadia
source: Leucadia Shareholders Letter 2005



comparison chart Leucadia - Berkshire Hathaway - S&P 500

The shop is run by Ian Cumming (Chairman of the Board) and Joseph Steinberg (President) which are deemed to be responsible of this notable long term performance.


BALANCE SHEET

Balance sheet is extremely liquid at the moment.
Long term debt stands at about 1 billion against 1.4 billion of net currents assets (which includes about 1.6 billion cash in cash or short term investment) and 3.8 billion of shareholders equity.
Hopefully in the next months at least part of this cash balance will be used in various investments opportunities.

One of the major assets items is a net Deferred Tax Assets worth about 1 billion which requires additional comment.
In 2005, following the sale of their telecom company WilTel to Level 3, Leucadia kept some assets in hands including this Deferred Tax Assets.
Since WilTel has accumulated about $5.1 bil. losses it accrued a credit on future federal income taxes of about $1.0 bil. which can be used to offset Leucadia profits on future investments at certain conditions for a period of about 20 years.

Each year, every time that Leucadia will accrue eligible profits:
- balance sheet Deferred Tax Assets will be reduced in proportion on federal taxes that the company should have paid on its profits,
- in Income Statement, a tax expense will RECORDED but not PAID.

Note that to ascertain the true company profitability in the future you should add back the non-cash federal taxes to the net profit reported until the whole Deferred Tax Asset will be used.

After checking company investment track record and company statements we based our analysis of net worth on the assumption that in the next 15-20 years Leucadia will generate enough taxable income to fully take advantage of the tax credit assets reported in balance sheet.


MANAGEMENT

Top management, Ian Cumming and Joseph Steinberg, are the main point of strength of the company. They are responsible for the stellar long term investment returns but they are 62 and 66 year old. However their new employment contract signed in 2005 expires in June 2015. They are in good health and according to what can be understood from their comments in last shareholders letter and last shareholders meeting they seem as enthusiasts as ever.
They own about 24% of the company which is a good guarantee that they will move in line with long term shareholders interest.

This summer there have a been some notable insider buying. Two directors bought shares worth about $534.000 at an average price of $25.74, a level close to present quote.


AN UNDERGROUND WEALTH BUILDER

Leucadia is not an ordinary conglomerate and its profitability is not easy to ascertain by following their quarterly earnings releases. Wealth is not built by a regular stream of operating income out of of long term assets. Management goal is to increase over time the company net worth which usually does not appear in balance sheet or income statement till the assets sale.
In the past most of their investments were concentrated in private companies or hard/financial assets which fair value is elusive for analyst not specifically involved in the relevant industry.

How to evaluate the business ? The main criteria should be, like an ordinary stock mutual fund, the Net Asset Value. But unlike a mutual fund, usually you cannot rely on daily market prices of listed stocks or bonds since their assets are not always publicly listed .

A deep and relevant analysis would be so time consuming that brokerage houses and investment banks decided not to cover the company despite its $5.7 mil. market cap. It tells a lot on how poor is Wall Street job on providing added value information on balance sheet statements and how much time and money are spent on trying to get right up to the penny the quarterly earning figures.

However you are now in a somehow lucky period regarding this issue since more than half of total assets are made of cash and short terms investments.
Out of total $5.5 bil. total assets appearing in last balance sheet for quarter ending June 2006 you have about 2 bil. of cash and short term investments and about 1 bil. of deferred tax assets (see above) which require no adjustment to reflect their fair value.

On top of that financial statements report a collection of minor assets which adjustment to get fair value would have only a very minor impact on reported balance sheet for two reasons:
- assets were acquired a short time ago (less than 1 year/1 year and half ago)
- they represent a minor share of total company assets

Here are the main assets excluding cash:

• $400 mil. invested in Fortescue, an Australian iron ore mining company ($300 equity and a $100 mil. note);
• timber and plastics manufacturing: paid $133 mil. in Apr.05 for Idaho Timber plus Conwed (plastics) which employed about $82 mil. assets;
• wineries located in California (225 acres in Napa Valley) and Oregon (115 acres in Willamette Valley), combined net investments amount to $71 mil.;
• real estate assets which book value at the end December 2005 was $166. I suppose that these assets should be materially undervalued. Accounting rules require to depreciate such assets though they tend to increase their value over time especially these last 3-4 years of white-hot real estate market;
• restricted 5.6 mil. shares of Canadian mining company INMET (worth today $ 265 mil. against $78 mil. reported in the books);
• a 30% interest in Goober Drilling paid $60 mil., plus a secured loan to the same company of $126 mil. (loan balance was $53 mil. in June 2006);
• $91 mil. investment to rebuild the Hard Rock Biloxi casino and hotel completely destroyed during Hurricane Katrina;
• about $250 mil. in a various hedge-funds and investment partnerships;
• Berkadia (it sounds like a joint-venture between Berkshire and Leucadia ? you're right, it is) which is close to complete the liquidation of assets of bankrupt Finova Capital Corporation.

After adjusting for market value of Inmet and real estate assets and after deducting unfunded defined benefit pension plans (calculated by Leucadia using a very conservative discount rate around 5.1%) and adjusted marked to market value of Fortescue equity I estimate that stock is trading at about 1.40 times adjusted B/V, more or less in line with the 1.50 times book value calculated as per official financial statements.

If you decide to buy the stock and want to follow the company investments or if you are willing to do some further research I highly recommend to read Leucadia candid, detailed and well written shareholders letters. You will have a good feel on how assets are performing and how management intend to move to allocate capital without the burden of time consuming assets valuations.

Since last summer, despite a buoyant stock market, shares have been performing poorly. The reason is that since Cumming and Steinberg have a strong investment discipline and they are not finding enough attractively priced distressed assets . The reason is that "competition for investment opportunities, roared back in the form of 35-year old hedge fund managers-private equity firms who have never known a bear market-and other investors willing to invest at high prices in risky assets with seemingly cheap money (they cite in their 2004 shareholders letter as example an ebullient junk bond market" and "hot potato loan market").
In the same 2004 shareholders letter, Cumming and Steinberg have been clear on their investing discipline: "either we invest in high returning opportunities or have the money in the bank or under our mattresses". At that time lack of opportunities induced a pessimistic tone: "if we run out of ideas or steam we will let you know and develop a plan to return money to shareholders" they said.

However their comments in their 2005 shareholders letter and during their shareholders meeting in spring 2006 were somehow more optimistic: "We have many things in the hopper that look interesting and hopefully by next year at this time we will have a measurable reduction in cash and an increase in higher yielding investments."

Since U.S. market of distressed assets seems ultra competitive due to hedge funds and private equity funds abundance of cash, Leucadia is looking more at foreign investments. Fortescue deal is a first step in this direction.


RISKS

If management is unable to finalize an attractive deals pipeline worth at least $2-3 bil., company will be unable to compound shareholders equity at the present 20% long term average rate and Deferred Tax Asset may loose value.

Foreign investments may prove less profitable than the U.S. distressed assets deals which historically have been the company bread and butter and the main source of profits.


CONCLUSION

If management is able to match even 3/4 of their historical investment returns paying present 1.4/1.5 book value seems a fair price. Don't forget that in this price you also have included a free built-in hedge since the worse the economy, the more opportunities for Leucadia to profitably invest their large cash hoard.

I plan to plan to buy a 1/3rd or 1/2 position at around $25.50/26.00 per share.



Disclosure: the author has no position in Leucadia at the time of posting.
Under no circumstances does the information in this post represents a recommendation to buy or sell stocks. Such information must be considered only as first step for further research.