Assessing the impact of the American Jobs Act on the Municipal Bond Market is less than a straightforward proposition. Almost as soon as it was unveiled, a debate broke out. At issue was a proposal contained in the bill to limit income tax breaks for individuals earning over $200,000 (or $250,000 for families) as a mechanism for funding the bill – at least partially.

Some people felt that the bill’s intent was at odds with this funding mechanism for two primary reasons:

• • Muncipal bonds are the primary means of financing infrastructure projects in this country.
• • Municipal bond interest is tax exempt in many cases.

Other participants in the debate felt that the impact would likely be minimal, and that the municipal bond market would shrug off the impact. A closer examination of the facts and circumstances shows that, while both sides have valid points, a definitive answer remains elusive.

The Obama Administration’s proposal would seek to limit the tax deductibility from its current maximum 35% tax rate, to just 28%.  Individual investors in the top 35% tax bracket could continue to deduct interest. However, after the first $200,000 of income, they would only be able to deduct interest at the 28% tax rate.

Clearly, the instrument is likely to be less attractive for at least some percentage of the tax-free investor population. What is less clear is whether this population is large enough to have a significant impact.

Municipal bonds for infrastructure have traditionally been issued at longer maturities, i.e. 10+ years.  The traditional buyers for these issues were sophisticated investors playing a trade known as municipal bond arbitrage, which relied on historical correlations between different bond market instruments. These correlations broke down during the financial crisis in 2008. As a result, many of these investors were left high and dry, and the municipal bond arbitrage trade is no longer widely practiced.

As a result, demand at the long end of the curve effectively dried up as the municipal bond yield curve steepened in response to the decline of its natural market. (See Figure 1 below.) This was unfortunate for the municipal bond market.

As part of the administration’s response to the crisis, the Build America Bond (BAB) program was established. By subsidizing 35% of the interest payments of qualified municipal issues, the program made municipal bonds attractive to the much larger taxable investor base. In the first 16 months of the BAB program, states issued over $105 billion in BABs, or approximately 25 percent of the municipal new issue market. In fact, studies conducted on the program found that, over time, local and state governments were able to obtain financing 54 basis points cheaper than issuing in the regular municipal bond market, making it an unqualified success story from the administration’s point of view. (See Figure 2 below.)

For many investors, the decline of the municipal bond arbitrage trade notwithstanding, the next best alternative to a municipal bond enjoying tax exempt status at the 35% tax rate may well be the same bond enjoying tax exempt status at a 28% tax rate. With the Treasury yield remaining microscopic, and corporate bonds viewed as a much riskier alternative, some folks may just decide to stay put.  (See Figure 3 below.)

Individual investors continue to make up a sizable percentage of the market for longer-dated municipal bonds. The loss of this segment in its entirety would certainly have an adverse impact on the market for longer-dated municipal bonds.  However, given the success of the BAB program, and the lack of obvious alternatives to long-dated municipal bonds, common sense would argue for a modest decrease in demand from individual investors. Other bond market participants could absorb it, with the assistance of the BAB or some similar program. draft

Another open question is whether the proposed legislation could unintentionally force municipal yields higher, thereby having the ironic consequence of retarding infrastructure development. Eliminating or reducing the tax exempt status of municipal bonds would force yields higher, making many projects too expensive for local governments to pursue.

In a normal environment, an extra 10, 20, or even 30 bps may not have been enough to kill a project. At time when local government budgets are stressed, however, the extra cost may just be enough to cause the deferral of infrastructure projects.

There’s an additional point to consider: any market gets priced at the margin. In the municipal bond market, individual investors are the margin. If, for some reason, demand for municipal bonds were to decline as investors suddenly opted for an alternative asset class, yields could rise precipitously as bond prices dropped.

Conversely, it is a well-known aberration of the bond market that long-dated municipals yield significantly more than their corporate counterparts on an after-tax yield basis. As a result, municipal yields would likely not need to increase to compensate for the full amount of the lost exemption, making the increase more palatable than otherwise.

Finally, the government still has a hand to be played in all this. If the government opted for indirect participation through an extension of the BAB program, net effective yields for municipal issues could be even lower than expected.

Predictably, opinions are mixed on the subject. While, for example, a Morgan Stanley Research report predicts little impact, a Citigroup study argues that borrowing costs would rise “significantly” for municipal issuers. For the time being, according to Bloomberg, municipal bond yields have held fairly steady and figure to remain so under current market conditions. For now, that’s the best assessment anyone can make of the situation.

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Last week, I made a case for an imperfect company with strong cash flow and business prospects. This week, I want to delve further into the valuation of that company to get a better sense of our margin of safety at current price levels.

Comparables

At its current price around $56, Autoliv (ALV) presents a compelling value compared to its peers.  As you can see from the table below, similar companies garner higher multiples for lower return on equity or assets. On almost any multiple of price, the company’s valuation is depressed — no doubt as a result of the market’s anticipation of a significant fine.

I went back and looked at historical PEs over the prior 10-year period, and found that the stock has traded in the 12 to 15 times earnings range, which would put it dead smack in the middle of this crowd.

Earnings Power Value (EPV) Basis

My Earnings Power Value (EPV) analysis yielded a value of between $60 and $163 a share. EPV looks for a “normalized” earnings level, and discounts it by the company’s weighted average cost of capital (WACC). Since WACC calculations are a messy and inaccurate affair, I used a range of discount factors to perform the analysis. Even at a very conservative 13% WACC, the analysis yielded a value of over $60.

Discounted Cash Flow (DCF) Basis

My DCF analysis yielded a value of between $44 and $109 a share. The $44 valuation assumed that business would actually shrink by -4% annually for the next 20 years.  The high end of the valuation assumes growth of 4%, which I believe is a conservative figure.

The goal of these valuations was not to pinpoint an exact figure but, rather, to come up with a range of values for the business if it didn’t have the price-fixing investigation hanging over it.  That way, I could back out the value that the market is assigning to the penalty.

At a current PE of just over 8, the market is pricing in a penalty equivalent to roughly 40% of its prior market value, or roughly $3.4 billion.

What the authorities will end up assessing as a fine is anyone’s guess. JP Morgan thinks a reasonable worst-case scenario would be in the area of $800 million, assuming assessments on both sides of the Atlantic. Just to be ultra conservative, let’s say that the fine is an even $1 billion.

As a straight assessment, it’s difficult to reconcile the fine with the punishment that the stock has taken. In order to damage the company to the extent of its market decline, the terms of the fine would have to (a) be exceedingly onerous, i.e. full payment within one year, or (b) impact the company’s future business prospects. Given the limited number of globally integrated suppliers, and the fact that collusion necessarily involves more than one party, this does not seem likely.

Risks to the thesis

Naturally, there are risks to this thesis. The number one risk in my mind is that the problems of the developed economies spread to their emerging market counterparts.

Another risk is that the fines are far higher than estimated. While possible, common sense argues that this outcome is unlikely, and that ALV represents a calculated risk with an attractive upside.

Disclosure: No Position in ALV

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“Catching falling knives sometimes results in cuts.”
–Whitney Tilson, noted value investor

“The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.”
–Howard Marks, noted value investor

Making a long call in this market calls for a large pair of brass you-know-whats. No sooner have you staked a claim to a long position, than the market turns and makes you look foolish. In short, while the recent swoon has made a generous number of bargains available, they can always get cheaper. That’s why it’s important to build that margin of safety into your calculations.

You also need to be able to keep an eye on the long-term picture so that you don’t get shaken out of a position too early. If the trend is intact, market dips can present buying opportunities.

Autoliv (ALV) is a Swedish company in the business of making safety-related components for light vehicles. In this emerging market, the rising middle class is driving the trend by demanding better and safer cars.

Early in July, ALV got absolutely hammered, crashing 11% intraday on updated news that an ongoing antitrust investigation on both sides of the Atlantic would probably significantly affect operating results and cash flows in the coming quarters. In its last statement on the matter, ALV management had indicated that they did not think the investigation would result in meaningful penalties. Boy, was that a wrong call.

Now, I’m not suggesting that the investigation is not serious. Nor am I suggesting that the penalties are likely to be small. What I am arguing is that, given the lousy macro environment, this market absolutely HATES bad news of any sort, and over-penalizes fundamentally sound companies that have run into a rough, but not unmanageable, patch of road.

Tellingly, in their latest quarterly conference call, management clearly indicated their continued willingness to expend capital in order to ramp up their rapidly growing emerging markets businesses. These are not the actions of a company that believes an existential hit to its capital base is imminent. If it did, the rational move would be to hunker down and preserve cash and capital. The subtext, and the key to this investment, is that while not publicly commenting on the investigation, management continues to believe in the viability of their business model, and the profitability of the opportunities in front of them.

What a potential investor needs to know about the passive safety systems industry, which encompasses such things as seatbelts, airbags, etc., is that the pool of global suppliers is extremely small. Only three companies – TRW Automotive Holdings (TRW), ALV, and Takada Corp. — play in these waters. This makes for a nice wide moat for the lucky few.

Conversely, the global automotive giants that they service are very familiar with their overall price structure because of the nature of the competitive bidding process. In addition, the OEMs dwarf their suppliers by several multiples.

Let’s take a closer look at this business. It is a monster of a cash machine. The ratio of cash flow from operations versus net income has never been under 1.0 over the past 10 years. In addition, earnings before interest, taxes, depreciation, and amortization (EBITDA), operating income, and net income have all been trending up nicely since the 2008 crash.

Revenue has increased from $6.8B at year end (YE) 2007 to $7.8B on a trailing 12-month (TTM) basis. At the same time, return on assets (ROA) has increased from 5.23% YE 2007 to 10.53% TTM, and the stock sports a dividend yield of 3.29%. The company’s debt to equity ratio has been trending down since hitting a high of 66% YE 07 to 20.3% TTM. With the exception of that nasty antitrust overhang, this is a company that is hitting on all cylinders at the moment.

Better yet, its future prospects continue to look good. Although ALV’s developed markets (DM) business is projected to remain net FLAT between 2007 and 2016, their emerging markets (EM) are projected to more than double over the same period. As a result, DM is expected to fall from 62% to 42% of total business.

ALV management sees this trend accelerating as their DM business has languished in the wake of the Great Recession. Consequently, they have concentrated their future investments in their EM business.

Projected investments in capacity are as follows:

Source: ALV documents

These investments are expected to impact the company’s cash flow from operations (CFO) and working capital requirements as these investments play out. This is a sign of a growing business and does not bother me.

It is worth noting that the company has a large amount of intangible assets on their books. In general, a large ratio of intangible assets is not a good sign. Hard assets tend to make it easier to put a floor under a valuation. In this case, however, I’m not that concerned. I’m more comfortable with the situation primarily because of the wide moat that the company enjoys which is, in itself, a measure of safety. Moreover, since the company expanded by purchasing smaller players, it could be said that the goodwill is the price that the company paid to expand its moat.

This is a far cry from a technology company buying a smaller competitor in a market where the technological lifecycle is 18 months, or a situation where the industry is widely fragmented and one small competitor purchases another, smaller competitor. Not all intangible book value is bad.

Next week, I’ll take a closer look at some of the company’s risks, as well as its valuation.

Disclosure: No positions in any companies mentioned in this article.

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In my last post, I discussed the qualitative reasons why I believe that Cover-All Technologies (COVR) deserves your consideration. This week, I want to focus on a valuation of the stock.

First, though, it bears mentioning that 43% of the stock is held by insiders. Specifically, one G. Russell Cleveland, who runs the investment firm RENN Capital Group. Cleveland or entities associated with him control 30% of the company’s stock.

Ordinarily, this might give me pause, because the needs of the majority shareholder may not always coincide with the needs of others. From what I can tell from Cleveland’s behavior, I do not believe this is a major concern. First, he’s not interested in a short-term flip of his investment.  He has been involved with the company since 2001. In the world of professional investing, that’s close to a century! This is patient money we’re looking at.

Second, he publicly espouses an investing philosophy that he terms “CEO investing.”  To make a long story short, in small, illiquid companies, the greatest asset — or liability — is the CEO. Therefore, Mr. Cleveland’s firm looks to make investments in organizations where the CEO has (a) some real skin in the game — stock options don’t count — and (b) a vision of how he wants to grow the business. The man believes so passionately in this approach, he even wrote a book about it!

Lastly, if you compare the period before the man got involved — May 1996 to Jan 2001 — to the period afterwards — Feb 2001 onwards — the difference in the stock’s performance is striking. I don’t believe that this is a coincidence. As a value investor, I think I can get behind this approach.

Now, let’s move on to the valuation.

I will use two different methodologies to arrive at a fair value estimate.  I could have used more but, for our purposes, I think this is sufficient.

Comparables

I include a comparables analysis provided by COVR in one of their analyst presentations, but updated with more recent data. I think it shows COVR in a favorable light.

Personally, I think the broader software categories are not a good match for COVR.  They offer a niche product with a limited, if still undeveloped, market.  Smaller and more focused companies are a better comparison.  I assembled a representative list so I could make the comparison.

Compared to the broader industry, COVR looks relatively cheap. However, in comparison to the specialized grouping, the valuation looks more reasonable, but still attractive.

Graham Formula

In addition, I also used the common Ben Graham formula for intrinsic value, which is normally expressed as:

P = Projected EPS * (8.5 + (2*Growth Rate)) * (4.4/AAA yield)

I used the following inputs:

• 4.5% Corporate Bond Rate

• Growth Rate between 5% and 10%

• Normalized EPS of between .10 and .15 per share

Using these inputs in the formula yielded a per share valuation range between $1.76 and $4.11.  At a recent price of $2.37, this would suggest a 25% downside versus a 73% upside on fair value. That’s a risk/reward ratio of 1:4, which remains attractive.

All valuation techniques are approximations of true value at best. In the universe of probability in which we live, the best you can do is to stack the odds in your favor.

My take on this company is that it has the weight of intangibles on its side: the trend towards more regulation, the presence of Mr. Cleveland, and the investment community’s increasingly desperate search for growth in the face of a slowing economy.

A prospective investor, however, must proceed with his eyes open. A small, illiquid stock is bound to have several stomach-churning moments and, like any smaller business, will be exposed to the influences of the larger economy. But, with some luck and the continued, proven execution skills of this management team, perfectly satisfactory results should be within reach.

Disclosure: I have no position in COVR.

Follow us on Twitter @CompleteGrowth.

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“You gotta dance with who ya brung”
– Golfer Sam Snead opining on the need for flexibility in your game plan

Hey there, sports fans. With the Greek debt crisis and the debt ceiling creating drama in markets all over the world, it hasn’t been a lot of fun out there. It takes guts to make any kind of call in a market like this. And I’m going for it!

Cover All Technologies (COVR) is a microcap (approximately $59 million market cap) holding company. Its main operating subsidiary is Cover-All Systems, Inc., which provides software and services to the property and casualty insurance industry. The software focuses on the entire lifecycle of an insurance policy, from underwriting to quoting to billing. In addition, it offers ongoing support services that comprise the incorporation of recent insurance rates, rules, and forms changes.

This goes to the heart of my title this week. While momentum-driven markets can be tricky for value investors to navigate, they are not impossible. One major trend that we can exploit to our benefit is the slew of legal and regulatory changes aimed at the broad financial industry. From this perspective, COVR looks to be in the right place at the right time with the right product.

Competitive Advantage

The company has a number of competitive advantages that, taken together, add up to a significant moat. The most important of these is the extreme stickiness of their business model. Once a customer signs a license contract, he is on board for a five-year commitment. In addition, the nature of the software’s function requires it to be highly integrated into the client’s overall workflow. As a result, the costs to switch to another company are extremely high, making it very difficult for competitors to encroach.

The flip side of this is that the sales cycle tends to be fairly long and complex, resulting in “lumpy” revenue streams. The company just had a blowout quarter. In March, with its revenue engine clicking on all cylinders, it reported a 38% increase from the prior year’s quarter.

The company’s other advantage is a little subtler. It won’t turn up on any value screens. It required listening all the way through a company presentation, and it concerns the way the software has been designed over time. The company’s technical philosophy has led to what the CEO described as a hub and spoke design, with the software’s major functionality clustered in centrally positioned “hubs.”  This allows modifications and additional functionality to be quickly — and relatively painlessly — bolted on to the hub, thus increasing the rate of innovation and customer service.

Business Model Momentum

Like most other software companies these days, Cover-All has discovered that there’s money to be made in what’s known as Professional Services (PS). The PS team comes in after the sale has been made, and customizes the out-of-the-box software to the client’s specifications. These customizations don’t come cheaply. COVR’s Professional Service revenues are up by 50% from the same quarter a year ago.

Growth Prospects

The company has a decent set of growth prospects. Organically, as discussed above, the current regulatory environment promises to provide a multitude of opportunities over the next few years.

In addition, the company has a clean balance sheet, with almost no debt. Going forward, this allows them the flexibility to make small, accretive bolts on acquisitions when the opportunity arises. In some cases, this can be the more cost effective way of getting a new functionality to market.

International expansion is another option. It’s my sense that, while this is on the company’s radar, it has chosen not to focus on it for now. In a company this small, focus is all-important. I’d rather they marshal their resources towards capturing the immediate opportunities in front of them rather than diffuse their limited resources. At any rate, it doesn’t appear that growth opportunities will hinder their prospects for some time to come.

Management team

John Roblin, age 66, is the Chairman and CEO, and has been with the company since 1999. He has held a number of senior positions at large, public insurance companies, which should give him a very good understanding of what his customer base needs. Manish Shah, age 40, is the company’s President. He has been with the company in a variety of capacities since 2000.

Also worth mentioning is G. Russell Cleveland, a noted small cap investor who has been involved with the firm for the past 10 years. (More on him next week.) During the last decade, these three have overseen an extensive revamp of the company’s technology that culminated with the Amex listing last May. I’m expecting more of the same going forward.

Next week: Valuation

Disclosure: I have no position in CVR.

Follow us on Twitter @CompleteGrowth.com.

The Republic of the Philippines is a small country that’s located in Southeast Asia, but it’s big in resources. These include chiefly gold, copper, nickel, iron, and chromite. Thirty years ago, the country was the number four mineral producer in the world. This makes it an ideal supplier to China and other resource-hungry countries in the region.

With commodity prices rising, and global markets awash in liquidity, it’s understandable that some of that capital would look for a better return than a U.S. Treasury rate. Since only 2% of “high potential” sites in the Philippines are covered by mining contracts, opportunities are present. Curious as to how this set of circumstances might be playing out on the ground, I recently met with senior executives from a major mining concern in the Philippines, as well as the Chamber of Mines.

Indications of a bubble might include the presence of large, new capital projects, the approval of projects that were deemed marginal in the past, and the presence of many new players on the local scene. Curiously, perhaps, this did not seem to be the case.

First, the effects of cheap money are definitely being felt. Funding conditions have never been better, with different offers and proposals being regularly floated. In this case, “funding” refers to both debt and equity, as new projects are typically funded with a mixture of both in a 1:3 ratio. Anecdotally, large, multinational banks tend to be more aggressive in their proposals. This may be unsurprising given their access to cheap dollars.

Funding for new mining projects begins some two to three years before the first production ore is mined.  This is typically the amount of time required between the time the company has sufficiently de-risked the claim to begin site preparation, and the time that actual production can begin. It’s at this point that new funds can actually be put to use. Prior to this, the funds constitute “negative carry,” which requires that interest be paid on unproductive capital.

In the past, low commodity prices and regulatory hurdles resulted in a long period of hibernation, from which the industry only began to recover a few years ago.  With this memory still fresh, the folks I met with were primarily focused on keeping their balance sheets clean.  Given the bullish trend surrounding long-term commodity prices, there doesn’t seem to be a perception that the funding window will close anytime soon.

New international players have appeared on the local scene, such as Xstrata (XTA.UK). Some have partnered with established locals, while others have tried to go it alone. However, other players, such as Anglo American PLC (AAL:UK), have picked up stakes and left.

The turnover does not have the feverish feel of some 21^st century gold rush. New capital is also being raised, some of it on Australian and Canadian exchanges, where there’s a familiarity with higher risk mining “juniors.”

Then there’s the question of the capital equipment involved. Lead times for new equipment take something on the order of 30 months for delivery.  Having been burned in the past by volatile commodity prices, the small coterie of specialized mining equipment companies have steadfastly refused to expand production beyond what they consider to be a sustainable level.  This places a kind of natural “handbrake” on any industry exuberance.

I came away from my inquiries with the impression of an industry that, while bullish, was far from feverish.  While I’m not saying that a bubble could not yet occur, any over-exuberance at this point is tempered by long lead times and longer memories.

Disclosure: No positions in any stocks mentioned.

There has been no shortage of media reporting on the winner-takes-all argument between Bruce Berkowitz and David Einhorn over the value of St. Joe Co. (JOE). Berkowitz recently raised the stakes by taking on an activist role in the company, which has resulted in the ouster of company CEO Britt Greene.

What has been lost in the media frenzy is a very similar situation involving David Winters and Consolidated-Tomoka Land Co. (CTO). Lack of media focus on this developing situation could create a better opportunity for patient, value-minded investors.

David Winters, the activist manager of the Wintergreen Fund (WGRNX), is no less renowned in the investment community than Einhorn or Berkowitz.  For whatever reason, though, he does not get the same level of press coverage. His investing pedigree goes back to Max Heine and Michael Price of the Mutual Series funds prior to their acquisition by Franklin Resources (BEN).

For readers who are unfamiliar with those names, Heine was the legendary founder and Price his longtime lieutenant at Mutual series. Price was one of the first to take an activist bent to the traditional buy-and-hold approach of the value investor. Following the Templeton buyout, Price departed the company, leaving Winters in charge.

Winters had a successful run as the chief signal caller at Mutual Series. He departed in 2005 to start his own shop. In classic nice guy fashion, he formed a mutual fund rather than a hedge fund to allow his friends and family to invest next to him. The Wintergreen Fund’s mandate, however, is extremely broad. This allows Winters to invest in a manner similar to a hedge fund.

Consolidated-Tomoka was one of the fund’s first holdings in March of 2006. Consolidated-Tomoka Land Co. is a small — $188 million market cap and 2010 revenues of $13.4 million — company headquartered in Daytona Beach, FL.  Much like St. Joe, Consolidated-Tomoka owns approximately 12,000 acres of prime Florida land, most of it just outside of Daytona Beach, most of it undeveloped, and most of it carried on their books at 1902 prices.

CTO’s revenues are derived from rental income, golf courses, and agricultural properties. Their stated strategy is a so-called Sec. 1031 exchange involving the transformation of some of its agricultural properties into rental properties, thus increasing its base of income without triggering any tax consequences. The vision for some of the remaining land is to be used for growing hay. You heard that right. Hay.

Daytona Beach is one of the only cities left on Florida’s east coast with thousands of contiguous acres of undeveloped land next to the city’s announced plan for future development. Winters feels that CTO has a unique opportunity to shape a future not only for itself, but also for the entire county of Volusia.

To provide some perspective, 12,000 acres is roughly equivalent to half the area of a city the size of San Francisco. Daytona Beach itself is about 38,000 acres, so the land represents an area about 1/3 of its current size. Such an asset should be worth more than $188 million to its shareholders.

However, with only 12 full-time employees at the end of 2010, CTO runs with a very small crew. They outsource most of their developmental activities. Over the past five years, it likely became clear to Winters that the CTO team did not possess the vision or expertise to carry out such an ambitious long-term goal. In the past, Winters has lobbied with some success to replace board members with personnel with relevant expertise. (The roster read like a roll call of the Old Boys Club of Volusia County.) Earlier this year, he upped the stakes by increasing Wintergreen’s stake in the company to 47%, and openly lobbying for change at the top.

With the departure of CEO McMunn this month at Winters’ urging, the board’s next step will be to hire a CEO capable of realizing a new vision. In the short term, I would expect significant additional expense as he builds out the company’s capability. For example, given the lack of any bench depth, I would expect additional headcounts to grow considerably because, to be properly realized, the company will have to enlist support from many stakeholders on multiple fronts. To his credit, it appears that Winters has already begun this process.

Given the depth of the recession, particularly in Florida, this will not be a quick fix turnaround. Documents from Volusia County’s Office of Economic Development paint a picture of a fragile and slow recovery. Just as in the case of St. Joe, the value of this vision won’t be realized in six or eight months, but likely closer to the next 10 years. Along the way, however, I would expect multiple catalysts that could reward a patient investor.

Disclosure: Long WGRNX

A fascinating case study is playing out this week in the investment world.

Hank Greenberg, the former CEO of American International Group (AIG), was a legend of the insurance industry.  The hand-picked successor of the firm’s founder, Greenberg had a reputation for understanding risk like few other people on the planet. AIG, and Greenberg by extension, was also renowned for prescience in international business and cultures. The firm was operating in China and the rest of Southeast Asia way back in the ‘40s, well before emerging markets became a fashionable dinner party subject. AIG’s Asian businesses were among its most valuable assets after the Crisis.

Greenberg was ousted from the firm prior to the financial crisis. Some say his departure helped cause AIG’s collapse, given his irreplaceable understanding of the firm’s risk exposure. When he left, he retained a few symbols of his past power and position, perhaps none more important than C.V. Starr & Co. (Starr).

Named after AIG’s founder, Starr is Greenberg’s personal investment vehicle. Its portfolio, as of 12/31/10, was comprised of only 10 securities, five of which were ETFs.

Early this week, that portfolio took a huge hit when Deloitte, the auditor for its second largest position, China MediaExpress Holdings (CCME), abruptly resigned. Already the subject of intense Internet bulletin board rumor and speculation, the stock promptly plunged. Currently, trading has been halted, and prospects do not appear promising.

Starr’s 3-million share position in CCME made it the largest institutional shareowner by a factor of nearly 10. Given that the bulk of Greenberg’s fortune is tied up in AIG stock, I suspect that those dollars will be sorely missed.

Far be it for me to gloat over Greenberg’s misfortunes. Lord knows, I admire a manager who runs a concentrated portfolio. At a minimum, it tells me that he has conviction in his investment choices versus a closet indexer. What I will do, however, is try to learn something from this.

First, let’s take a look at the $330mm – as of 12/31/10 — Starr portfolio.  With a mix of ETFs (64%) and microcaps (36%), it appears to represent a ‘barbell’ approach to diversification. That is, roughly two thirds of assets are well diversified, while the remaining third is not diversified at all. How well did that strategy work?

In truth, while one may be tempted to write it off completely, I think it’s too early to tell. I will keep my eye on the portfolio over the next few quarters. I think that, while the CCME debacle must have stung, it cannot have been an entirely unexpected event, given how the portfolio was constructed.

C.V. Starr & Co. Portfolio as of 12/31/10

Source: 13F Filings

The presence of an activist investor is usually good news for shareholders. With a few notable exceptions, his presence can be very good news for the investor’s wallet. The issue, of course, is time — as in, how long is it going to take before I start to see some results?

Beyond an initial reactionary bump in the stock price, the answer to that question is usually – unfortunately — “it depends.” As a very rough rule of thumb, however, six to 12 months is about the average length of time before a major catalyzing event — i.e. special dividend, spinoff announcement, etc. — occurs.

Barington Capital’s involvement with Ameron International (AMN), a $655M (sales) industrial chemical and infrastructure company, is a good example.

Starting about a year ago, Barington took a stake in Ameron and began agitating for change.  Specifically, the hedgies thought that board accountability could be improved, and the business could be rationalized.

Ameron is made up of three operating units, only one of which is generating economic profits. The company also has interests in several joint ventures, one of which was sold last year.

Source: Barington SEC filing

To understand the impact of Barington’s activist activities in their proper context, a timeline of relevant events is helpful.

Timeline of Events

03/29/10 – Barington letter suggests changes to improve stock performance.

03/31/10 – 67% of voting shares at annual general meeting (AGM) in favor of requiring Chairman to be an independent director.

06/25/10 – Board approves new stock ownership and retention policy for board members.

08/04/10 – Board amends bylaws to provide for separation of Chairman and CEO roles after current CEO Marlen retires in 2012.

09/15/10 – Company signs agreement to sell ownership stake in joint venture for $82.5M.

10/22/10 – Sale of joint venture TAMCO.

01/05/11 – Barington sends letter to directors suggesting that the Board investigate the company’s employment of Marlen’s sons, which had not been previously disclosed. Public letter writing campaign between the Company and Barington ensues.

02/28/10 – Barington files proxy statement with SEC seeking to elect James Mitarotonda — Barington principal — plus one other nominee to the Ameron board as independent directors.

As we can see from the timeline, Ameron attempted to appease the activists by capitulating on several minor demands, all the while fending off their more troublesome requests. Barington, by the way, has had a reasonably solid track record of success with prior projects, such as AG Schulman, Pep Boys (PBY), and Steve Madden (SHOO).

When company management has been cooperative, Barington has not been reticent about complimenting them in public. This was not to be the case with Ameron, however, and last week, a catalyst was formed in the guise of a shareholder solicitation letter. Barington is seeking to win a proxy contest to place two of their representatives on the Ameron board.

Why did it take this long for them to make their move?

This past year was a drama in three acts. The first act was dedicated to understanding the degree to which management was willing to play ball. Once they established that management’s interest in meaningful change was not high, the second act became a waiting game.  Between the end of the third and the fourth quarters of last year, institutional ownership of Ameron’s shares increased by 33%, to 83% of the total float. That, my friends, was the so-called smart money positioning itself for the payoff.

Finally, 12 months after firing off their first letter to Ameron, and having established reasonable assurance of institutional support for their initiatives, Barington is finally going for the jugular. This is the final act in this drama.

I think there is a high likelihood that Barington will win the proxy contest and nominate its directors to the board at the AGM later this month. From there, I believe that Marlen’s resignation will be the inevitable outcome. To be sure, the timing is uncertain. In the end, no matter how long it takes, the patient money is likely to be rewarded in this situation.

Full disclosure: No position in AMN

Investing is not an exact science. It’s a game of odds. Great investors are very good at handicapping those odds — as a certain bespectacled octogenarian from Omaha can attest. For the rest of us, stacking the deck is the preferred methodology.

Yukon-Nevada Gold (YNGFF) is a small, unprofitable gold mining company with a market cap of about $536 million that just happens to have an abundance of positive catalysts in hand. The company was formed in 2007 as the result of a merger between two mining firms. Subsequent environmental and safety infractions cost the company dearly — the stock plummeted to just two cents per share when authorities shut down the operations.

In early 2009, a group of European investors, along with the Canadian company, Sprott Resources (SCP.TO), injected just enough capital into the operation to keep it afloat. Then they brought in Robert Baldock, an experienced mining executive, to turn things around. The company is once again in full compliance and, as announced in August of 2010, is producing gold at a rate of 150,000 ounces per year.

Gold roast

The company’s key asset is its roasting facility, one of only three in Nevada. Roasting is a necessary step to prepare the type of gold ore found in the so-called Carlin Trend mining region prior to the cyanide leaching — gold recovery — process.  Due to its environmental impact, however, no new roasting facility permits have been granted in the past 12 years.  This makes the facility extremely valuable, since roasting remains the only economic means of processing this type of gold ore.

The company has estimated the facility alone to have a value in excess of $750 million. While it’s difficult to determine the actual value of such a facility on the open market, it is certainly the case that the permitting process is a slow and difficult one.

Lofty goals

The company announced milestone goals that they hope to hit on the way to an eventual goal of producing 1 million ounces per year by 2015.

End of 2011 – up to 250,000 ounces (+67%)

End of 2012 – up to 400,000 ounces (233%)

Initially, the company’s existing mines will account for about 50% of production volume, with the remainder coming from outsourced ore. Thanks to the shortage of roasting facilities in the area, this will not be a particularly challenging goal to meet. More importantly, however, it will also improve the firm’s scale efficiencies, which will result in lower unit costs.

Starting in 2013, production from the new mines that come on-stream will replace the outsourced ore. The SSX/Steer mine is planned to restart in Q1/2011, and the Starvation Canyon mine will restart in early 2012. By 2015, 100% of production will come from company-owned facilities. At that point, if all goes well, the company will be a solid midrange gold producer.

Turnaround play

So far, I’ve described a fairly straightforward turnaround play that’s highly dependent on management’s ability to execute its plan. There are a few more catalysts that make this idea even more interesting.

The first has to do with a continuation of a theme from my previous two posts — the looming specter of inflation.  Gold miners are one of a select few who are able to raise prices during inflationary cycles. Most have already seen a run-up in their prices, which has made them less attractive. Yukon-Nevada, being a small, obscure Canadian company — with a tarnished history to boot — has had the good fortune not to suffer the same fate.

This brings me to the second catalyst.

On February 16, the company announced that it was “seeking advice and examining options and requirements” for listing on a U.S. stock exchange. Although the timing of such a move is uncertain, it would bring increased visibility, coverage, and interest from the investment community.

Last, it’s also worth noting that the company has entered into a 50/50 exploration and production (E&P) joint venture with the Northwest Geological Exploration and Mining Bureau for Non-Ferrous Metals of the People’s Republic of China (NWME).  I do not believe that the market has ascribed much, if any, value to the venture, owing to its relatively unproven nature. This means that any positive news arising from this entity has yet to be priced into the stock’s value.

A look at the risks

Obviously, any small company is subject to more than its fair share of risks. Junior Canadian mining companies are legendary for their self-promotion.

One other fairly serious risk facing a potential investor is the prospect of significant share dilution. The company has been raising capital through private placements and so-called “inducement warrants” (see note below), both of which are dilutive and on terms which are not particularly favorable for existing shareholders. Hopefully, a U.S. listing will bring with it better access to the capital markets.

Clearly, this isn’t a stock suitable for widows or orphans. It’s likely to be a volatile ride. But, between the positive traction from operational improvements, the momentum from inflation-induced pricing increases, and the increase in visibility from a U.S. listing, I’m hard-pressed to think of a situation with more positive catalysts stacked in a patient investor’s eventual favor.

Note on Inducement Warrants: The company is hoping to raise some $59 million by reducing the exercise price on some 236 million warrants at an average discount of 18% of the original exercise price. If successful, this will result in an average cost of 25 cents per share — a discount of about 68%, which is a very good deal for the warrant holders.

Disclosure: I am LONG shares of YNGFF