Wednesday, August 28, 2013

Munger's Daily Journal: Decisive Shift Into Stocks

Daily Journal Corporation (DJCO) has had, to say the very least, substantial success with its investments in recent years.

The company is a publisher based in Los Angeles that has been shifting its excess cash into stocks picked by Charlie Munger and J.P. Guerin.

Charlie Munger is the non-executive chairman of Daily Journal and, of course, the vice chairman of Berkshire Hathaway (BRKa). While better known for serving as Warren Buffett's business partner, he's also been more quietly serving as the chairman and a director at Daily Journal since 1977.

J.P. Guerin is the vice-chairman of Daily Journal.

Well, they've had so much success in recent years that, back in February of 2013, the SEC formally asked why Daily Journal shouldn't be considered an investment company (as defined in the Investment Company Act of 1940).

Here's the Daily Journal's rather lengthy response.

Among other things, the SEC noted the high percentage of Daily Journal's total assets that are now marketable securities. This is important for the following reason as explained in Daily Journal's response: "...the Investment Company Act (the 'Act') defines an investment company as an issuer (i) 'engaged … in the business of investing, reinvesting, owning, holding, or trading in securities' and (ii) whose assets are at least 40% investment securities."

They go on to further explain that "the Act exempts from this definition any issuer 'primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities.'"

I found this part of their response, where they explain why in their view the above noted exemption applies, of particular interest:

"...Daily Journal is not just 'primarily' engaged in businesses other than investing - it is entirely engaged in other businesses. The Company and its two wholly-owned subsidiaries have nearly 275 employees and contractors, all of whom are engaged either in the publication of newspapers and magazines or the development and licensing of case management software.

There is no question that Daily Journal's marketable securities currently exceed 40% of its total assets. This is due to the wise decision of the Board of Directors in 2009 to begin shifting the Company's cash and cash equivalents into marketable securities that have appreciated significantly. The Board recognized that this decision would be contrary to the conventional (but questionable) notion that the least risky way to preserve corporate capital for the long-term benefit of stockholders is to invest it in government bonds at interest rates approximating zero, notwithstanding rising inflation.

That the Company even had excess cash to invest is due primarily to the confluence of a unique aspect of its publishing business and the country's largest financial crisis in more than 70 years. The Company's newspapers are 'adjudicated', which means they are eligible to publish legal notices, including notices of residential foreclosure sales that are required by California and Arizona law to be published by the foreclosure trustee in an adjudicated newspaper. The Company aggressively competes for the opportunity to publish trustee foreclosure notices, and there were lots and lots of them to be published in California and Arizona beginning in 2006.

So, while the 'Great Recession' ironically benefitted Daily Journal, the Board knew that it needed to plan for the Company's post-recession operations. To do that, the Company needed to (1) hedge a very difficult environment for newspapers generally, (2) provide for an asset base from which to pursue attractive acquisition opportunities, and (3) establish a minimum net worth that would enable it to bid on significant government software contracts that the Company had been too small to qualify for in the past. Accordingly, the Board decided to purchase three securities selected by Charles Munger, the Company's non-executive chairman, and J.P. Guerin, the Company's vice-chairman. Those investments were quite successful, and the Company now holds positions in six securities."

In July of 2013, the SEC said they had completed their review while making it clear future actions could still be taken.

Consider that, at the end of 2004, Daily Journal had net cash and investments (at that time primarily U.S. Treasury Bills) of $ 11.26 million. After subtracting notes payable of $ 4.55 million, net cash and investments was ~ $ 6.71 million.*

As of the most recent quarter -- nearly but not quite 10 years later -- Daily Journal had cash and investments (now, primarily made up of the six stocks) of $ 134.7 million. After subtracting $ 14.0 million in margin borrowing net cash and investments was ~$ 120.7 million.**

So I'd say they've put their capital (including free cash flow over that time) to rather wise use over the past decade or so.


No position in DJCO; long position in BRKb

* In 2004, Daily Journal earned $ 3.73 million on $ 34.82 million in revenue. While earnings have been quite a bit higher in recent years, the company has earned $ 2.81 million on $ 26.65 million in revenue over the first three quarters of 2013. A similar annualized run rate. Still, seems tough to judge what the future earning power might be. So, as is pointed out above, though Daily Journal was actually impacted favorably by the "Great Recession", earnings appear to be coming back down to earth from temporarily inflated levels. The important lesson is that, instead of, with excess cash, making dumb investments in the core business that might have generated questionable returns, they waited patiently then decisively bought marketable securities they believed to be mispriced and cheap. That should sound familiar to anyone who's been following what Charlie Munger and Warren Buffett have been saying and doing over these many years.
** Investments were primarily in common stocks but also certain bonds were purchased as explained in the Liquidity and Capital Resources section of prior 10-Qs and 10-Ks. Also consider that Daily Journal recently invested $ 14.0 million in cash -- $ 11.878 million net of cash acquired -- to buy all of the outstanding stock of New Dawn Technologies. So cash and investments would otherwise be even greater.
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