David Einhorn's Ira W. Sohn Investment Research Conference Speech

Ira W. Sohn Investment Research Conference

David Einhorn, Greenlight Capital, “The Curse of the Triple A”

May 27, 2009

Buffett Aide Sokol Says Housing, Economy Aren’t Near Recovery

May 28 (Bloomberg) -- The U.S. housing market is nowhere near recovery and signs of stabilization are premature, said David Sokol, a top aide to billionaire investor Warren Buffett who oversees the nation’s second-largest real estate brokerage.

Sokol was among money managers who told an investment conference in New York the economy is still deteriorating and they don’t have a lot of confidence in President Barack Obama’s economic policies.

“We’re not seeing the green shoots,” said Sokol, head of MidAmerican Energy Holdings Co., which owns HomeServices of America Inc. “We don’t see improvement.”

MidAmerican is owned by Buffett’s Berkshire Hathaway, and Sokol is considered a possible successor to Buffett as head of Berkshire. Sokol spoke before reports today showed new-home sales posted their second increase in three months during April, and mortgage delinquencies and foreclosures rose to records in the first quarter.

Homes in the process of foreclosure are creating a “shadow backlog” of unsold properties that will continue to hang over the market, Sokol, 52, said in a speech yesterday at the Ira W. Sohn Investment Research Conference in New York.

While official statistics show a 10- to 12-month supply of unsold homes, “we believe the backlog of homes for sale is twice that.”

Balance in 2011

Many people who want or need to sell their homes haven’t put them on the market yet because the outlook for sales has been poor, he said. “It will be mid-2011 before we see the market in balance,” with no more than a six-month backlog, he said.

The National Association of Realtors reported yesterday that the number of previously owned houses on the market in April climbed 8.8 percent to 3.97 million, a 10.2 months’ supply.

Sokol suggested government efforts to ease the crisis are actually drawing out the recovery. “We really need to let the economics work through the system,” he said.

It is still difficult and costly for businesses to borrow, Sokol said, creating “headwinds” for recovery. He predicted the U.S. unemployment rate would rise above 10 percent from April’s 8.9 percent.

Bruce Berkowitz on Bloomberg

Exploding debt threatens America – by John Taylor

Something to think about…..

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.

…

The time for such excuses is over. They paint a picture of a government that is not working, one that creates risks rather than reduces them. Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged and worsened the financial crisis. The problem is that policy is getting worse not better. Top government officials, including the heads of the US Treasury, the Fed, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission are calling for the creation of a powerful systemic risk regulator to reign in systemic risk in the private sector. But their government is now the most serious source of systemic risk.

The good news is that it is not too late. There is time to wake up, to make a mid-course correction, to get back on track. Many blame the rating agencies for not telling us about systemic risks in the private sector that lead to this crisis. Let us not ignore them when they try to tell us about the risks in the government sector that will lead to the next one.

…………………

An inflation-related paragraph from Mr. Buffett’s Annual Letter:

“This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly.”

If You Think Worst Is Over, Take Benjamin Graham's Advice - by Jason Zweig

It is sometimes said that to be an intelligent investor, you must be unemotional. That isn't true; instead, you should be inversely emotional.

Even after recent turbulence, the Dow Jones Industrial Average is up roughly 30% since its low in March. It is natural for you to feel happy or relieved about that. But Benjamin Graham believed, instead, that you should train yourself to feel worried about such events.

At this moment, consulting Mr. Graham's wisdom is especially fitting. Sixty years ago, on May 25, 1949, the founder of financial analysis published his book, "The Intelligent Investor," in whose honor this column is named. And today the market seems to be in just the kind of mood that would have worried Mr. Graham: a jittery optimism, an insecure and almost desperate need to believe that the worst is over.

You can't turn off your feelings, of course. But you can, and should, turn them inside out.

…

Mr. Graham's immersion in literature, mathematics and philosophy, he once remarked, helped him view the markets "from the standpoint of eternity, rather than day-to-day."

Perhaps as a result, he almost invariably read the enthusiasm of others as a yellow caution light, and he took their misery as a sign of hope.

………………..

Related books:

The Intelligent Investor

Security Analysis: Sixth Edition

TED Talk - Dan Ariely: Are we in control of our own decisions?

Related previous post: TED Talk - Dan Ariely: Why we think it's OK to cheat and steal (sometimes)

Related book: Predictably Irrational: The Hidden Forces That Shape Our Decisions (also available in an Audio Book)

Talent: A difference that makes a difference - by Greg Downey

Thank you Miguel for finding this!

Malcolm Gladwell’s thoughts on this topic in his book Outliers are interesting as well. Here’s a quote from Gladwell on talent that may be a useful one to review before reading this article:

“Talent is the desire to practice. Right? It is that you love something so much that you are willing to make an enormous sacrifice and an enormous commitment to that, whatever it is -- task, game, sport, what have you.”

Gladwell also mentions the “Matthew Effect” in his work, which gets at the main point in Downey’s article. The Matthew Effect was a label used by the sociologist Robert Merton that’s based after the New Testament verse that goes, “For unto everyone that hath shall be given, and he shall have abundance. But from him that hath not shall be taken away even that which he hath.” The main point being, in regards to expert performance, that a small initial advantage can snowball into a much larger advantage.

One of the core observation of Ericsson’s research is that expert performance seems to take a minimum of 10 years or 10,000 hours of ‘deliberate practice,’ progressively more challenging, and expert coaching, even with people labelled by others as ‘prodigies’ (see Ericsson, Krampe, and Tesch-Römer 1993). As Ericsson, Prietula and Cokely (2007) describe, repetition is not enough:

When most people practice, they focus on the things they already know how to do. Deliberate practice is different. It entails considerable, specific, and sustained efforts to do something you can’t do well—or even at all. Research across domains shows that it is only by working at what you can’t do that you turn into the expert you want to become.

The problem for many people is that they’re not practicing deliberately; if they did, they would see a bigger improvement in their performance.

…

To put it simply, talent identification can become a self-fulfilling prophecy, pernicious because it widens the gap between those who are ‘promising’ from those who do not show early signs of ‘talent,’ even if those alleged markers of talent do not actually feed directly into the final expert result. That is, talent identification may focus on variables that are irrelevant for future accomplishment and yet still produce both enormous disparity and achievement in those labelled ‘talented,’ although the labelling is empirically incorrect (outside of the socio-cultural coaching system itself).

What may be a small initial difference, even a neurological advantage, can be compounded and exacerbated in many cases by the culturally-based perception that the small initial difference represents ‘talent,’ some innate superiority waiting to reach fruition. Once a person is identified as ‘talented,’ the socio-cultural mechanisms around sport that embrace and seek to develop that talent, to varying degrees fix that early diagnosis by transforming it into a distinctive developmental niche.

…

Clearly, there are initial differences in ability, some of which may be due to innate advantages in some individuals. But I suspect that a cultural system designed to identify ‘talent’ early and concentrate coaching resources on those with early promise can actually make the expert skill more rare as it demotivates those who might develop expert skill without the early advantage or mature more slowly. Rigorous talent identification may produce a handful of highly skilled individuals, but it may concentrate training resources so much that it makes the overall skill more rare than in a more open developmental program.

Conclusion

In summary, although I agree with Ericsson that expert performance clearly requires extraordinary efforts at development, strong coaching, and intense motivation, I don’t want to underestimate the importance in this process of very early differences in ability. Far from being irrelevant, early differences may contribute to future expertise, as they are compounded, exaggerated, or even leveraged into entirely unrelated abilities. If resources are allocated depending upon early diagnosis of ‘talent,’ then talent matters. The more a society believes in ‘talent,’ the more likely it is to become a reality, and the greater disparity we are likely to find between those designated as promising from those who don’t show early promise.

………………..

Related previous post: What it takes to be great

Related books:

Talent Is Overrated: What Really Separates World-Class Performers from Everybody Else

The Talent Code: Greatness Isn't Born. It's Grown. Here's How.

Outliers: The Story of Success

The Road To Excellence: the Acquisition of Expert Performance in the Arts and Sciences, Sports, and Games

David Winters in OID

David Winters in the March 2009 edition of Outstanding Investor Digest:

Winters: So if you see a debt obligation that you might make 50% in as an arbitrage to reorganization, for example, and you look at a stock that you might make 1,000% in over time if you get lucky, I’d rather own the 10-bagger. And I think that’s the problem — that one’s really an arbitrage to reorganization, and the other one is ownership of a business that might pay off huge.

If you look at what happened in ’73-’74, you could have invested in a retailer called W.T. Grant, or even in the railroad reorganizations, and you’d have made good money. But if you’d purchased the equities of the best companies, you’d have become really rich.

…

Attendee: Some believe that a lot of money will be printed up and distributed wholesale throughout the world by the U.S., and that it may decrease the value of the dollar significantly. What are your thoughts about the possible devaluation of the dollar?

Winters: I think it’s part of the reason why you want to invest globally, and why you want to invest in companies that can raise their prices over time.

Very few people are talking about inflation right now. We’ve seen a big deflation. Every asset you can think of besides cash has gone down in value. Oil’s down by about two thirds since June. Housing prices are down. However, ultimately, printing all this money has to either result in an inflationary effect or a devaluation of the U.S. dollar.

That’s why we love countries like Switzerland — because the Swiss franc has actually appreciated over time. It’s a well run little country of 7.8 million people — and they have some of the best companies in the world.

            I mentioned Nestlé. But we also like Schindler — the elevator and escalator company. Roughly 50% to 70% of its business is maintenance and upgrades — with the balance consisting of selling new elevators.

Well, the world becomes more urban over time. And you have to maintain your elevators and escalators in order to have a safe building. Even if the service contract looks expensive, you pay the price. Can a building owner really say, “Tough — I’m not going to have safe elevators in my building?”

As an investor, you always have to think about what’s not happening. At the top of the market, nobody thinks about the market going down. Right now, you can’t find an optimist. And you can’t find anybody who thinks about the decline of the purchasing power of the dollar. Clearly, clothes are cheaper. Wal-Mart may lower their prices. And cars may be cheaper.

But for a lot of other things, the prices just go up. The prices of professional services go up. Plumbers aren’t lowering their prices. So you’ve got to think about it, diversify, and be in businesses that can capitalize on that over time.

....................

Links to others in that same issue:

Seth Klarman in OID

Fairholme's Bruce Berkowitz and Charlie Fernandez in OID

Latest Remarks from John Bogle

Some of the latest remarks from John Bogle:

If You Can Trust Yourself...

The Culture That Gave Rise To The Current Financial Crisis

The End of "Soft Dollars"?

A Crisis of Ethic Proportions

For more, visit The Bogle eBlog.

Book: Enough: True Measures of Money, Business, and Life (also available in an Audio Book)

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Seth Klarman Interview at the TEF Endowment Management Seminar in July 2008

An excerpt that I found very interesting:

…one of the things that’s vastly different from being an analyst to running your own fund — and I can’t emphasize this enough — is that they comprise incredibly different skills. The inability to think about risk the right way may not matter at all for an analyst. We’re not asking for their judgment on risk, we’re asking for analysis and facts, and then secondarily, their opinion. It’s the portfolio manager who eventually needs to be able to identify risk, whether it’s an excessive concentration, a failure to diversify, a failure to hedge, or a failure to understand the risk that is sitting right on your shoulders and you don’t realize it. Failure to recognize those things can kill people. I think we’ve had a few analysts that have disappointed, but no real disasters. But I have observed people that have had shockingly bad judgment in running a portfolio at other firms, and I think those almost could never have been identified a priori. The hard thing to swallow is the realization that your very smart analyst is not able to think well about the bigger task.

………………..

Related post from last week: Seth Klarman Letters: 1995 - mid 2001

Hussman Weekly Market Comment: The Destructive Implications of the Bailout - Understanding Equilibrium

One of the features that has enabled the bureaucratic abuse of the public during the past year has been the frantic, if temporary, flight-to-safety by investors. The Treasury has issued an enormous volume of debt into the frightened hands of investors seeking default-free securities. This has allowed the Treasury to finance a massive and largely needless transfer of wealth to bank bondholders so easily over the short-term that the longer-term cost has been almost completely obscured. But by transferring wealth from those who did not finance reckless loans to those who did – providing monetary compensation without economic production – the bureaucrats at the Treasury and Federal Reserve have crowded out more than a trillion dollars of gross investment that would have otherwise have been made by responsible people in the coming years, shifted assets to the control of those who have proven themselves to be irresponsible destroyers of capital, and have planted the seeds of inflation that will cut short any emerging recovery.

…

The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.

…

The second fact is that as a result of more than a trillion dollars of new issuance of Treasury securities with relatively short durations, it is a tautology that there is a mountain of what is mistakenly viewed as “cash on the sidelines” invested in these securities. This mountain of “sideline cash” exists and must continue to exist as long as these additional government securities remain outstanding. It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered. The analysts and financial news reporters who observe this enormous swamp of short-term money market securities, and talk about “cash on the sidelines” as if it is spendable in aggregate immediately reveal themselves to be unaware of the concept of equilibrium and of the nature of secondary markets (where there must be a buyer for every security sold, and a seller for every security bought).

…

At present, it is not valid to say that the economy is weak because people are saving too much, because if gross savings were up, gross investment would also be up. One might say that the economy is weak because people are unsuccessfully attempting to save more, but it is far more accurate to say that the economy is weak because gross investment is collapsing despite a greater willingness of individuals to save. If we don't get those distinctions right, we'll end up with policies aimed at discouraging savings, which by their very nature will end up discouraging investment and will make the economy suffer interminably. Growth-oriented policies encourage new investment, and require an economy with the capacity to save in order to finance that investment. As long as we have a set of economic policies aimed at running massive government deficits at the same time individuals are encouraged not to save, we will risk driving this economy into the ground for a very, very long time.

Videos: Buffett, Munger, and Gates together

These were brought to my attention via the Reflections blog, which has posted a few other things of interest recently.

HOW DAVID BEATS GOLIATH - by Malcolm Gladwell

When Vivek Ranadivé decided to coach his daughter Anjali’s basketball team, he settled on two principles. The first was that he would never raise his voice. This was National Junior Basketball—the Little League of basketball. The team was made up mostly of twelve-year-olds, and twelve-year-olds, he knew from experience, did not respond well to shouting. He would conduct business on the basketball court, he decided, the same way he conducted business at his software firm. He would speak calmly and softly, and convince the girls of the wisdom of his approach with appeals to reason and common sense.

The second principle was more important. Ranadivé was puzzled by the way Americans played basketball. He is from Mumbai. He grew up with cricket and soccer. He would never forget the first time he saw a basketball game. He thought it was mindless. Team A would score and then immediately retreat to its own end of the court. Team B would inbound the ball and dribble it into Team A’s end, where Team A was patiently waiting. Then the process would reverse itself. A basketball court was ninety-four feet long. But most of the time a team defended only about twenty-four feet of that, conceding the other seventy feet. Occasionally, teams would play a full-court press—that is, they would contest their opponent’s attempt to advance the ball up the court. But they would do it for only a few minutes at a time. It was as if there were a kind of conspiracy in the basketball world about the way the game ought to be played, and Ranadivé thought that that conspiracy had the effect of widening the gap between good teams and weak teams. Good teams, after all, had players who were tall and could dribble and shoot well; they could crisply execute their carefully prepared plays in their opponent’s end. Why, then, did weak teams play in a way that made it easy for good teams to do the very things that made them so good?

Ranadivé looked at his girls. Morgan and Julia were serious basketball players. But Nicky, Angela, Dani, Holly, Annika, and his own daughter, Anjali, had never played the game before. They weren’t all that tall. They couldn’t shoot. They weren’t particularly adept at dribbling. They were not the sort who played pickup games at the playground every evening. Most of them were, as Ranadivé says, “little blond girls” from Menlo Park and Redwood City, the heart of Silicon Valley. These were the daughters of computer programmers and people with graduate degrees. They worked on science projects, and read books, and went on ski vacations with their parents, and dreamed about growing up to be marine biologists. Ranadivé knew that if they played the conventional way—if they let their opponents dribble the ball up the court without opposition—they would almost certainly lose to the girls for whom basketball was a passion. Ranadivé came to America as a seventeen-year-old, with fifty dollars in his pocket. He was not one to accept losing easily. His second principle, then, was that his team would play a real full-court press, every game, all the time. The team ended up at the national championships. “It was really random,” Anjali Ranadivé said. “I mean, my father had never played basketball before.”

David’s victory over Goliath, in the Biblical account, is held to be an anomaly. It was not. Davids win all the time. The political scientist Ivan Arreguín-Toft recently looked at every war fought in the past two hundred years between strong and weak combatants. The Goliaths, he found, won in 71.5 per cent of the cases. That is a remarkable fact. Arreguín-Toft was analyzing conflicts in which one side was at least ten times as powerful—in terms of armed might and population—as its opponent, and even in those lopsided contests the underdog won almost a third of the time.

In the Biblical story of David and Goliath, David initially put on a coat of mail and a brass helmet and girded himself with a sword: he prepared to wage a conventional battle of swords against Goliath. But then he stopped. “I cannot walk in these, for I am unused to it,” he said (in Robert Alter’s translation), and picked up those five smooth stones. What happened, Arreguín-Toft wondered, when the underdogs likewise acknowledged their weakness and chose an unconventional strategy? He went back and re-analyzed his data. In those cases, David’s winning percentage went from 28.5 to 63.6. When underdogs choose not to play by Goliath’s rules, they win, Arreguín-Toft concluded, “even when everything we think we know about power says they shouldn’t.”

…

David can beat Goliath by substituting effort for ability—and substituting effort for ability turns out to be a winning formula for underdogs in all walks of life, including little blond-haired girls on the basketball court.

…

It makes no sense, unless you think back to that Kentucky-L.S.U. game and to Lawrence’s long march across the desert to Aqaba. It is easier to dress soldiers in bright uniforms and have them march to the sound of a fife-and-drum corps than it is to have them ride six hundred miles through the desert on the back of a camel. It is easier to retreat and compose yourself after every score than swarm about, arms flailing. We tell ourselves that skill is the precious resource and effort is the commodity. It’s the other way around. Effort can trump ability—legs, in Saxe’s formulation, can overpower arms—because relentless effort is in fact something rarer than the ability to engage in some finely tuned act of motor coördination.

“I have so many coaches come in every year to learn the press,” Pitino said. Louisville was the Mecca for all those Davids trying to learn how to beat Goliaths. “Then they e-mail me. They tell me they can’t do it. They don’t know if they have the bench. They don’t know if the players can last.” Pitino shook his head. “We practice every day for two hours straight,” he went on. “The players are moving almost ninety-eight per cent of the practice. We spend very little time talking. When we make our corrections”—that is, when Pitino and his coaches stop play to give instruction—“they are seven-second corrections, so that our heart rate never rests. We are always working.” Seven seconds! The coaches who came to Louisville sat in the stands and watched that ceaseless activity and despaired. The prospect of playing by David’s rules was too daunting. They would rather lose.

The Clear Choice

The following write-up is from my colleague, Matt Miller, on one of our favorite investment ideas right now (also available in PDF format: HERE).

The Clear Choice

By Matthew Miller

One of the particular areas of the market that offers opportunity for enterprising stewards of small amounts of capital is the small and micro-cap arena. Although potentially rewarding, such activity requires a high degree of discrimination when it comes to one’s choices in allocating capital. It is particularly important to understand fairly precisely the earnings power of such companies, as in many cases stated earnings may be unpleasantly fleeting.

Keeping in mind that we are looking for obscure, small and micro-caps that offer sustainable earnings power, the potential for large a reward, and limited possibility of permanent capital loss, we point your attention to Clear Choice Health Plans (Ticker: CCHN.OB). Stated simply, the Clear Choice thesis is that an investment in its common stock at recent prices amounts to acquiring, for next to nothing (after consideration of excess capital), a health insurance business whose operating earnings power is approximately $14 million. Such an investment would be made at less than half of liquidation value.

Clear Choice, a Bulletin Board company which is not registered with the SEC (the company came public via an intrastate stock offering), is headquartered in Bend, Oregon and provides health insurance and services for mostly rural individuals and businesses. Clear Choice offers Medicare, Medicade and commercial plans, as well as third party administration (TPA) services. Their business, in terms of membership months, over the last three years is presented below:

	2006	2007	2008
Medicare	128,549	135,568	135,980
% of Total	27.11%	25.45%	24.92%
Growth		5.46%	0.30%
Medicaid	229,841	233,032	256,377
% of Total	48.47%	43.75%	46.98%
Growth		1.39%	10.02%
Commercial	65,488	113,484	127,535
% of Total	13.81%	21.31%	23.37%
Growth		73.29%	12.38%
TPA	50,338	50,542	25,793
% of Total	10.61%	9.49%	4.73%
Growth		0.41%	-48.97%
	------------	------------	------------
Total	474,216	532,626	545,685
Growth		12.32%	2.45%

A very substantial portion of the Company’s business is done in eastern Oregon, specifically the area that falls east of the Cascade Mountains. Though holding licenses for the states of Oregon, Washington, Idaho, and Montana, the company only recently (2008) moved into its first non-native state, Montana. A recent acquisition, which will be discussed later, expands the company’s TPA business into several additional states.

Believing that many of the best competitive advantages are local competitive advantages, we are particularly intrigued by Clear Choice. The company’s share of Medicare Advantage and Medicaid in its services territories is approximately 97% and 80% respectively. What is more, there is a significant likelihood that Clear Choice will become the sole provider of Medicaid in eastern Oregon at some point in the near future. Potential state initiatives calling for a single provider of Medicaid in a particular service territory is being contemplated. Clear Choice would seem to be the natural sole provider given its local market share and ownership profile. Nearly 23% of the company’s shares are owned by CONET, a consortium of hospitals in Oregon which is the largest in the state. Additionally, the company was formed by a number of physicians in the state which remain a large shareholder contingency.

Though typically not attracted to health insurers, especially at a point in US history where the future business model may not look precisely like the historical business model, the valuation of Clear Choice allows one to be relatively indifferent about the future direction of health care in the United States. Below is a brief overview of the company’s valuation:

Price / Share		$8.65
Shares Outstanding		1,701,048
Market Capitalization		$14,714,065
BV of Shareholders Equity			$49,278,945
Price / BV			0.299
LTM Net Earnings			$3,264,000
Price / LTM Earnings			4.508

Though intriguing, the picture presented above does little to impart on one the true earnings power of Clear Choice. Over the last several years, as management has grown the business, it became quite apparent that a new claims paying system was necessary. The cost of developing its own system being prohibitive, the company looked to an independent provider. After several months of work by the provider, it became obvious in 2006 that the provider would not be able to deliver the system the company was looking for. It wrote off nearly $2.4 million that year to reflect the disappointment. Since then, the company found a new provider and by the end of 2008 was substantially finished with the implementation of a new claims paying system. Unfortunately for the income statement, approximately $3.6 million was run through it in additional expenses related to this implementation in 2008. The new system has allowed the company to trim its fixed investment (including people) in this area which should provide significant savings going forward. This thesis has started to prove itself by virtue of the Q4 administrative expense ratio improvement.

Two additional items have obscured the company’s earning power over the last 24 months: a temporary rise in medial claims expenses and the construction of a new corporate headquarters building. In 2007 and early 2008, the company began to experience increased medical utilization and a compression in its medical loss ratio. By the end of 2008 the medical loss ratio has declined to a level commensurate with a steady-state, as rate increases have begun to work their way through the company’s business. Also in 2008, Clear Choice completed the construction of a new corporate headquarters building on company owned land. In 2001, the company acquired the property and towards the end of the company’s most recent office lease made the decision to build on its land. It completed a nearly $14 million build in mid-2008. The company occupies about half of the building and is currently seeking a tenant to lease the remainder of the space. Shown below are the company’s key ratios which show the impact of the investment in the new claims-paying system, the brief rise in the medical loss ratio and the construction and later move-in of the company’s new home office.

		2004	2005	2006	2007	2008
Medical Loss Ratio		80.24%	81.67%	86.60%	91.20%	87.00%
Administrative Expense Ratio		8.03%	7.44%	8.30%	11.00%	10.60%

We expect the business of Clear Choice to produce an 86% medical loss ratio and a 7.5% administrative expense ratio over time (if the future of health insurance is similar to what it is today). Given those parameters and the 2008 scope of business, we adjust the valuation to the following:

LTM Adj Operating Income			$14,071,000
Price / LTM Adj Operating Earnings			1.046

This exhibit would give the company very little credit for the earnings potential of its significant investment portfolio. Below is the summary of the portfolio at the end of 2008.

View PDF for table [too large to paste on site]

Based on company indications and state regulatory filings, we believe that the company’s allocation to common stocks (which is unusual for a health insurer) represents excess capital not needed for the current scope of the company’s business. This figure of $14 million at cost, approximates the entire current market cap of the company, hence our assertion that you are nearly getting the current business for free.

At an approximate industry average and median of about 5.5 times operating income, the valuation seems to be quite off, as illustrated below:

LTM Adj Operating Income			$14,071,000
Price / LTM Adj Operating Earnings			5.500
			-----------------
Implied Value of Op Earnings			$77,390,500
Plus: Non-Operating Capital			$11,800,000
			-----------------
Total Company Value			$89,190,500
Value / Share			$52.43

What is most attractive is that the company currently trades at a 70% discount to book value in addition to the earnings power discrepancy. We believe that book value is fairly indicative approximation for liquidation value, given its component parts. A substantial portion of book value is freely-traded investments (stated at market value on the balance sheet), receivables, and real estate. Though one could argue about the exact price of the company’s new headquarters, given the current real estate market and high relative unemployment in Oregon, we believe its book value is at least its salable value. What gives us such confidence is that the company’s six acres of land was purchased for $4.50 per square foot in 2001 and that same land was appraised at the completion of the building at $18 per square foot. This would imply an approximate $3 million not recognized on the balance sheet.

Three additional points are worth a mention. At the end of December, Clear Choice acquired a small TPA business, Trusteed Plans Service Corporation, which covers approximately 55,000 lives in Alaska, Washington, Idaho, Montana, Oregon and Nevada. This new business, which substantially adds to TPA covered lives, also expands the state presence of the company into several adjoining states. This may assist the company in moving forward with its expansion of underwritten products in those new territories. Though financials, including the acquisition, have not been disclosed, we believe this complementary acquisition will prove to be of long-term strategic importance.

Additionally, the company is currently battling a hostile takeover. A smaller, private company in Oregon, Agate Resources, is attempting to buy Clear Choice at a 15% premium to the 120 day moving average, which at the time of the offer was $12.62. The stock is now at a 31% discount to what we and management believe was a grossly inadequate offer. We highly encourage those interested to review the “Shareholder Communications” on the company’s website in response to the offer.

And finally, the company is currently rewarding shareholders with a substantial buyback. During 2008, Clear Choice spent over $1.9 million repurchasing shares at very attractive prices below book value. The total authorization of $5 million means approximately $3.1 million can still be repurchased. This would represent a further reduction of approximately 21% in the shares outstanding.

In short, we believe Clear Choice Health Plans to be a “clear choice” for those seeking to allocate capital to a micro cap with little downside and substantial upside. There appears to be such a discrepancy in the company’s earnings power and liquidating values that it is worth moving into a health care company despite uncertain future legislation. If the future of health insurance in the US is even remotely similar to that which exists today, Clear Choice has the durable earnings power needed for investments in small and micro-caps to be successful. If the future looks nothing like the past, the liquidation value would seem to protect our downside. We believe the risk/reward at $8.65 is heavily skewed to the buyer of its shares.

*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision. The author and poster of this article both have an indirect interest in the stock of Clear Choice Health Plans (CCHN.OB).