Showdown in the Sunshine State

Two of Wall Street's savviest value investors, Bruce Berkowitz and David Einhorn, pride themselves on their rigorous analysis. Now they're locked in a scorched-earth dispute over the value of some Florida real estate. How could they look at the same facts and reach such wildly different conclusions, and what does that say about the “value” of value investing?

You know a real-estate development is in trouble when the Hertz GPS denies that one of its major streets even exists. You really know it’s in trouble when Google Maps also shrugs, and asks if you wouldn’t like to know more about a similarly named town in Costa Rica.

I had gone to the Florida Panhandle to find out more about an outfit named the St. Joe Company. It sounds like the sort of place that makes designer coffee cake or handcrafted pine furniture, but until recently it was the largest landowner in Florida, a former timber barony that has spent the past decade or so transforming itself into a real-estate developer. Its current roster of developments covers acres of some of the world’s most beautiful beachfront property: sugar-white sand and emerald-green waters unfolding along a pristine, undeveloped coastline. If heaven has beaches, this is what they look like.

I was visiting the beaches because they seemed to hold the key to a very public dispute over the value of St. Joe Company’s assets, and its stock price, that was taking place between two money managers named David Einhorn and Bruce Berkowitz. Both are fairly famous “value investors” of the Warren Buffett school—that is, they rely on analyses of stocks’ fundamentals to reveal stocks that are exceptionally cheap, or outrageously expensive. Both had put rather a lot of money where their mouths were, and that money was talking, loudly. Einhorn’s money was shorting the stock, practically screaming that the company was way overvalued. Meanwhile, Berkowitz’s nearly 30 percent stake in St. Joe Company was proclaiming that the company’s best days were yet to come—and it was speaking not only for Berkowitz, but for all the individual investors who had poured billions into his Fairholme Funds. Like a lot of other people, including many money managers, I couldn’t understand how two very smart guys with strong track records could have such different—and vehement—opinions on what’s basically a simple real-estate operation. Even if both men are known for ignoring the herd and going their own way, shouldn’t we know by now which companies were going to recover from the bubble? So I headed to Florida, to survey the landscape over which this epic battle was taking place. That is, if I could get a GPS to take me there.

The street I was trying to reach was called Firefly Circle, part of St. Joe’s SummerCamp Beach development, where the company had a bunch of lots for sale. The firm’s Web site located it in an area called St. Teresa, about an hour south of Tallahassee. But no matter how frantically I stabbed at its buttons, the GPS was adamant: there was no such street. As I alternately swore and pleaded with the computer, I had the sardonic thought that my battle with the Hertz GPS was part of the larger dispute between Einhorn and Berkowitz: if you can’t find a development on a map, is it worth going there? Indeed, is it worth anything at all?

Eventually I stopped trying to reason with my consumer electronics and just started driving south. I figured I’d run into it—which I did, though I drove past it several times before I realized I was there. The eastern part of the panhandle is not the Florida of Miami Vice and Girls Gone Wild; it’s more like what you see in 1940s movies like Key Largo—empty, underdeveloped, and a bit haunting. SummerCamp Beach turned out to be acre upon acre of loblolly pine, a few houses scattered near the waterfront, and long suburban drives arcing through untouched forest. At 6:30 p.m., when I stopped in at the development’s lone restaurant for some pretty tasty fried shrimp, it was just me and a few retirees, none of whom seemed to live there; they were going to a 7 o’clock lecture at a nearby marine-research facility.

SummerCamp Beach was one of the places David Einhorn had highlighted in a 139-slide PowerPoint presentation before the New York Value Investing Congress in October. Einhorn spent an hour pounding home his argument that the company was grossly overvaluing the real-estate assets on its balance sheet. St. Joe Company had more than half a million acres of land, which it valued at about $750 million. And it derived most of that value from the 41,000 acres for which the company has development rights.

In fact, three St. Joe developments that still have many unsold lots, including SummerCamp Beach, account for almost $300 million of the company’s book value. But Einhorn thinks the real value of that land might be more like $40 million. His target value for the company is $7 to $10 per share, mostly from the rural land that the company is slowly selling off to fund its development operations. When he took the podium, the stock was trading around $24. And as had happened before when Einhorn had given one of his little talks, the effect was rather electric: St. Joe’s stock dropped almost 20 percent over the next couple of days.

And yet, places like SummerCamp Beach are exactly the future that Bruce Berkowitz is betting on. Berkowitz runs a nondiversified mutual-fund company, not a hedge fund, which means he doesn’t sell stocks short, just buys and holds them. He’s so good at it that Morningstar named him its domestic-stock-fund manager of the decade for the 2000s; he generated returns of 13.2 percent when the category average was pretty much zero. And he has bought and held quite a lot of St. Joe Company. Where Einhorn sees worthless pine trees, Berkowitz apparently sees a happy vision of the houses that will one day stand in their place.

Einhorn has a history of making bold short calls—as well as very public cases against the companies he’s shorted. Most famously, he shorted Lehman Brothers, told people the company was a house of cards—and was proved grimly right when the company, and the economy, imploded. More than a few people have argued that his public attacks on the companies he shorts are a rapacious attempt to create a self-fulfilling prophecy. CEOs, in particular, are fond of this argument.

Einhorn’s book on his six-year short of Allied Capital, Fooling Some of the People All of the Time, shows that he’s not above giving markets a push: hiring investigators, filing lawsuits, even getting regulators involved, all hastening the day when the companies he has shorted face a reckoning on the bourse. But it also conveys a sincere desire to fight the dark forces of fraudulent accounting—and for all the CEO complaints, Einhorn has uncovered malpractice at multiple companies. In asking essentially a single question—“Why are you carrying this asset on your books at that price?”—his dogged investigations have exposed not just overoptimistic valuations, but gross deceptions of investors and regulators, even fraud.

Einhorn isn’t suggesting that optimistic valuations are hiding darker secrets at St. Joe Company, but could that be the case? In January, after a number of shareholders started preparing to sue, the Securities and Exchange Commission announced that it was opening an informal inquiry into St. Joe’s accounting. But the parallels with Allied Capital and Lehman Brothers don’t quite work. St. Joe’s financial statements aren’t that hard to understand: the firm has a great deal of land and relatively few liabilities, and by Einhorn’s calculations it spends about $50 million a year to run operations. By contrast, the statements of financial firms like Allied and Lehman were a confusing tangle; only painstaking detective work uncovered their improper accounting for the default risk on the assets they owned, like loans and mortgage-backed securities.

Loans have a limited upside: they can’t really be worth more than the sum of the principal and the interest payments. So when companies didn’t factor in the risk that some of the loans would go bad, they were essentially valuing those assets at their maximum possible cash flow. Einhorn was saying the assets should be valued at what they could be sold for, not what the company thought they were “really worth”; that sale price would best reflect the riskiness of the assets.

That’s also what he’s saying about St. Joe Company’s real estate, but real estate is different: its value can, if conditions are right, go up quite a lot. Still, Einhorn’s argument seems compelling when you’re sitting in SummerCamp Beach’s empty restaurant, or walking, as I did the following day, through the vacant streets of WindMark Beach, his “favorite” of the St. Joe properties. Here, about an hour southeast of Panama City, everything has been laid out for a bustling community that has yet to arrive: stunning beaches, roads and boardwalks, even street lamps, and benches where neighbors can sit after a stroll. Only instead of houses, the streets are lined with neat rows of signs that name the owners of the empty lots, inviting writerly comparisons with grave markers.

The development’s commercial street looked to me more promising, at first; every building seemed to have a twee sign out front—and also a for lease sign in an empty window. Next to the main strip, a few houses had actually been built here and there—large, airy, comfortable-looking. But surrounded as they are by forlorn lots, they are somehow even more disturbing than the empty, waiting cul-de-sacs; the effect is that of one gleaming, pearly-white tooth jutting out of otherwise empty gums.

As Einhorn points out, speculators—or their bankers—own many of those empty lots and buildings, and they are eager to unload. This will undercut St. Joe’s ability to sell its remaining lots at the prices it needs to get. Meanwhile, taxes must be paid, a sales office must be maintained, headquarters must be subsidized. Unless people start coming, and building, one can argue that St. Joe’s real estate at WindMark isn’t so much an asset as a liability: to cover the carrying costs of residential land that can’t be sold, the company will have to continue selling off actually valuable rural land, until there’s nothing left. Walking through that commercial ghost town, I find it hard to disagree.

Bruce Berkowitz himself has said he doesn’t disagree with a lot of Einhorn’s points; he just differs in time horizon, vision—and his faith that management can be changed. While Einhorn wants St. Joe to cut its residential real-estate losses before the overhead eats up the remaining value in the timberland, Berkowitz wants to unlock the company’s potential. In the new year, he and his partner joined St. Joe’s board, floated a plan to streamline operations—and then startled everyone by resigning on Valentine’s Day, citing the board’s reluctance to confront management problems. “We may have a very different view with David on long-term asset value within the company,” Berkowitz told Reuters. “But we do agree that Joe has the wrong business plan, ineffective governance and needs to stop wasting stockholder money.” Berkowitz is still not giving up; as this article went to press, the resignations looked like the opening salvo in a fight for the board, which he may well win.

Despite all the hours I spent traipsing along empty roads, I’m not quite ready to bet against Berkowitz. For one thing, if you dig into the numbers in Einhorn’s presentation, you find that his $7-to-$10 estimate of the company’s share value is not all that different from the actual book value: $9.51 on the last financial statement. When Einhorn gave his speech, the company’s shares were trading at more than twice their book value. People weren’t buying the company for its liquidation value; they were buying it because they thought St. Joe Company’s land would be worth more in the future. That’s not a question of fraud; it’s a matter of opinion.

For Einhorn, good accounting seems almost like a truth potion: get the balance sheet right, and the “true value” of the stock follows. And for some of his short positions, that’s been true—it seems very unlikely that a change in strategy could have salvaged Allied’s dodgy loans. But changing the relative weights of timberland and residential developments on the balance sheet doesn’t tell us whether prices will recover—or whether management will get its act together. And no accounting method can make investors stop dreaming about those fabulous beaches. Frankly, trapped as I have been in the cold snaps gripping Washington, I’m dreaming of them myself.

For all the management woes, that optimism isn’t entirely crazy. A new, larger airport opened in May, linking the historically hard-to-reach area with regions outside the Deep South. Though Einhorn’s presentation outlined reasons that the airport will not be the boon that St. Joe claims, Buck Horne of Raymond James, a Florida-based financial-services firm, disagrees. According to Horne, traffic at the new airport is already at nearly triple the level of the old one, and has ample room to expand if necessary. And St. Joe Company, which provided the land for the airport, owns the ring of land immediately surrounding it; since the airport authority’s ability to develop its acreage for non-aviation uses is restricted, that’s a prime spot. Besides, the company still owns a substantial portion of the little remaining undeveloped waterfront not controlled by the state. And no one’s making more shoreline.

As of February 15, when we went to press, the company’s stock was trading up since October, at around $26 a share; a lot of investors still seem to believe in Florida real estate. So do the locals. I stopped in nearby Mexico Beach to see Ryan Harmon, whose family has been selling real estate for 30 years. He says that while prices are down by 50 to 60 percent since the peak of the bubble, they seem to have bottomed and he’s finally making more deals, with volume up 20 percent. And while almost all of his customers used to come from Tennessee, Georgia, or Alabama, he’s now seeing more buyers from Texas and beyond—a change he attributes to the airport. “I don’t think we’ll see prices move much in the next year,” he says, “but I do think we’ll clear out a lot of inventory.”

Of course, along lengthy stretches of the coastal highway, every third or fourth house seems to have a For Sale sign. Can even an influx of buyers from Texas and Maryland really buy up all that excess? More important, can they do it fast enough to save St. Joe Company and its shareholders?

Questions like these reflect the challenge of value investing in the present era. As originally practiced by value investors, stock-picking was something close to a sure thing: you looked for stocks trading close enough to their asset value that they provided a substantial “margin of safety” against loss, and you looked for business fundamentals that offered substantial upside in the future. These were relatively easy to find in the early part of the 20th century, when stocks were still seen as a relatively new, risky form of investing. That was especially true during the Great Depression, which hammered the market so badly that you could regularly find stocks trading below the liquidation value of the company’s assets—conditions that recurred, to a lesser extent, in the 1970s and in early 2009. Many people argue that stock markets have become much more efficient, thanks to more capital, a legion of professional analysts, and computing power that can screen thousands of stocks in a few seconds for anomalies such as a firm trading at less than its book value. As a result, the great deals that were available to famous value investors such as Warren Buffett are a lot harder to find. (See “What Would Warren Do?,” September 2009.)

That means value investing has had to get more sophisticated—and, one might argue, riskier—by taking more short positions, as Einhorn does, which can bankrupt someone who shorted a stock at $20 and has to cover that short at $100; by piling on more debt; or by investing in situations where a total loss is possible. Berkowitz remains on the conservative side, and he talks a lot about looking for that margin of safety, something offered by substantial real-estate assets like those controlled by St. Joe or by Sears Holdings, another longtime Berkowitz project. But even these can plummet in value. As a result, value investing can’t just be about the cool, clear logic of accounting. It involves educated guesses about the messy future of industries, technologies, and the macroeconomy.

Faced with this many intangibles, investors might find their best guide to be history—specifically that of the first Florida real-estate bubble. In the mid-1920s, Florida experienced a land boom that rivaled, even surpassed, the scale of the recent madness. The litany of justifications is eerily familiar: the beaches, the gentle tropical breezes, the endless sun, all were finally opened up to the teeming masses of the northeastern cities by the advent of the automobile. Between 1920 and 1925, Miami’s population more than doubled, as speculators swarmed south. Overstretched railroads devoted more and more of their freight space to food and building materials, and finally gave up on the building materials so that the swollen population could eat; one enterprising contractor found himself with a lot full of bathtubs, and no materials with which to build them into an apartment house. Meanwhile, the price of lots doubled, tripled, rose to 10 or 20 times their original value.

This obviously couldn’t last, and it didn’t; as Frederick Lewis Allen drolly noted, “Just as it began to be clear that a wholesale deflation was inevitable, two hurricanes showed what a Soothing Tropic Wind could do when it got a running start from the West Indies.” Florida land values collapsed, leaving behind bank failures, municipal defaults, and half-finished subdivisions crumbling into the sandy soil. The whole mess was memorialized by the Marx Brothers in their 1929 film, The Cocoanuts: “You can have any kind of a home you want to. You can even get stucco. Oh, how you can get stuck-o!” winked Groucho at feckless speculators, and many did; in the late ’20s, seemingly every town in America had its poor sap who lost his shirt in Florida. But the Florida bubble has been eclipsed by its more famous sibling, the 1929 stock-market crash.

Land values in Florida didn’t recover until after World War II. On the other hand, they did recover. The feverish deals that Groucho mocked ultimately gave us places like Coral Gables, Boca Raton, and Miami Beach, whose foundations were laid during that era. Many of the speculators who built them went broke—but their successors got very rich.

The development of the Florida Panhandle seems almost inevitable; there’s only so much beachfront left in Florida, and these beaches are particularly spectacular. But the pattern of that development, and when it will arrive, is harder to foresee. In the end, Berkowitz and Einhorn and all of us spectators have the same problem with Florida real estate as I did with my GPS. We know where we want to go. But we don’t know how to get there, or how long it will take.