Deferred Gratification: The Case Study of the Daily Journal Corporation

Category: Equities, Markets 1,041

“If you haven’t prepared, you won’t have the courage to seize it. When I bought all that stock that the Daily Journal has in, like, one day…I knew something about Bank of America. I’ve lived in the culture, I’ve known the Bank of America bankers, I know a lot about what’s right with it and what’s wrong with it. I knew a lot about Wells Fargo. I knew a lot about U.S. Bank.”

“I talked about patience. I have read Barron’s for fifty years. In fifty years I found one investment opportunity in Barron’s, out of which I made about $80 million with almost no risk. I took the $80 million and gave it to Li Lu, who turned it into $400 or $500 million. So, I have made $400 or $500 million from reading Barron’s for fifty years and finding one idea. Now, that doesn’t help you very much, does it? Well, I’m sorry, but that’s the way it really happened.”

– Charlie Munger, 2017

The Charlie Munger faithful were recently treated to another annual meeting of The Daily Journal Corporation, a company in which the billionaire is Chairman. Of course, Munger’s notoriety is mostly attributable to his role as Vice Chairman of Berkshire Hathaway. The Daily Journal Corporation has published legal newspapers for many years, relying primarily on public notice advertising for income. Public notice advertising is advertising that is required legally for certain notices to be placed in a newspaper approved by the courts. More recently, Munger has invested the Daily Journal’s excess cash in common stocks and corporate bonds – which is what has attracted it so much attention over the previous decade – and created a software company through acquisitions called Journal Technologies.

Since Munger is the Chairman of the company and the individual primarily in charge of capital allocation, it is no surprise that Daily Journal’s success has his fingerprints on it, although Gerald Salzman, who has run the day to day operations for many years, does not receive as much credit as he probably deserves. The Daily Journal specifically illustrates Munger’s oft-repeated admonition to ‘defer gratification’ throughout life and investing.

“It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.”

It is a peculiar comment to make to investors because the act of investing is an act of deferred gratification (unless someone is investing with debt). Saving and investing requires deferring consumption now in the hope that later, more consumption is possible. But, this principle of deferred gratification can also be applied with more nuance, and the manner in which Daily Journal has been run provides some terrific examples.

The Daily Journal’s purchases of marketable securities are a very good example of this practice in action, but the management of Journal Technologies also provides plenty of lessons for business owners and managers. Both are discussed at some length below.

Some Background

One of Munger’s previous law partners was hired to oversee the sale of the Los Angeles Daily Journal in 1977, inciting a bid from Munger of $2.5 million, which he won. The purchase was made through the New America Fund. That fund was a closed-end fund that Munger had purchased in his previous investment partnership below its net asset value and moved its philosophy into value investing. J.P. Guerin was Munger’s partner at the New America Fund and when the fund liquidated in 1986, Daily Journal shares were distributed to owners of the fund, with a large share going to Munger and Guerin. Acquisitions over time brought additional legal publications into the fold.

Once attractive acquisitions in the publishing field became scarcer and it also became clear that the world was becoming less kind to print publishing, the company would often invest its excess cash in treasury bills and notes. By the end of 1998, the company’s cash and treasuries balance was $13 million, and $6.7 million of that balance was used to purchase 80% of a software company called Choice Information Systems, which was renamed Sustain Technologies. In its first year as part of The Daily Journal Corporation, it had revenues of $1.3 million. Following the acquisition, Munger once again began doing little with excess cash besides purchasing treasuries. Then, one of the best things to ever happen to The Daily Journal Corporation occurred: the global economy went into a severe financial crisis.

The financial crisis contributed to the good fortune of Daily Journal in two ways. First, it substantially increased the demand for foreclosure notices to be published in the company’s newspapers. Cash flow from operations was $2.8 million in 2006, but increased to $5.0 million in 2007, $6.6 million in 2008, and $8.4 million in 2009. By the end of 2008, the company’s cash and treasuries position had grown to $23 million, which could be put to work because of the second way the financial crisis benefited the company: extremely attractive investment opportunities had become available.

Marketable Securities

The quote at the beginning of this article regarding Wells Fargo, U.S. Bancorp, and Bank of America is instructive. Munger very well may have purchased the Daily Journal’s entire stake in Wells Fargo and U.S. Bank on the same day in March 2009. During that quarter he invested $15.5 million of Daily Journal’s funds in those two common stocks, which today are worth a little more than $100 million.

The following quarter, a corporate bond was purchased for $4.9 million. The timing and the price fluctuations of the corporate bond strongly indicate that it is Dow Chemical bonds that are due in May 2039 that were purchased in the secondary market shortly after issuance, with a $5 million par amount and a coupon of 9.4%. The previous year, Dow Chemical had agreed to buy Rohm and Haas for $19 billion, with Berkshire Hathaway agreeing to provide $3 billion of the funding at an 8.5% interest rate in securities convertible to common shares. After Dow Chemical dragged its feet for a period of time, it closed the deal with funds raised through preferred equity and a bridge loan in the spring of 2009. The May issuance of long-term bonds was part of Dow’s efforts to pay off the immediate bridge loan with longer-term financing.

From his comments, but also simply based upon what he had bought, it is apparent that when action was taken Munger did not spend much time researching investment options. That was because he had spent his life already doing so, even though it was not always immediately apparent that he could put that knowledge to use. That is two-fold deferred gratification: compounding knowledge waiting for good moments to deploy it and refusing to invest every cent of cash as it came in immediately but letting it pile up on multiple occasions in savings vehicles. This is not the typical result in corporations. That is partly because corporations that maintain excess cash are seen as inefficient by many market participants and are targeted by activists who demand share buybacks, acquisitions, or special dividends. Individuals do not have to experience this sort of pressure, but they often make the same mistake because they implicitly refuse deferred gratification and consistently invest in whatever the best option in front of them currently is rather than being patient.

It is also worth mentioning that the 2009 investments did not work out as well as they have because of intelligence or knowledge. Most market participants are aware of which businesses are good and which are not and everyone knew in the spring of 2009 that Wells Fargo was the bank that was the healthiest among the large financial banks. JP Morgan Chase also exited the financial crisis in good shape, but because of its investment banking franchise, it was harder to gauge what the future of the bank was. In other words, the investment was not successful because Munger knew something other people did not or information that was non-public. He had funds that others did not and he had spent his life feeling comfortable enough about the businesses that when a difficult situation arose he was able to invest with conviction.

Munger also clearly wanted securities that could enhance the cash flow of the corporation and give it flexibility when the surge of foreclosure notices subsided. Wells Fargo and U.S. Bancorp were forced to severely curtail their dividends but later restored them as the economy stabilized. The Dow Chemical bonds were available at an interest rate more than a point higher than what Berkshire Hathaway received. Daily Journal is receiving $5 million annually in interest and dividends, but $3 million of that total comes from the purchases made in 2009 of Wells Fargo, U.S. Bancorp, and Dow Chemical bonds.

During the spring and summer of 2011, purchases were also made of BYD and Posco. BYD is a Chinese company that has been involved in several businesses such as manufacturing batteries and producing electric vehicles. Posco is a Korean steelmaker and has been the only mistake in Daily Journal’s portfolio. The company took write-downs on its Posco position until much of it was sold late in 2014. The BYD position, however, has been a home run.

The BYD investment came during a period of time when Chinese GDP was decelerating and automobile demand was becoming more uncertain. In the summer of 2012, an article was published on Fortune’s website which said the following:

“Chinese car and battery manufacturer BYD has not been Warren Buffett’s most successful investment, and another poor earnings report came out on Friday. The company announced that its net profit decreased almost 90% year over year to RMB27 million. The news sent shares down almost 3%, bringing the stock down almost 74% for the last five years.

Buffett’s history with the company began in 2009, when he bought 10% of the company for $230 million, or slightly over $1 per share, on an idea from his partner, Charlie Munger. As recently as the second quarter of 2012, Berkshire Hathaway subsidiary MidAmerican Energy is the company’s second-largest shareholder.”

A chart of BYD’s stock price over the previous ten years is below. Munger’s purchases came during the two periods of time in 2011 and 2012 when the price dropped below $2 per share. (Munger purchased H-shares on the Hong Kong market. The chart below is of those same H-shares traded OTC in US$.)

Berkshire Hathaway’s $230 million investment in BYD came in September 2008. At the time it was widely reported that the investment was discovered by Li Lu and that Berkshire’s involvement came via Charlie Munger. After the investment was made and the stock soared, many stated that similar investments were often unavailable to the average investor and that the very fact Berkshire Hathaway had made the investment caused the investment to perform well. Later, when the stock dropped from earlier highs, others speculated that it was a terrible decision that had worked out poorly. Berkshire’s stake today is worth about $2.1 billion, good for an annualized return of about 26% per year.

The decline in the stock price had given Munger a gift that he did not pass on, and one that was widely available to other investors. Understanding the Daily Journal’s cost basis in BYD requires some estimates as to how much Posco and BYD were being bought at any given time, but because write-downs were later taken on Posco and much of it was sold for close to its adjusted cost basis, a reasonable estimate of the cost basis in BYD can be made, which is about $8.5 million for 5 million “H” shares, or about US$1.70 per share. The purchases were done three to four years after Berkshire’s investment at a higher cost. But, the stake is still worth $44 million as of the end of 2017.

A final investment worthy of considering is Bank of America, which was made at a cost of $13.6 million, $5.90 per share, in the final months of 2011. That August, Berkshire announced a $5 billion investment in Bank of America in the form of preferred shares that came with warrants. By the time of Munger’s investment, the Berkshire investment had already been widely disseminated. In fact, Berkshire’s warrants were exercisable at $7.14 per share. Following the investment, the stock popped, but then fell further because of lingering concerns regarding Bank of America’s contingent mortgage liabilities.

Over the previous couple of years, Daily Journal has also invested about $20 million in foreign securities and today owns seven securities in their portfolio. It is not possible to identify this seventh security because it is not possible to know if Munger was only buying this security over this period of time or if he was also adding to the BYD position. At present, the Daily Journal owns at least 5 million BYD “H” shares, but could possibly own more.

The chart below is a very close approximation of cost and market values for the securities in the Daily Journal portfolio.

Journal Technologies

Deferred gratification can be found within the business operations as well. It is not worth dwelling excessively on the publishing business, even though examples of deferred gratification exist here as well, such as the decision to sustain continual losses at The San Francisco Daily Journal prior to it prevailing over competitors. It is a certainty that it will continue declining and eroding in value. It also seems likely that at some point in the future laws requiring the placement of public notice advertising in adjudicated journals will be revisited.

Perhaps the best example of deferred gratification in operating a business is Jeff Bezos and Amazon. Amazon has consistently under-earned what it is capable of so that funds could be used to maintain a dominant e-commerce platform and create the Amazon Web Services business, among others. Journal Technologies is engaging in a similar experiment at a much smaller scale.

The Daily Journal’s experience with software dates back to the acquisition of Sustain Technologies in 1999. That business was managed well and grew quickly. In its first year under Daily Journal ownership, Sustain earned revenue of $1.3 million. Before the recession hit results, revenue had grown to $4.9 million. But, Sustain was never going to have the scale it needed to succeed in software. Having only 30 employees at the time additional software companies were purchased, it was unlikely that the necessary scale in the development and maintenance of software was available. Two additional companies were purchased in 2012 and 2013, New Dawn and ISD, for a combined $30 million, that greatly aided in reaching a level of scale that would give the combined operations a plausible route to success.

Today, 205 are employed by Journal Technologies, up from 140 employees immediately after New Dawn and ISD were acquired. Overall compensation expenses have soared from $19 million in 2013 to $32 million in 2017, resulting in losses that have steepened. Those employees have been hired mainly to improve the case management software of Journal Technologies.

Munger has often commented on how hard of a business case management software is. It takes a long time to reap rewards following an initial client contact and dealing with courts is not generally easy. But, that means that many potential competitors never enter the space and once a client is gained and the software is installed, the business tends to be very sticky. Looking through the financial statements so far for Journal Technologies is not very gratifying, but there is good reason to believe that that gratification has been deferred rather than absent.

Journal Technologies classifies its revenue in three categories: licensing and maintenance fees, consulting, and other public service fees. New Dawn and ISD both had contracts acquired along with the companies that have been run-off, creating a revenue headwind. The other public service fees revenue is generated from commissions received when traffic tickets are paid online using Journal Technologies’ software. That part of the business has also contracted, perhaps largely because of amnesty programs implemented by California. It appears, though, that these headwinds have mostly been absorbed into the income statement. In the most recent quarter, other public service fees showed growth for the first time in several years and licensing, maintenance, and consulting revenues may be starting to accelerate.

If desired, Journal Technologies could be managed to show a profit within the next couple of years, but it is not possible to determine right now where the inflection point will be when management decides that incremental revenues should no longer be entirely invested back into software development. Over the previous year, Journal Technologies has lost $8.5 million after excluding expenses for the amortization of intangible assets. It lost $8 million in 2017 and $3 million in 2016. However, if this quarter truly marked the end of the decline in public service fees, then revenue growth is very likely to compound at higher rates than the past several years.

Lessons for Business Owners and Investors

Because of the crowd that Charlie Munger attracts, most of his followers cling to what they can learn about purchasing securities, and the Daily Journal is a wonderful case study on the management of a securities portfolio. But, the lessons for owners and managers of businesses should not be neglected. Deferred gratification is just as important of a concept for the running of a business as it is for investing in businesses. Specifically, it is not always necessary to gain an edge by trying to solve easy problems, in fact, solving harder problems is often more profitable in the long-run because as gains are made, the competitive advantages embedded in a business become harder and harder to take away.

Even individuals engaged in providing professional services can benefit from the case study of the Daily Journal. Often times, professionals focus inordinate amounts of energy and time marketing their services through social media and search engine optimization or through networking. While not strictly a waste, deferred gratification would lend one to focus instead on doing the absolute best possible job in solving their client’s most difficult problems and continuing to compound knowledge in their chosen field. As time passes, it may feel like nothing is being achieved, but the more effort that is invested in delivering a superior client experience, the more separation between the professional and peers will take place.

As investors will always be asking, is the Daily Journal Corporation an attractive investment now? It is certainly not priced to be an immediate home run and uncertainty regarding succession planning should always be in investors minds. The company did just receive a big boost from tax reform that lowered the deferred taxes on investment gains by $15 million. The securities portfolio of $250 million netted against a $29 million margin loan, a $2 million mortgage on Journal Technologies’ headquarters, and $50 million in deferred taxes, is worth $170 million against a market capitalization of $310 million.

The traditional business is dying and generating revenue of just $17.6 million now. It may have one more life left if foreclosures again increase, but with the world becoming more and more digital it is very hard to believe that at some point in the future laws regarding public notice advertising are not changed. A basket of publicly traded local newspaper stocks trade for an enterprise to sales ratio of 80%, valuing Daily Journal’s publishing business at $14 million. That number may be too optimistic, although the company does own its headquarters in Los Angeles, where little to no work for Journal Technologies is taking place. It has a value of $25 million – $30 million, so if the business was ever exited or sold, valuable real estate would be freed up with a value in excess of the publishing assets.

An article was recently published that claimed that the Daily Journal was now a tracking stock for Wells Fargo. That is not quite the entire story, despite the large stake that the company holds. The article also noted that the software business was bleeding money and not presently attractive. The article is not linked because the purpose here is not to disparage anyone, but it is not the proper way to understand the Daily Journal Corporation.

The main determinant of Daily Journal’s future value will be the performance of the software company and owners should actually wish for it to presently bleed money rather than gratify themselves immediately by maximizing present income. The securities that are producing $5 million in dividends annually are going to aid the company in having the financial stability to invest in software and build a terrific franchise.

Tyler Technologies is the most direct competitor to Journal Technologies and it currently trades at an enterprise value to sales ratio of 8.2. Interestingly, Lou Simpson, the former portfolio manager at GEICO, has about 5% of his investment portfolio currently in Tyler Technologies. Journal Technologies is worth $200 million at the same multiple. That valuation is not as crazy as it may seem. Successful software companies deserve generous price to sales multiples because as growth comes, the growth is almost all incremental profit. Most software companies have a gross margin of 90%. The business is also clearly gaining traction and is being run in the right way, which is to not go crazy trying to spend every available resource in marketing, but to invest relatively large sums in creating the kind of product it would want to buy. With each installation and with each relationship, the company learns more about the specific needs of clients and can then incorporate that into future software updates, leading to a virtuous cycle of product development. The odds favor Journal Technologies strongly in future success and that success or failure will determine the outcome of an investment in Daily Journal common stock today.

A reasonable fair value for the company is roughly $400 million, combining the divisional valuations and making an adjustment to deferred taxes since the securities are most likely to be held. Today’s price is a 20% discount to that value, which is good but not great. The price has not moved much since 2015. The wise course would be to keep an eye on the company and if market fluctuations drive the share price down much lower than today’s, perhaps because of a general market selloff, be ready to accumulate shares. That is a strategy which Charlie Munger himself could approve.

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