I mapped out my 2006 investing strategy back at the end of September. It was simple: Buy Fairmont Hotels & Resorts (NYSE:FHR). It was a straightforward asset play. The company's balance sheet sorely undervalued its real estate because accounting rules do not allow assets to be marked up. As a result, Fairmont's properties are carried on the balance sheet at their acquisition value -- an event that in some cases took place decades ago. But as Fools are certainly aware, real estate tends to appreciate over time.
When Bill Mann discovered this company for Motley Fool Hidden Gems subscribers, he estimated that the present value of the real estate alone more than covered the company's $2 billion market cap. That meant the hotel management business was free, and it didn't take me more than a few quick looks at the income statement -- $200 million in EBITDA -- to figure that free was a pretty good price to pay. Time was all it would take. I had my strategy for the year.
And then Carl Icahn stepped into the sandbox.
Crazy Carl
On Nov. 8, Mr. Icahn disclosed that he and affiliated interests owned a little more than 9% of Fairmont's outstanding shares. According to Fairmont CEO William Fatt, "The filing persons indicate an intention to encourage Fairmont to maximize the value of Fairmont for its shareholders." This means that Icahn -- like Bill, like me, and like Fairmont management itself -- saw pretty clearly that the market was way off in its assessment of Fairmont's worth. Between the brand, the business, and the real estate, I estimated Fairmont to be a potential double a few years down the road and eventual total returns that would annualize north of 15%.
While I'm fairly patient, Mr. Icahn is more of the git-r-done type. From his hostile takeover of TWA in 1985 to more recent efforts to oust Blockbuster's (NYSE:BBI) leadership and potentially oust Richard Parsons from the Time Warner (NYSE:TWX) board (not, for the record, an executive that makes my list of the top 10 execs in need of ousting), Icahn has long been willing to bend some fingers to make a quick return, even where time could yield a somewhat larger reward.
Nevertheless, Mr. Icahn did not become a billionaire by being passive. And I view the current situation as bittersweet. While I need to figure out a new 2006 buying strategy, my portfolio has benefited from Fairmont's approximately 25% price appreciation since Mr. Icahn announced his interest. And now, Mr. Icahn has announced a $1.19 billion deal to take majority control of the company. I won't be accepting that tender offer -- and I hope other Fairmont investors won't, either -- because we can do better. (The company has rejected the bid.)
But Fairmont has a diffuse ownership base. The company was spun off in 2001 by the formerly widely held conglomerate Canadian Pacific. With officers and directors of Fairmont holding only 0.12% of the company (75% is held by institutions), Icahn likely believes it will be difficult for shareholders to unite against him, particularly when staring at an already nice short-term return. Yet a look at the institutional holders gives me some confidence that management has allies in T. Rowe Price (9% as of Sept. 30) and Marty Whitman's Third Avenue Management (2.5% as of Sept. 30), among others. Marty Whitman, for example, is a revered value guru with a long time horizon. Fairmont is a top 10 holding in Third Avenue Real Estate Value, along with historical outperformers such as Vornado (NYSE:VNO) and St. Joe (NYSE:JOE). The fund boasts five-year annualized returns of nearly 20%.
The benefits of buyouts
There will be some fireworks at Fairmont before it's all sorted out, and I'm confident that Hidden Gems subscribers will do well on the deal -- either 25% sooner or much more later. But the Hidden Gems team is getting used to this. Shire (NASDAQ:SHPGY) bought out Transkaryotic not too long ago for what ended up as a 230% return for subscribers. And Stride Rite (NYSE:SRR) nabbed Saucony, earning subscribers 160% returns. These events have helped the scorecard, to be sure: The team's portfolio of picks is beating the market by 20 percentage points since July 2003. But we all feel pretty strongly that they'd be doing even better if nothing had ever been bought out at all.
When you make your living finding underappreciated, underfollowed small caps that have outsized growth prospects relative to market value, buyouts are a fact of the marketplace. And just like master investor Marty Whitman, Bill Mann and Fool co-founder Tom Gardner are very good at it. To see their best ideas and join a community of investors that is thousands strong, click here to take a 30-day free trial to Motley Fool Hidden Gems. There is no obligation to subscribe and you'll enjoy immediate access to all of our research and our discussion boards, and a subscription will even get you a free copy of our brand-new Stocks 2006 report.
Tim Hanson owns shares of Fairmont Hotels and Time Warner. Time Warner is a Motley Fool Stock Advisor recommendation. The Motley Fool has adisclosure policy.
