Hiring of Todd Combs at Berkshire Hathaway Does Little to Solidify Warren Buffett Succession Plan

Maybe I am way off base on this, but given that Warren Buffett is the greatest investor we have ever seen (or even if you disagree with me, he has to be in the top few, right?) I would have expected more when Berkshire Hathaway decided to start hiring outside investment managers to eventually replace him. Given Buffett’s knowledge and connections in the industry, coupled with the fact that this job opening has to be one of the most intriguing ones for a value investor anywhere on the planet, it seems as though they should have been willing (and able) to hire someone who we have at least heard of before. The addition of Todd Combs, an unknown 39-year old hedge fund manager who graduated business school just eight years ago, is not only baffling but I doubt that it instills all that much confidence for Berkshire shareholders.

Let’s review some facts about Combs and the hiring process, according to an article recently published in the Wall Street Journal:

1) Combs graduated from Columbia Business School in 2002, and worked as an equity analyst for 3 years before being seeded with $35 million in 2005 to start a new hedge fund, Castle Point Management, focused exclusively on financial services companies.

2) While assets have grown to about $400 million during the five years Combs has been an investment manager, his cumulative returns over that span are 34%, less than 7% per year. Depending on the risk profile of the fund, which is unclear, this may or may not be very impressive, but it is interesting that Castle Point returned 6% in 2009 (when the S&P 500 rose by more than 26%), and in 2010 has actually lost 4% of its value (despite the S&P 500 rising by 6% during that time). Combs’ five-year track record is not only extremely short, but it also doesn’t scream “Berkshire Hathaway.”

3) It is also interesting that Combs sent Buffett a letter in 2007 to apply for the job as Berkshire’s next investment manager but Buffett was unimpressed (his resume “didn’t distinguish itself” according to the WSJ article). Only recently did Combs send a second letter to Charlie Munger, which impressed Munger enough to advance the process and resulted in him being hired shortly thereafter.

To me, none of this information taken on its own can prove whether or not Combs is ready for the prime time or not. I have no doubt he is a very smart guy and his personality seems to fit with Buffett, Munger, and Berkshire well. His focus on financial services is important as Berkshire has a large insurance operation and invests in a lot of banks and other financial companies. That said, if I were a Berkshire shareholder I would be asking why this is the best they could do. Hiring an young, unknown fund manager with a five-year track record seems risky given how many more well known, established, and proven people are out there and would likely have been honored to join the Buffett team. In the case of Combs, it will be years before we find out exactly how good he is at picking stocks and managing tens of billions of dollars.

Full Disclosure: No position in Berkshire Hathaway at the time of writing, but positions may change at any time.

For-Profit Education Stocks Worth Monitoring Even As Government Implements Reforms

Shares of Apollo Group (APOL), the leading for-profit education company (think University of Phoenix), fell a stunning 23% Thursday to $38 after the company withdrew its 2011 financial outlook in light of upcoming changes to their industry. With the unemployment rate at 9.6%, enrollment at for-profit schools has been surging in recent years as people try to boost their resumes by completing online college courses and earning an associate, bachelor, or graduate level degree. As a result, the private firms running schools such as University of Phoenix have been minting money.

The interesting part of the story is that for-profit colleges typically get more than 80% of their revenue from Title IV student loan programs subsidized by the U.S. government. With taxpayers footing the bill for all loan defaults, the colleges themselves have absolutely no direct financial exposure whatsoever if students rack up thousands in debt and cannot repay the loans. As loan defaults rise, the U.S. Department of Education is finally taking notice and is set to release new guidelines for Title IV funding. As you may imagine, if lending guidelines are tightened, new enrollment at these colleges could drop off considerably. The new rules, set to be issued in coming months, are likely to set maximum default rates for schools who want to accept Title IV loans, as well as gainful employment guidelines to help ensure that students will actually have the ability to repay these loans based on the jobs they secure with their new degrees (a communications degree online, for instance)

The market’s violent reaction to the sector on Thursday was triggered when Apollo Group withdrew its 2011 financial guidance in anticipation of these new rules. For the first time ever, for-profit schools are going to have to scale back growth plans and actually become more than simply fierce marketing machines. Maximizing enrollment at all costs is no longer going to work. In fact, Apollo is now requiring all new students to attend an orientation program which spells out in more detail exactly what kind of financial commitment these degrees require. The company says that about 20% of prospective students voluntarily withdraw from the program after attending the orientation. In addition, the company’s admissions staff will no longer be compensated based on enrollment rates, as the company seeks to increase the quality of their students, thereby reducing loan default rates and boosting retention rates.

While there is no doubt that enrollment growth rates will tumble at for-profit colleges, it is far too early to pin down exactly how their businesses will be impacted by these changes. I think it is worth it for investors to monitor the situation carefully, as some values may ultimately be worthy of investment consideration at some point in the future (the stocks are already down a lot from their highs). In the case of Apollo, the company’s enterprise value of about $4.2 billion compares with fiscal 2010 EBITDA of $1.4 billion and free cash flow of nearly $900 million. At 3 times trailing cash flow, these stocks are already in deep value territory.

It will be important to see if scaled down marketing and increased financial awareness for students serves to merely slow down enrollment growth or also seriously cuts revenue and earnings for these companies. Exactly how much revenue is reduced and expenses rise will determine if and when these stocks reach a point where the risk-reward is worth an investment. At current prices it appears that the market is pricing in cash flow declines of 33-50% over the next 1-2 years. While possible, we surely do not know that kind of hit is a given at this point in time. If it proves overly pessimistic, shares of Apollo could become quite attractive, as the schools remain strong cash flow generators.

Full Disclosure: No position in APOL at the time of writing, but positions may change at any time.

Still Very Much A Buyer’s Market in Housing

A reader recently asked me why I have not updated my housing inventory chart lately (it has been about a year since my last periodic update) and the simple reason is that I forgot.  As you can see after I added the last 12 months or so of data, the U.S. housing market was unable to continue drawing down inventory during 2010. Months of supply have risen again despite price stability in most markets.

What this tells me is that we have many more months (and probably years) to go before inventories get worked down enough to see meaningful price appreciation in the housing market. Now, this does not mean that prices will be taking another large leg down in coming months. Ratios of incomes and home prices are now much more realistic so there will be buyers eager to step up when deals present themselves. I would expect several more years of a relatively flat housing market (I am talking about the national market — any individual area always has its own supply-demand dynamic). Long term buyers will likely be shielded from material downside risk in all but the most overbuilt markets, but they will truly have to be long-term thinkers when counting on equity appreciation above and beyond their principal repayments. As a result, there is little need to hurry into the home builder stocks. There will be a turn there at some point, but it is likely a ways off.