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Circle of Competence Issue #34

Quote of the week: "The stock market is filled with individuals who know the price of everything, but the value of nothing." - Phil Fisher


Update on Dell tracking stock merger (DVMT)

Back in issue 19, I discussed how I believed (along with several other investors, which I linked to in my discussion in the bottom of issue 19) that Dell was getting the tracking stock of VMWare for a steal (essentially at an almost 40% discount to its pure mathematical intrinsic value).Well, as in most activist merger situations, it takes time for the activists to gather their thoughts, resources, and make a move.

This week, none other than our favorite activism king, Carl Icahn, wrote a scathing letter that lays out very simply the case that Andrew Walker from Rangeley Capital laid out in this post earlier in July. It seems that Icahn is not shying away from an all out litigious battle with Dell for what may be breach of fiduciary duty by 'independent directors' and is willing to take Dell to task in order to sweeten the deal for minority DVMT shareholders. Here are some of the quotes that I liked most:

On the opportunity:

"After researching the current situation, I quickly realized that while we have unearthed many undervalued opportunities in the past, very few companies compare to the current opportunity and the massive undervaluation of DVMT — which exists in plain sight for all to see."

On DVMT's intrinsic value:

"The Dell Tracker currently sells for approximately $92 per share but is worth on a pure mathematical basis approximately $144 per share"

On who benefits from the current deal structure:

"Make no mistake, if the current “opportunistic” deal succeeds, 100% of the discount, approximately $11 billion, will be an economic windfall mostly attributable to Michael Dell and his Silver Lake partners."

On who is at fault:

"Otherwise, it is unquestionable, in my opinion, that the independent directors breached their fiduciary duties to the DVMT stockholders. How else can one explain an agreement that so obviously transfers $11 billion in value to the controlling stockholders at the expense of the minority stockholders?"

On the potential future value of VMWare:

"We believe this could result in over $12 per share of free-cash flow generation in a few years, and a stock price of potentially over $250 per share. Clearly Michael Dell and Silver Lake take us for fools if they think that we would exchange this future value potential for only $94 per share."

So what?

DVMT's stock price seemed unmoved by Icahn's letter, but it seems that the small minority shareholders have found their potential saviors in Icahn to play hardball on their behalf. I look forward to watching the story as it unfolds, but at the end of the day, I side with the minority shareholders of DVMT (and by extension, in this particular situation, with Icahn).

Sears Bankruptcy

Monday, Sears finally filed for Chapter 11 Bankruptcy and will continue to operate out of bankruptcy protection through the holidays. Eddie Lampert, the former CEO and head of ESL investments (his personal hedge fund), stepped down from his post and will continue to help work the company through the bankruptcy proceedings. He gave employees a passionate speech asking them to double down during the holiday season to prove that they deserve to reorganize as a company and not be liquidated.

What can investors learn from the long, slow, painful demise of one of the greatest retailers of old? Well, here are two general lessons I have been thinking about this week.

Customer Experience

I listened to a wonderful podcast by Barry Ritholtz on Masters in Business by Bloomberg this week, where he interviewed Barbara Kahn from Wharton's school of business about the retail revolution. In this episode, Professor Kahn explains that retailers typically have two ways to compete: either they can increase the pleasure of customer experience, or they can decrease the pain of the customer experience. In many ways, Sears was doing neither as they let stores fall into disrepair and were unable to reinvest in store capex due to declining sales and high debt burdens. Meanwhile, Walmart began offering their low price guarantee, decreasing the pain of high department store prices. Then along came Amazon, which introduced not only further pricing pressure but the convenience of shopping from home - simultaneously decreasing the pain and increasing the pleasure. Buffett predicted back in 2005 that other companies would take advantage of high department store's (like Sears) gross margins and create a better customer experience with lower prices through scale. And yet, sometimes value traps still catch the best investors sleeping.

Human Costs

Speaking of value traps, as a value investor, it is easy to look at a public company's balance sheet and price/book ratios and get excited about an opportunity to turn a business around or liquidate it for a profit. What isn't easy, however, is dealing with the human collateral of turning an operation the size of Sears and Kmart around and navigating through the enormous amount of stakeholders' interests in a business of this size. John Hempton of Bronte capital this week revisited his 2011 short thesis of Sears and shared his opinion rather bluntly:

"My view: owning Sears as a property play is a demonstration of the arrogance and breathtaking naivete of much that passes on Wall Street. Sears Holdings has over 300 thousand employees. I don't know how you successfully liquidate a business integrated with that many lives. I don't know of anyone who has ever successfully liquidated a business with that many employees.** I am not sure it can be done and it certainly can't be done by someone with my skill-set (highly analytical, ability to spy value or value traps but no people management skills and not much tact)."

When you have a hedge fund billionaire stripping a company of its assets and laying off workers to keep a 125+ year old company afloat, the headlines don't treat you well. Workers don't want to go without a fight. Pension obligations must be honored. And the list continues. Already we've seen several private equity firms come under fire for attempting not to honor payment plans to employees of bankrupt companies recently - and some of their limited partners were NOT happy. Essentially, companies are so much more than book values and ratios on paper. They are living, breathing organisms that make noise when they are dismantled and dismembered.

To wrap it up, I'd like to go back to Buffett's experiences with consumer retail and declining businesses - Berkshire Hathaway (the original textile mill) and Hochschild Kohn. He was 0/2 on both of these investments, but was able to salvage cash from the bleeding Berkshire to roll into other investments. His investment in Hochschild Kohn was breakeven at best. He learned these two valuable lessons early in his career:

1. Buying a declining business at cheap multiples may actually be buying an overpriced business (a classic value trap).

2. Buying a declining business that will eventually go away carries with it the risk of significant human collateral (Berkshire Hathaway's mill eventually had to close because it was destined to lose money forever, though it was painful because it employed a large percentage of people in its town).


- Hedge fund billionaire rode the worst trade of his life to the bottom (Bloomberg)

- Euclidean Technologies' Q3 investor letter discusses their machine learning research on equity investing

- Tren Griffin on lessons from pro poker player Annie Duke, author of 'Thinking in Bets'

- When business executives become reluctant statesmen (NYT)

- US government deficit grew 17% in fiscal year 2018 (WSJ)

- Thousands of southerners planted trees for retirement but it hasn't worked (WSJ)


- Investor's Podcast interview with Howard Marks

- Capital Allocator's podcast Ted Seides with Michael Schwimer of Big League Advance

- Invest like the best - Patrick O'Shaughnessy interviews Ali Hamed, Brian Harwitt, and Marc Porzecanski on their innovative lending business

- Brent Beshore on building a mini Berkshire Hathaway with Digital Exits


- Jeff Bezos wants us to leave Earth for good (Wired)

- MoviePass is under investigation for securities fraud (TechCrunch)

- Amazon patents Alexa technology that reads voice patterns to alert you to sickness, depression, and sell you medication (Ars Technica)


- Esports company Cloud9 raises $50M (Forbes)

- Kepler Communications raises funds to expand satellite communication offering

- Devoted Health raises $300M megaround from Andreessen Horowitz to expand its Medicare Advantage plan coverage in Florida on its tech platform (TechCrunch)

- Instacart raises another $600M to deliver groceries to every house in America (TechCrunch)

- Amazon funds Closed Loop Fund with $10M to help make recycling easier in American cities (TechCrunch)

- Icon raises money to help it lead the 3D construction movement (TechCrunch)

- SpaceX competitor Vector raises $70M to help build more rockets (VentureBeat)

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