In a field of dead financial institutions, the opportunities are plenty for the hungry value investors. They key, of course, is identifying which provide a tasty meal and which are rotten to the core. It’s a matter of separating the EZ pickin’s from the E. coli. It has been called many things - a conglomerate, an investment holding company, a younger smaller version of Berkshire Hathaway. To some, however, it is simply the best distressed investment firm in the world. This latter view is most apt in my mind.

Leucadia National (NYSE: LUK) has been around a long time. Since 1978, the company has compounded its equity at a 20 per cent annual clip. Every dollar invested in Leucadia in 1978 turned into over $900 today - a track record that lays waste to the return on the S&P 500 over that span, beating it 16-fold.

Leucadia buys assets that are out of favor and cheap, often in bankruptcy, and then it works to rehabilitate the company. Basically Leucadia is a vulture.

Lately, though, the results have no been so stellar. Ian Cumming and Joseph Steinberg, chairman and president, respectively, readily concede that their results over the past two years have not been good.

Their accounting for this in their annual letter is insightful. First, they recall a similar time in the late 1990s when there was a tremendous increase in asset prices. Leucadia sold many of its holdings at that time for huge gains - sales that, in retrospect, look brilliant.

Cumming and Steinberg note the competition from “35-year-old hedge fund managers - private equity firms who have never known a bear market - and other investors willing to invest at high prices in risky assets with seemingly cheap money.” They call them “unguided optimists.”

The Leucadians, too, cite their own reasons for optimism about the future. They note that of the dozen or so companies that still maintain AAA-investment grade ratings, four are under investigation for alleged financial mischief. In discussions with a bank chief, Cumming and Steinberg relate how the banker that “allowed that many deals will likely blow up.”

“While we thank the banking community for creating future inventory for future investments,” they write, “It is difficult to remain disciplined and on the sidelines in a game we love.”

Leucadia sits on a pile of cash: about $1.6 billion ready for future investment, as I write. As Cumming and Steinberg say, their investment philosophy is “bimodal”: either they invest in high-return opportunities or they sit on the sidelines. There are few better ways to play the turn in the credit cycle than to shack up with Leucadia and its excess cash.

Leucadia relies on a handful of investment principles that stitch together the apparently unrelated investments that make up its portfolio.

These principles are often repeated in their annual letters (I’ve read them all going back to 1998):

1. Don’t overpay.
2. Buy companies that make products and services that people need and want and that provide them as cheaply as possible with consistently high quality. Search out candidates in out-of-favor industries that have turnaround potential. Our record as midwives to resuscitating disorganized, unprofitable, bedridden, and moribund companies is pretty good.
3. Earnings sheltered by net operating loss carryforwards are more valuable than earnings that are taxed by the IRS.
4. Pay employees for performance and expect hard works and honesty in return.
5. Don’t overpay.

This is a neat collection of simple but effective principles. Leucadia’s disparate collection of businesses makes a lot of sense in the context of this investment philosophy.

A Throwback to the Way Business Used to Be

I also like the fact that Cumming and Steinberg own 25 percent of Leucadia between them. Compensation is modest, only $650,000 in salaries each last year- a drop from $1.8 million each in 2003. You hardly ever see that.

There was a time when it would have stuck the investing public as absurd that a man would run a company without owning a big stake in the enterprise. This is a point made in Frederick Lewis Allen’s The Big Change, a highly readable and entertaining look at sociological changes in American life, published in 1952. Allen discusses the radical change in corporate ownership:

In 1900, capitalism was capitalism indeed. Businesses were run by their owners, the people who had put or had acquired the capital with which to finance them… It would seem wildly irrational that a man should manage the destinies of a corporation while owning only a minute fraction of its stock, as so frequently happens today.

Leucadia is also a bit of a throwback in this respect, in that management owns a good chunk of the enterprise. This should align their interests more with yours as a shareholder.

An investment in Leucadia is also a bet on the investment acumen of Cumming and Steinberg. Bearish commentators worry about succession plans, as Cumming and Steinberg are both in their late sixties, in much the same way people worry about replacements for Buffett and Munger. Fortunately, money management is a game that can be played late in life. Marty Whitman is still chugging along past his eighties, and Sir John Templeton is in his nineties. I think worries about succession are a bit premature in the case of Cumming and Steinberg.

Anyway, I love Leucadia as a long-term keeper stock, as long as Cumming and Steinberg are calling the shots. It’s also a great way for the everyday investor to play the vulture market.

Otherwise, while I like the idea behind vulture investing, it’s beyond the pale of most investors. I’ve added it on here only because so few investors seem aware of the money to be made in this area. Plus, you can keep your eyes out for companies coming out of bankruptcy and give them a good look. While you won’t make the killer gains the vultures made in the bankruptcy process, you can still make massive gains, since most investors will likely shun a fresh bankruptcy graduate - giving you an opportunity to get the jump on the rest of the field.

[Joel’s Note: Don’t know of any beleaguered financial institutions that might be filing chapter 11 anytime soon, do you? For fine-tuned vulture investors like Cumming and Steinberg, the pickings ought to be plentiful up and down Wall Street over the next few months.

Chris is an expert at sourcing out these kind of opportunities; ways you can hook onto what the best investors of the era are doing, grabbing a piece of the action for yourself along the way. Today’s insight is an excerpt from Chris’ new book, which is positively packed with ideas just like this. You’ll get through it a lazy weekend, but it will find a nice slot on your shelf as a reference book in the future. If you’d like to pick yourself up a copy, click here: Invest Like a Dealmaker: Secrets From a Former Banking Insider

—- Investing in the Era of “Peak Everything” —-

Oil hit a new record high… Gas could soon be $4 a gallon… silver, wheat, corn, you name it — all the “resources” of daily life are soaring in price!

Yet there’s a way to protect yourself and profit in the days ahead…

Join Us in Vancouver in July for an Exclusive Look at…

A View From the Peak: Seeking Profits in a Time of Risk and Scarcity

——————————————–

[Joel’s Note: Not wanting to leave the head honcho of the central planners out of it, we hunted around quickly for a quote befitting of Mr. Bernanke himself. Thanks to the great Douglas Adams for this one.

“If it looks like a duck, and quacks like a duck, we have at least to consider the possibility that we have a small aquatic bird of the family anatidae on our hands.”

Until tomorrow…

Cheers,

Joel Bowman
Rude Awakening