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January 10, 2009

American Eagle and Abercrombie: Inventory Foretells Margin Squeeze


Source: Flickr by k-ideas

This holiday shopping season has been dismal for retailers. Retail sales slipped dramatically year-over-year. Luxury sales were most hard hit clocking in at a 35% drop in sales year-over-year while women’s apparel saw a 23% decline. Most retailers resorted to large discounting of their products to move merchandise. One retailer however decided to go against the retail herd and refused to discount any of their merchandise sacrificing sales in the interim.

Video

Abercrombie and Fitch (ANF) considers itself a premium brand in the teen apparel space. The company believes discounting will hurt the brand. According to Chairman and Chief Executive Michael Jeffries in an earnings call with analysts, "promotions are a short-term solution with dreadful long-term effects." Abercrombie’s main competitor in the space, American Eagle Outfitters (AEO), on the other hand has aggressively discounted its products in an effort to move inventory.

I believe Jeffries has a point. In a post the last summer, I suggested Target (TGT) should raise their prices in an effort to match the perception that Target more expensive than competitor Walmart (WMT). Human psychology has us place a higher value on items that are higher priced. Jeffries is aware of this psychology thus believes discounting will erode consumers’ perception they company's tees and jeans are of higher value than their competitors. Even though any casual observer can see Abercrombie’s and American Eagle’s clothing is of the exact same quality.

Generally, I would not have a problem with Abercrombie’s approach. But, if the company is going to successfully execute the no discount policy, they must do a better job with inventory management. Abercrombie seems to have flooded stores with merchandise consumers seem, for the moment at least, unwilling to buy. On the other hand, American Eagle has scaled back on inventory growth anticipating a tough holiday season. Sales and inventory growth for the most recent quarter from the same quarter a year ago are as follows:

Abercrombie’s, as opposed to American Eagle’s, aggressive approach in inventory management is bound to cut into the company's margins. For the most recent quarter Abercrombie has gross margins of 66% and has averaged the same over the last five years. American Eagle on the other hand has gross margins for the most recent quarter of 41%, down from its five year average of 46%.

Operating margins are another story. While Abercrombie sports some very high gross margins, their operating margins are very close to American Eagle’s. In fact Abercrombie’s cavalier attitude regarding inventory management, among other things, has chipped away at its operating margins. Abercrombie’s average operating margins for the past five years were 19% but were only 11% in its most recent quarter. Meanwhile American Eagle’s operating margins for the past five years average 18% but were 13% in the most recent quarter.

Although both companies will see their margins shrink due to anemic consumer market, I would bet you will see American Eagle’s operating margins continue the trend of outpacing the margins of Abercrombie’s in the very near future. Although both stocks are down substantially over the last year, I would expect American Eagle to rebound while I am not too optimistic about Abercrombie right now.

Disclosure: I and the clients of Brick Financial Management, LLC owned share of American Eagle Outfitters and Target at the time of this writing. But positions can change at any time.

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January 02, 2009

Best To Go With The Devil You Know

The stock market ended the year of 2008 posting one of its worst annual price performances ever. The Standard & Poor's 500 index dropped 38.5% for the year marking its worst performance since 1937’s 39% drop in the index. In fact it was the first time the index saw a 30% or more drop in price in those 71 years. So if you survived this year, give yourself a pat on the back.

Investors over the past year made many wrong moves, paralyzed by fear, they drove down stock market prices to unreasonable levels. One bright spot is patient investors could invest in stocks very cheaply. Valuation levels had not been at those levels since the early 1980’s. Although the S&P 500 has advanced more than 20% from its low of November 20th, there remain bargains to be had.  

With so many bargains to choose from, some investors may experience paralysis because of greed. Which stock does one pick? In such an instance, it is best to invoke the spirit of Charles Munger, co-chairman of Berkshire Hathaway. In an Outstanding Investor Digest article some years back Munger was quoted as saying:

“For an ordinary individual, the best thing you already have should be your measuring stick. If the new thing isn’t better than what you already know is available then it hasn’t met your threshold. This screens out 99 percent of what you see.”

Although I picked up a few new positions for myself and my clients’ portfolios, in following Munger’s advice I found that the positions already in the portfolios were of solid companies that were similarly beat down as the market. Every nook and crannie of the market was hurt this year. It couldn't be avoided. And the potential of being hurt further is still present. However, when choosing where to allocate funds, sometimes it is best to go with "the devil you know".

Instead of scouring the investment universe for the new thing, I simply averaged down. The following chart marks the return of a few positions from the beginning of the year to the S&P 500’s low on November 20th and then the return to the end of the year from that November date compared to the market’s return.

 

Although as a group the stock of these companies declined to a similar degree as the market, their rebound so far as been nearly 50% greater. Although it is too soon to say, I believe superior companies will bounce back to a greater degree than the average stock. I think this is what we are seeing in the chart above.

Disclosure: I and the clients of Brick Financial Management, LLC owned shares in all the companies mentioned in this post at the time of this writing. But positions may change at any time.

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December 12, 2008

The Auto Bailout and Mental Accounting

Source: Flickr by Cobalt at www.flickr.com/photos/cobalt/1422157740/
Source: Flickr by Cobalt

Last night the $14 billion bailout for the auto industry failed in the Senate primarily because the United Auto Workers union refused to accept a pay cut for its members. This likely spells big trouble for the Big 3 as collectively they are asking for funds in excess of $30 billion. General Motors (GM) alone, which employs a quarter of one million workers, needs $8 billion over the next two months to stay afloat according to its CEO Rick Wagoner.

Supporters of the bailout are now looking to the White House and the Treasury to step in. To date the Bush administration has resisted dipping into the remaining balance of the $700 billion TARP earmarked for the banking industry to help the Big 3. The Bush administration’s position in this regard is well understood. It wants to reserve the remaining TARP funds for the banking industry “just in case”. But there is also no denying reluctance to use the TARP funds to assist the auto industry is really grand scale mental accounting.

Mental accounting, as studied by Richard H. Thaler, is the way we attribute a monetary value or utility to an economic transaction, situation or expectation. It tends to separate those values in different accounts according to their origins and purposes. Mental accounting can also be seen as the failure to see the entire financial picture and how one decision affects another. To understand this concept on a personal level it is best to consider a couple of examples.

  • A divorced mother holds a grudge against her ex-husband and father to her children on whom she depends for child support. In an effort to exact revenge against the ex, the mother makes crank calls to the father’s place of employment causing him to loose his job. This in effect decreases the mother’s income in the form of child support. The mother failed to connect that her income was dependent upon his. In her mind they were separate.
  • A consultant on a temporary project wants a file cabinet to store just a few papers. The local office supply store has small, medium and large size cabinets which cost $200, $250 and $300 respectively. Being analytically minded the consultant buys the largest cabinet as he calculated it would allow him to get the most space per cubic inch for his money. However, he failed to consider he had only enough files to fill half of the smallest cabinet. In essence, he wasted $100 dollars. When something sells for below the mental price we have assigned it, the deal takes precedence over the actual utility of the item.

Whether the government uses the TARP money, some other funds or does nothing at all, we as Americans will collectively “pay” for the automakers woes. Perhaps it will be in funds going directly to the companies. Or perhaps it will be in increasing the welfare and unemployment rolls. It may come in increasing bankruptcies and foreclosures among former workers of the industry. At this point, we, Americans, the government, cannot avoid expending these dollars either directly or indirectly.

In the interest of full disclosure, I wrote an earlier post suggesting giving money to the automakers amounted to a very bad investment decision. I stick by that position. In 2007, GM lost $38 billion in 2007 and Ford (F) lost $2.7 billion. However, in no way was I suggesting nothing be done. As an investor, I am against the bailout. As an American, I can see the government giving the Big 3 the billions they are asking for – I will just close my eyes and hold my nose when and if they do.

Disclosure: I do not, nor do the clients of Brick Financial Management, LLC, own any securities mentioned in this article. But positions may change at any time.

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November 21, 2008

5 Things To Be Thankful For In This Market (Part 2)

Many of us may find it hard to be thankful for much in this economy, especially when it comes to our portfolios. From its October 9, 2007 peak of 1565.1, the S&P 500 has been down as much as 52% hitting 752.44 on November 20, 2008. But every cloud has a silver lining. The other day I decided to list a few things to list a few things to be thankful for in this, and most bear markets. Here's #2.

2.     Low P/E Ratios

Last month, I pointed to a Wall Street Journal article by Jason Zweig where he points to a Benjamin Graham measure of valuing the stock market adopted by Yale professor, Robert Shiller. Dubbed the “Graham P/E”, it divides the price of major U.S. stocks by their net earnings averaged over the past 10 years, adjusted for inflation.

At October 24, 2008, when the S&P 500 stood at 876.77 the Graham P/E was 15 (I have included November 20th’s low of 752.44, a Graham P/E of 12.5, represented by the red line), the lowest it had been for nearly 20 years the suggestion being the market was greatly undervalued and investors were acting irrational. However, Chris Carroll a Johns Hopkins Professor of Economics, takes a slightly different position in a recent white paper. He points out the numbers predict a 6% or so rate of return over (grey dot, 8% at the red dot) the next 12 years net of inflation, about the historical average. Hardly the panic many market pundits have talked about.

Source: Chris Campbell/Benjamin Taylor

Whether the current market provides for the buying opportunity of a lifetime or simply a return to normalcy as Carroll suggests is of little concern to me. I am finding quality companies at P/E multiples never available before. One company that fits the bill is Coach (COH), the leader in the handbag and accessory market.

 Since being spun off from Sara Lee almost a decade ago, Coach has grown its tangible book value by 49% per year and has not seen its return on equity dip below 40% in seven years. The company has raised its earnings per share by 47% per year and year-over-year EPS has increased every quarter for the at least the last five years including its most recent. Coach also has nearly $410 million in cash with only $2.2 million in debt.

In any other environment Coach would be selling for 25-30x earnings and has since it went public years ago. But today an investor can have Coach for a cool 8x earnings. I must agree with Warren Buffett when he says,

“…fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”

Disclosure: I do not, nor the clients of Brick Financial Mangement, LLC, hold any positions in the companies mentioned but positions may change at any time.

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October 10, 2008

Buffett and Cramer Agree: It’s Time to Buy

It’s a little amusing to me how much attention Jim Cramer’s comments about pulling your “5-Year-Money” out of the market and sitting it in a safe place like cash or bonds garnered over the past few days. I for one, having given similar advice, didn’t find it that controversial. An investor, especially an individual investor, should never put their near term money at risk in the stock market.

Some professionals, like Henry Blodget [video], have even gone as far to say Cramer’s call to action is at odds with what Warren Buffett is doing, which is buying up strong franchises like, Constellation Energy, GE and Goldman Sachs. I beg to differ. Underlying Cramer’s call was any money investors do not need for near term purposes, should absolutely be at work in the market. It’s time to buy.

There are deals in the stock market that can be had right now that will likely not be seen again for quite sometime. A few are:

  • Berkshire Hathaway (BRK-A, BRK-B): If there was ever a time to invest in Buffett’s company it’s now. For years the firm held $50 billion in cash searching for investments to make. This year alone, Buffett has invested $40 billion. He received warrants on both the GE and Goldman Sachs deals and though both are currently out of the money, they stand to be highly profitable investments. Berkshire’s A shares are likely worth $150,000 to $160,000 before accounting for how the company’s new investments will impact the business. Shares ended the day at around $113,000 per share, representing a 25% to 30% discount.


  • Perini (PCR): Perini, a construction and general contracting concern has been trading well below the value of their backlog of sales and orders waiting to be filled. The company also recently announced $248 million in new contracts in Florida and Virginia. The stock gained almost 20% today skyrocketing at the end of the day to $17.64, but still trades near cash on the balance sheet of $15.55 per share.


  • Delia’s (DLIA): Recently Foot Locker (FL) offered to buy this clothing retailers direct marketing business CCS for $102 million. The enterprise value (market cap + debt – cash) for the entire firm is only $66 million. The market hasn’t responded yet as the stock continues to hover around $2 per share although it gained almost 10% today. The selling in the market is pervasive and there just aren’t any buyers right now. But there will be for this company which is likely trading at less than half it’s true worth.

Disclosure: I and the clients of Brick Financial Management, LLC owned share of Berkshire Hathaway, Perini and Delia’s at the time of this writing.

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August 16, 2008

Netflix Flub Fixed

Credit: http://flickr.com/photos/beautyredefined/2389559961/

If you are a movie lover like me, even a casual one, then there is a good chance you are a subscriber to Netflix. Netflix (NFLX) has been providing online movie rental subscription services for the last decade or so. It allows subscribers access to a library of movie, television, and other filmed entertainment titles on DVD and delivers them to your home. Cool right? The company serves over 8.4 million subscribers – I am one of them.

Over the past three days, Netflix flubbed. For some reason the usually reliable company had a technology problem that disrupted the delivery of its DVDs. Netflix was able to ship some discs on Tuesday and Wednesday but none on Thursday.

In what seems to be the company’s personality it was proactive in acknowledging a problem existed and subsequently offered a 15% credit to affected customers. Although the company could have been more forthcoming with the cause of the technology glitch, it swiftness in correcting the problem earns them some points. However, the credits could be costly to the company, estimated at as much as $3.6 million in revenue lost per day of delay.

Netflix’s shares are up about 17% year-to-date. Interestingly, the news of the week barely moved the stock’s needle. In fact the shares are up about 1% week-over-week. This is probably good news for the company as its customers seem to be an understanding crew, and the market seems to think these glitches won’t hurt Netflix’s bottom line.

I was expecting my Netflix yesterday but have not received it yet. I will give the company a break though. They seem to be on top of it.

Disclosure: I did not, nor did the clients of Brick Financial own any shares of Netflix, Inc (NFLX) at the time of this writing. I however, am waiting for Strange Wilderness to arrive in the mail at any moment

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August 11, 2008

Actions Speak Louder Than Words… And Quarterly Returns

Bill MillerNot long ago, Bill Miller who serves as the fund manager of Legg Mason Value Trust mutual fund (LMVTX) issued the fund’s semiannual letter to shareholders for 2008. Miller laments the fund’s poor performance over the last year (July to July), down 34%. Famously, Miller’s fund beat the S&P 500 index a bunch of years in a row. However, as a Fortune magazine article points out, Miller doesn’t provide much guidance for how his fund (or investors) can return to the glory years going forward.

I disagree. The old maxim “Actions speak louder than words” can no doubt be applied here. Throughout this troublesome market, Miller has spoken loudly by adhering to his investment principles. A few of those principles, distilled beautifully by Janet Lowe in her book The Man Who Beats the S&P, are to:

Observe, but don’t forecast, the economy and the stock market. The market has so many players all using different bases from which to compete and adapt to one another. This results in unpredictable short term movements in the economy and the market. There is no simple formula that can predict these movements. Forecasting is folly. However, observing these movements and behaviors provides investment insights.

Seek companies with superior business models and high returns on capital over time. Over long periods, companies meeting these criteria have proven to provide high returns to their shareholders.

Buy businesses at a large discount to the central tendency of their true value. In true value investing style Miller always provides himself a margin-of-safety. In his latest letter, Miller points out that Financials now provide this margin-of-safety as the market prices of these companies are at all time lows compared to their underlying economics. However, remembering that “forecasting is folly”, the performance of these investments in the short term cannot be predicted. Over the long term they should do well.

Sell when 1) the company reaches fair value; 2) you find a better investment or bargain; 3) the fundamental logic for the investment changes. Miller sells to when it maximizes the returns of his portfolio. Most investors, amateur and professional alike, sell at the most inopportune times, like now when the market is depressed.

I doubt Miller will ever be able to duplicate the previous success he enjoyed with Value Trust. But if investors hold fast to his fund or his principles, they should do well.

Disclosure: I did no own, nor did the clients of Brick Financial Management, any shares of Legg Mason (LM) or Legg Mason Value Trust (LMVTX) mutual fund.

 

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April 23, 2008

Still Uncertainty in Financials

Wall StFinancials are doing well even with news that would have normally sent the shares of companies in the sector on a downward spiral.  The earnings of banks are off by a long shot even in comparison to just last year. We're also seeing write offs left and right.  Last month when Bear Stearns basically went out of business and calamity was predicted, the market barely budged (the S&P 500 was down less than 1%). Lehman Brothers announced to the market that it had taken action to sure up its liquidity by raising $4 billion in capital. Why would the firm have done this if it wasn’t in trouble? With all the bad news coming in and undoubtedly more bad news in the near future it's interesting that the stocks of financial companies have actually done well. What one might garner from this is the sector has turned a corner. So does this mean we should all go out a buy a bunch of financial stocks? Quick answer: NOPE!  


My guess is we’re in a period where financials will oscillate. I for one still need to see more information coming in and how the market reacts. For the moment, I’m short the sector (SKF). It’s important to keep in mind the stock market discounts the future, meaning future information and events are usually accounted for in the stock’s current price. An investor’s job is to assess the probability of those future events actually occurring. How well one does that is where the money is made. Right now I’m betting things will get worse before they get better.

Disclosure: I and the clients of Brick Financial owned shares of ProShares Ultrashort Financials ETF (SKF).

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April 21, 2008

When Diversification is Good

Eggs

In case you haven’t heard the old saying, “Don’t put all your eggs in one basket”, the collapse of Bear Stearns (BSC) is a great example of why the phrase exists. As you may recall, last month Bear’s stock plummeted to less than $3 per share from a 52-week high above $150. Although Bear employees seemed to be a little better off than the former employees of Enron and Worldcom whose retirement savings were obliterated by the collapse of those companies, as Bear’s employee stock ownership plan accounts for only 3% of total shares.

However this belies the point. About 1.5 million Americans are invested heavily in their employer's stock and another 11 million Americans participate in employee stock ownership plans and the like. Should these companies fail, and the stock of those companies fall significantly, you’ll see a lot of folks working in their golden years. Although I believe in prudent concentration in one’s investment portfolio, there is such a thing as too much of a good thing. The best actions an employee can take is not to make their own company’s stock more than 10-15% of their overall portfolio.

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April 18, 2008

Blockbuster Bids for Circuit City

BlockbusterCircuit City

Blockbuster (BBI) video chain made an offer to buy Circuit City (CC) stores for about $1 billion on April 14th. That is more than the market value of Blockbuster so right off the deal smells bad. Not to mention, neither retailer provides was you would call a great shopping experience.

Bill MaherEven comedian Bill Maher took notice. In his HBO show "Real Time", Maher says,

"New Rule: Crappy companies don't get to merge with other crappy companies. This week, Blockbuster Video announced a hostile takeover of Circuit City. What a brilliant idea. The two places nobody goes anymore finally under one roof. Blockbuster's plan is to combine their expertise in never having the video you want--with Circuit City's high-pressure sales staff of ignorant teenagers--to create the ultimate in horrible retail experiences."

I coud not agree more.

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April 03, 2008

Traders Bet on Google to Buy Expedia

ExpediaTraders sent shares of Expedia (EXPE) up by about 15% over the last couple of days amid rumors that Google (GOOG) would be interested in purchasing the internet travel company. Certainly Google has the muscle to do it. But the company has not been agressive in acquiring e-commerce companies. Thus an acquisition of the travel company would represent a, albeit slight, departure from Google's current expansion modus operandi.

I find it interesting however that the companies did not outright deny they were in talks. A WSJ article (subscription needed) confirms the companies' reluctance to address the issue. Their respective silence seems slightly conspicuous to me. Definitely something to keep an eye on.

Disclosure: I and the clients of Brick Financial Management, LLC owned shares of Google at the time of this writing and do not currently but have owned shares of Expedia.

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May 03, 2006

PACCAR (Yawn!): Just Another Boring Undervalued Stock

I came across a nice synopsis of PACCAR (PCAR) on the Seeking Alpha blog. PCAR is one of our holdings but hasn't done much lately. The article is worth a read.

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May 02, 2006

Right About Being Wrong on JetBlue

A sound selling discipline is an oft-neglected part of a sound investing approach. A sell discipline will get the investor out of situations that show little promise and allow him to be available for situations that do. One of the sell criteria we employ at Brick Financial imparts us to sell a stock if “we have made a mistake in calculation or judgment.” Last August the clients of Brick Financial saw the criteria at work.

In August I wrote,

"We were cautious when we bought JetBlue: JBLU back in the spring of 2003… at the time it was trading at about 35x earnings which we thought was expensive… What we did not fully appreciate were some of the challenges that JetBlue faces. One was its vulnerability to rising oil prices. Although all transportation businesses were affected, airlines seemed to be especially so, and JetBlue was no exception. The other issue was the realization that although JetBlue’s operating and labor costs are presently low - as planes age, as employees become unionized, as new markets become more scarce – the company’s costs are bound to rise... We made several mistakes on this purchase... [ultimately] we did not provide ourselves a wide enough margin of safety [and] we should have weighed JetBlue’s rich valuation more heavily in our analysis…”

Since then, JetBlue has declined from a split-adjusted price of $12.71 to $9.69 at today’s (May 2nd) close. That move represents about a 24% decline. The company’s last two quarters were net losses, with the latest loss reaching $32 million. I would not say that I am clairvoyant, but some of the concerns I covered last summer have come to fruition. Larger competitors are pilfering the company’s business model and the company’s costs are catching up to it. The company, though nimble compared to other carriers, could not escape the ever-increasing rise in oil prices. It has also been forced to scale back on its expansion plans, sell some of its planes and shorten many of its routes.

A recent Wall Street Journal article underscores the company’s difficulty:

“ ‘We haven't done a good job at managing our business’ with aviation fuel costing more than $2 a gallon, said David Neeleman, JetBlue's founder and chief executive officer. The company's fuel bill rose 85% in the first quarter compared with a year earlier, and the average cost per gallon jumped 43% to $1.86. But the ‘silver lining’ in the record fuel price is that it is ‘helping us focus on becoming a better company,’ he said.”

 A sound sell discipline, and the ability to admit I was wrong, saved some money.

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February 07, 2006

Misgivings About BofA

Excerpt from Brick Financial's January 2006 Client Letter:

 

...The BofA sell was a little different. It too faced the daunting condition of a nearly flat yield curve. It, like most other large banks, is likely to see its net interest margins get worse before they get better. The recent earnings miss is a symptom of this. Although the company’s management expects their acquisition of credit card issuer MBNA to begin adding to earnings as soon as 2007, we’re skeptical.

 

Not that we think MBNA is a questionable business. Just the opposite. We think it’s a fine business. It is more that we think the management of BofA, especially its CEO Ken Lewis, has an uncomfortably optimistic outlook (euphemism for “misleading”) no matter the conditions of the economic climate. An example of what we mean is when management consistently reports pro forma figures rather than the more conservative GAAP figures. Pro forma figures have many assumptions or hypothetical conditions built in which allows for an alternative view of the financial statements. But that’s just semantics. Usually companies use pro forma figures to hide all the bad stuff.

 

On a recent conference call Ken Lewis stated that the company was able to grow earnings by 31% over a two year period. The GAAP figures revealed something not quite in line with what Lewis’s statement. Hedge fund manager Thom Brown (bankstocks.com) pointed out this discrepancy and recounted an email exchange he had with the company.
“This is what we refer to around here as ‘Charlotte math. By the lights of my Bloomberg, BofA earned $3.57 per share in 2003, $3.86 in 2004, and $4.15 in the year just ended. So over the past two years, earnings have risen by 16%, half the 31% growth that Lewis alleges. In response to my inquiry, a company spokesman emailed to say that the 2003 EPS Lewis was referring to are the pro forma numbers the company filed at the time of the Fleet deal in 2004. Which is to say, Lewis’s statement is nonsense. [emphasis ours] The fact is that investors don’t have a claim on retrospective pro forma numbers, nor do those numbers help build economic value over time. What matters are actual, here-and-now GAAP numbers. Lewis knows that, of course, but he threw out those phony numbers to make his performance look better than it really is. That’s our Ken!”

Evaluating the management of companies is essential to our investment process. We look for capable management. We look for management groups that treat their shareholders (and customers) with high regard. We need to feel like management is speaking with us candidly and honestly. We do not want management painting a rosy picture, were there really is none. We want management to “give it to us straight”. We just don’t get that feeling from the management of BofA...

Read the rest of the January 2006 Client Letter by clicking here.

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About Brick Financial Management, LLC

Blogged by Brick Financial

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Brick Financial Management, LLC is a Registered Investment Advisor specializing in providing investment management services to individuals, families, organizations and institutions. We implement highly focused stock, bond, and balanced portfolios using an investment approach commonly referred to as value investing. Disclosure

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