Berkshire Hathaway
On Safari: Exotic Fauna in Value Land

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By Grahamified
February 9, 2004

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One of the best-kept secrets in the current investment climate is this: any perusal of a cheap stock's financial statements is increasingly apt to feel more like a safari sojourn, or several wild carnival rides at least, than a review of the ledger. Investors determined not to look for extremely cheap stocks until everything gets noticeably cheaper need to know they may be missing a priceless opportunity. Amongst the current offerings in the undervalued ferment, there is a chance to experience some fairly exotic fauna if only one is willing to examine a few corporate disclosures.

This kind of diversion is scintillating in a way that cheap thrills in, say, a harlequin novel, usually are not. That is, whereas the average harlequin novel leaves nothing to the imagination, disclosures in Value Land today are very likely to leave a lot to it. A case in point is AON Corp. (symbol: AOC), one of the selections in a recent Motley Fool column titled, " Top Picks of Money Managers."

As a potential investor in AON Corp, it is nice to see AON common trade at the lower end of its price-book range, as noted by the column's author. But the excitement really starts with the following coy disclosure in AON's 10K footnotes:

We use special purpose entities and qualifying special purpose entities, also known as special purpose vehicles, in some of our operations, following the guidance of FASB Statement No. 140 and other relevant accounting guidance.

As many investors know, the expression "special purpose entities" refers to financial arrangements that management do not reveal on the balance sheet. These arrangements are created to finance expenses. Upon review of such footnote disclosures, one must try to ascertain why management reveals these liabilities in the footnotes rather than on the balance sheet, where investors might take them in fuller measure.

Here's what AON's management has to say about their special purpose entities (SPEs):

Certain of our special purpose vehicles were formed solely to purchase financing receivables and sell those balances to conduits owned and managed by third-party financial institutions. Subject to certain limitations, agreements provide for sales to these conduit vehicles continuing through December 2005. As of December 31, 2002, the maximum commitment contained in these agreements was $1.7 billion.

Given AON's net income of some $466 million, a "maximum" of $1.7 billion in potential commitments seems like something investors might want to better understand, especially given AON's potential commitments in this area rose about $300 million in the interim year. And what exactly are these "certain limitations"?

It's a good thing corporations aren't forced to accompany financial footnotes with music because a steam calliope would be the only suitable accompaniment to AON's description of its special purpose entities. Management does not get around to saying exactly what the "certain limitations" above might be. However, investors may be dazzled to know that some of AON's special purpose entities are in the Caymen Islands, and that one was "formed solely to issue notes to investors under a European Medium-Term Note Program", and that "the proceeds of the notes are used to purchase Funding Agreement policies". In the footnotes, words seem to be used to conceal facts about the intent, function and outcome of all of this, yet management exhibits both clarity and magnificent impunity about one point:

FASB Statement No. 140 provides that a QSPE should not be consolidated in the financial statements of a transferor or its affiliates (Aon's subsidiaries).

That is, regardless of whether you are dazzled or confused or completely stultified by AON management's description of certain SPEs, there's no law against what they are doing.

To be fair, careful readers will note that I am taking quotes from AON's footnotes out of context. But after reading all about AON's special purpose entities, I challenge any investor to clearly explain precisely how AON's SPEs work in any intelligible context.

Whoever does fully appreciate AON's SPEs probably also understands the magnitude of what management is doing in the pension department. Although the following can't really be seen on the balance sheet, and one must assemble the facts from scattered disclosures in the footnotes, management ultimately coughs up the fact that (1) AON's pension fund is underfunded, (2) they use a somewhat aggressive 8.5% expected return on pension investments (neatly situated just below the 9% expected return cut-off that the SEC says will trigger closer scrutiny), and (3) last fiscal year's pension losses ate away over $550 million in book value, after-tax. Since AON issued some $600 million of additional stock, the per-share change in book value is much larger than it initially appears. Obviously, there appears to be no problem with AON's pension fund making net income look better than it really is. The question is how greatly additional difficulties will contribute to reduced earnings and debits in book value. Concerning this and other points, management offers this remarkably scattered footnote disclosure:

For 2003, we project our pension expense to increase by $130 million over what was recorded in 2002. The increase in our pension expense was significantly impacted by the unrecognized loss of $1.6 billion at December 31, 2002. We also expect cash contributions for the defined benefit pension plans to increase by $40 million in 2003. In addition, under certain circumstances, we may be required to contribute significant additional amounts to our pension plans to satisfy provisions of the principal credit facility which supports our commercial paper program. We expect, however, to amend or replace such credit facilities.

Got that?

Who can say what a business like AON Corp. is worth? Personally, this issue seems priceless, as does most of what's currently billed as "cheap". What's disturbing is that in buying such ostensibly cheap stocks, one must pretty much ignore the significance of footnotes and hope for the best. Whatever such a discipline is, it should probably not be confused with value investing.

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