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Another Edition
In an earlier article, I discussed the basics behind a very unique company, the Daily Journal Corporation (DJCO). Chaired by Charlie Munger, Warren Buffett's business partner, the company has been undergoing a gradual transformation from a sleepy (though profitable) regional legal publisher to a quasi-capital allocator and now, finally, into a technology company focused on a specific niche of software. Despite the fact that the Daily Journal Corporation has received significant media attention over the past year, I believe that much of this coverage is for the wrong reasons.
Many news sources have overemphasized the company's large holdings of marketable securities and though the situation is interesting, I believe the reason for holding such securities is largely being overlooked in favor of the "home run" nature of these investments. While helping to increase the share price of the company, the firm's "mystery" portfolio of marketable securities must be understood for their main purpose: to provide the core operations of the Daily Journal Corporation an internal source of funding which can be used to fund growth and expansion.
In this article I will briefly discuss the core business of the Daily Journal Corporation and its marketable securities holdings. I will then discuss the company's expansion into software, the need for software in the legal industry and the potential for further advantageous acquisitions to be realized in the near term as one of the Daily Journal's competitors experiences significant economic hardship.
The Numbers on The Daily Journal Corporation
Having experienced considerable appreciation in the past six months, the company now has a market capitalization of $222 million and is now priced at $160.96 per share. Despite having increased significantly in price during 2013, the company is still of small size. Insider ownership of the company remains high, currently standing at 32%. Though the P/E ratio of the company now stands at 50, it is important to emphasize that many traditional metrics are not applicable to this company due to the fact that its holdings of marketable securities of other companies dwarf the size of the company's current operating assets.
Roots In Legal Publishing
(Portions paraphrased from my earlier article)
Owning over 10 publications in the western and southwestern United States in the states of California, Arizona and Colorado, the physical publishing segment of the company caters to the legal industry. Many of the publications owned by the Daily Journal are known as "adjudicated papers," meaning that they exist to make information public (as required by law). The company publishes the California Lawyer, a trade magazine sent to every single lawyer in California containing regular reports and updates from the California bar.
Like many types of niche publishers, this company benefits from a lack of capital requirements and the ability to generate high returns on invested assets. Due to the fact that the company required little in the way of capital expenditure, had a consistent source of business and was profitable, it engaged in frequent acquisitions in its history, expanding outward from California and into neighboring states.
When no attractive acquisitions were found, the excess cash produced by the enterprise was invested into treasury securities...until the financial crisis hit.
"The Mystery Portfolio": Perceptions and Reality
Many companies use treasury securities as a way to store excess cash, as it provides a risk free source of revenue. Unless you are Charlie Munger and a financial crisis is going on. During the depths of the financial crisis, Charlie Munger deployed the company's cash and cash equivalent holdings into other investments. While he did not disclose the specific nature of these investments, they have appreciated significantly since the financial crisis, garnering the Daily Journal Corporation significant notoriety in the media, who were quick to dub the company a "Miniature Berkshire Hathaway (BRK.A) (BRK.B)."
One of the biggest misconceptions surrounding this company is the fact that many investors are content to believe that the Daily Journal is a "miniature Berkshire" or another capital allocator (such as White Mountains Insurance (WTM), Markel (MKL), Leucadia (LUK) etc...). Despite this oft-repeated characterization and a subsequent SEC inquiry rooted in the "miniature Berkshire" line of reasoning, this assumption has been sufficiently refuted by law firm of Munger, Tolles, & Olson (where Charlie Munger practiced law before withdrawing to fully concentrate on his investments).
The refutation of the SEC's attempt to characterize the company as an "investment company" (and thus impose additional regulations) provided investors valuable information about where the company is heading in the future, its core operations and future expansion potential.
Daily Journal's Response: Section 3(a)(1)(C) of the Investment Company Act (the "Act") defines an investment company as an issuer (i) "engaged … in the business of investing, reinvesting, owning, holding, or trading in securities" and (ii) whose assets are at least 40% investment securities. But Section 3(b)(1) of the Act exempts from this definition any issuer "primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities."
The Section 3(b)(1) exemption applies in this case because Daily Journal is not just "primarily" engaged in businesses other than investing - it is entirely engaged in other businesses. The Company and its two wholly-owned subsidiaries have nearly 275 employees and contractors, all of whom are engaged either in the publication of newspapers and magazines or the development and licensing of case management software.There is no question that Daily Journal's marketable securities currently exceed 40% of its total assets. This is due to the wise decision of the Board of Directors in 2009 to begin shifting the Company's cash and cash equivalents into marketable securities that have appreciated significantly. The Board recognized that this decision would be contrary to the conventional (but questionable) notion that the least risky way to preserve corporate capital for the long-term benefit of stockholders is to invest it in government bonds at interest rates approximating zero, notwithstanding rising inflation.
That the Company even had excess cash to invest is due primarily to the confluence of a unique aspect of its publishing business and the country's largest financial crisis in more than 70 years. The Company's newspapers are "adjudicated", which means they are eligible to publish legal notices, including notices of residential foreclosure sales that are required by California and Arizona law to be published by the foreclosure trustee in an adjudicated newspaper.
The Company aggressively competes for the opportunity to publish trustee foreclosure notices, and there were lots and lots of them to be published in California and Arizona beginning in 2006.
So, while the "Great Recession" ironically benefited Daily Journal, the Board knew that it needed to plan for the Company's post-recession operations. To do that, the Company needed to (1) hedge a very difficult environment for newspapers generally, (2) provide for an asset base from which to pursue attractive acquisition opportunities, and (3) establish a minimum net worth that would enable it to bid on significant government software contracts that the Company had been too small to qualify for in the past. Accordingly, the Board decided to purchase three securities selected by Charles Munger, the Company's non-executive chairman, and J.P. Guerin, the Company's vice-chairman. Those investments were quite successful, and the Company now holds positions in six securities.
From this response to the SEC, I believe that it is fairly obvious that The Daily Journal will not sell off any of its securities holdings to realize a profit in the near to medium future and instead it will be able to leverage the income generated by these holdings through dividends and interest payments to finance future growth.
While I will not speculate as to what is contained in this "mystery portfolio," many others have tried to speculate as to the contents. I will say that I believe that Wells Fargo (WFC) is a very likely component in this portfolio and its increasing dividend will furnish the Daily Journal with more funds to pursue growth through opportunistic acquisitions in its operating industries.
The Move Into Software
While the Daily Journal Corporation has received a large amount of press for the "grand slam" investments its chairman made during the financial crisis, it is important to understand just why Munger purchased these securities: In order to obtain a method of providing a stable foundation for the Daily Journal to grow and adapt to change conditions.
Charlie Munger and the management of the Daily Journal had been able to foresee the significant changes on the horizon which threatened to alter the dynamics of both the publishing and legal industry and thus maneuvered the Daily Journal in order to adapt and prosper to these changes.
For those that follow the investment strategy of Buffett and Munger, one will notice that technology is a sector that is largely absent from their portfolio, a fact that makes the Daily Journal's move into legal software particularly noteworthy. The company's software operations have also experienced growth. The company's initial subsidiary, Sustain Technologies, provides lawyers, judges and related individuals with the ability to automate many processes (such as issuing notices, accounting, time management) that would normally be performed by hand. Given both the high hourly expense of legal work and the significant backlog of legal cases awaiting trial, any software that expedites the process is a welcome addition.
The company has also expanded in the software space through a recent acquisition late in 2013, acquiring the assets of the ISD Corporation. The ISD Corporation produces several types of software that facilitate the payment of court fines, enable the electronic filing of documents and help to both manage cases and facilitate probation monitoring and related recordkeeping.
Why Legal Software?: Bringing Efficiency To an Inefficient Industry
For a long period of time, law was an industry insulated from the inroads of technology, making it extremely difficult for any efficiencies to be realized due to the nature of the work (which required human reasoning, a lot of reading and extensive manual research). Large law firms in particular are often derided for billing an enormous amount of hours relative to the final work product achieved and though this is often an unfair characterization by angry clients, the process of legal work and research is both time consuming and inefficient.
In recent years, innovations in legal software, such as WestLaw (owned by Thomson Reuters (TRI)) or LexisNexis (owned by Reed Elsevier (RUK)) have enabled attorneys to search and cite relevant cases and data in minutes or hours rather than spending days or weeks to research by hand through tomes of federal, state or county case law. Since a large amount of legal work is done on a per-hour basis, any product that allows for time reduction yields substantial savings. The software itself is also extremely expensive to use and license for those using it, in some cases costing over a hundred dollars per search and over ten dollars per minute for large institutional customers.
The investments made by the Daily Journal Corporation into legal software to help automate and expedite other aspects of the judicial process represent another important addition to legal technology that has the potential to grow into a very profitable business over time as these systems gain increased acceptance.
I am also of the belief that there is more room to grow for the Daily Journal to grow this segment of its business, both due to the accelerating pace of software innovation in the legal space over the long term as well as the financial difficulties currently being experienced by a competitor of the Daily Journal Corporation in the same field.
Situated To Benefit From The Reorganization of The Dolan Company
Though the legal software and legal publishing sectors are small, the Daily Journal is not without competitors. One such competitor is the Dolan Company (DM) which, per Google Finance, "operates through two operating divisions: its Professional Services Division and its Business Information Division. Its Professional Services Division consists of two segments: mortgage default processing services and litigation support services. Its Business Information Division produces legal publications, business journals, court and commercial media, other online information products and services, and operates Websites and produces events for targeted professional audiences in 21 geographic markets across the United States. Its information is delivered through a variety of methods, including approximately 60 print publications and 80 Websites."
Despite the fact that the Dolan Company operates in the same industry, it has not enjoyed the same prosperity as the Daily Journal Corporation and is now undergoing a reorganization and could ultimately face bankruptcy or controlled liquidation. The Dolan Company has already engaged in asset divestitures in an attempt to regain a sound financial position which, from a mere glance at the performance of the common stock and preferred equity of the company, indicates the potential for more assets to be sold at distressed prices as this period of restructuring continues.
The woes experienced by the Dolan Company provide a vivid contrast with the strength of Charlie Munger's capital allocation strategy devised during the financial crisis, as the Daily Journal now enjoys a high degree of protection due to dividend and interest income generated from its marketable securities holdings and thus is insulated from downturns in its core legal business.
Given the past examples of Charlie Munger's investment habits and his knowledge of the legal field (Munger is himself a Harvard Law graduate), I believe that it is not unreasonable to believe that the Daily Journal Corporation will be well situated to make advantageous acquisitions from the Dolan Company in the near future.
These acquisitions could come in the form of conventional legal publications such as adjudicated papers (for example, the Dolan Company owns a significant stake in the Detroit Legal News (OTCPK:DTRL) in addition to many other publications), or, more interestingly in my mind, technology assets to supplement the Daily Journal's growing legal software portfolio.
One particularly attractive software asset owned by the Dolan Company is DiscoverReady LLC, a company which produces document review software using sophisticated predictive coding to scan tens of thousands of pages in a fraction of time (and for a fraction of the cost) it would take a lawyer.
Risks
It is also important to understand that the Software portion of the company's operations is still in its growth and development phases and is vulnerable to competition from larger companies in the enterprise software sector and consequently there is the possibility that the company could engage in protracted competition with a larger player in the software market.
Another important thing for investors to be aware of is that the value of the securities held by the company is vulnerable to broader market volatility. While I do not believe that fluctuations of price have any significant effects on the earning power of the Daily Journal in the long run, I believe that should one of the companies in the "mystery" portfolio reduce or halt dividend payments that the earning power of the Daily Journal could be impacted. Another element of risk in this area is that investors are not precisely aware of what they are purchasing and some could be uncomfortable with that fact. I for one trust the judgment of the company's chairman implicitly.
From a technical perspective, it is also important for investors to understand that the shares of the company are very illiquid due to its obscure nature and high levels of insider ownership. This illiquidity makes the stock vulnerable to periods of volatility that are not related to the operations of the company, as can be seen if one were to examine the company's performance over the past year.
Final Thoughts: Come For The Securities, Stay For the Growth
In addition to the company's core publishing business, the company also offers shareholders exposure to long-term growth in the Legal Software space through recent acquisitions. I believe that this portion of the SaaS market (Software as a Service) will continue to grow as both governments and private individuals seek to cut legal costs, improve case management and reduce court backlogs.
In the short term, I believe that the Daily Journal is extremely well positioned to benefit from the difficulties encountered by the Dolan Company, a competitor in the legal software and publishing market.
Should the Dolan Company be further forced to divest assets, I am of the opinion that the Daily Journal Corporation is extremely well placed to profit from these events and will have the opportunity to expand both through acquiring more physical publishing assets in addition to software offerings.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DJCO, over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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