Warren Buffett’s heir apparent?

We’re all looking for the second coming of Warren Buffett, but few of us are brave enough to declare we might have found the new messiah.

But one US money manager, Christopher Mittleman of Mittleman Brothers Investment Management, has gone out on a limb and nominated his potential successor: billionaire hedge fund investor Philip Falcone.

It’s a controversial choice because Falcone is, in the words of the New York Times, currently described as “embattled“.

After making $US1.7 billion by betting on the sub-prime collapse in 2007, Falcone has been embroiled in a serious of controversies, including the relatively poor performance of his fund, a decision to restrict withdrawals by investors, an investigation into the use of company funds to pay a $US113 million tax debt, and a highly-speculative investment in broadband.

Those issues have seen the share price of Falcone’s public investment company Harbinger Group fall from around $US7.40 two years ago to a low of about $US4.00 a week ago (the price has since recovered to $US5.12).

But Mittleman remains undaunted.

“Billionaire investors go in and out of favour, just like stocks,” he says in his letter.

“And while the main impetus behind our interest in Harbinger Group is that their largest assets appear to offer 100% upside potential, we also think Falcone’s investment acumen, access to capital and deal flow are not properly appreciated by the market at Harbinger Group current price.”

So who his Philip Falcone? And why is he controversial?

Junk bonds to hairbrushes

Falcon grew up in Chisholm, Minnesota, an old iron mining town south of the Canadian border. The youngest of nine children, he was an ice hockey player for went to Harvard on an athletic scholarship and briefly pursued a professional sporting career after graduation.

But when injury ended his dreams of hockey stardom, he turned to Wall Street, joining Kidder Peabody as a bond trader before he joined Barclays Capital.

In 1990, Falcone left Wall Street to have a crack at running his own business. With an old friend from Harvard, he pledged all his assets and borrowed heavily to buy a New Jersey-based hairbrush manufacturer called AAB Manufacturing.

It was a disaster. Falcone first discovered the company had overestimated its inventory and was hit by the collapse of its biggest customers. He lost everything and would not finish repaying the company’s creditors for seven years.

In 2001, Falcone joined Harbert Management Corporation and established a $25 million fund to buy distressed bonds in companies heading for bankruptcy.

Australian success

Ironically though, one of his big wins was a company on the rise – Andrew Forrest’s Fortescue Mining. Harbinger bought its original 5% stake in the company at 60c a share, and eventually owned a 9.5% stake that it started selling off in 2010, as the resource rent tax was floated by Kevin Rudd. By then, the shares were trading well above $5.

By 2006, the Fortescue investment and other successes meant Forrest had $US5 billion under management. He was starting to get interested in subprime and by 2007 had bet $US15 million – two thirds of it borrowed – shorting stocks.

“Once I get a conviction, I move big and quickly,” he told Vanity Fair in July.

His big bet came off. Falcone personally made $US1.7 billion from sub-prime disaster and his fund returned a staggering 166% in the 2007-08 year.

But then things started to go awry. In late 2008, Falcone experienced what he calls the “worst day of my life” when he lost $US1 billion in a day trying to sort financial services giant Wachovia (although he did eventually profit from shorting the stock).

A sudden fall

In the 2008-09 year, the Harbinger fund fell 22%. On Christmas Eve, Falcone angered some investors by effectively capping the amount they could withdraw from his fund in one quarter. While the fund would return 47% in 2009-10, some of the gloss was wearing off Falcone.

Investors were puzzled by his $500 million investment in the New York Times Company, built up in 2007 and offloaded in 2009 for half the price. “I’m not afraid to admit when I make a mistake, and that was not one of my best trades,” he told Vanity Fair.

There was also the matter of his huge investment in a company called LightSquared, a company that will develop a 4G network that aims to deliver cheaper mobile internet services to 100 million Americans.

Harbinger has sunk more than $US3 billion into the venture, which may need as much as $US14 billion over eight years to build its network. Many commentators have expressed concern that Falcone may run out of cash before his dream can be realised.

Falcone remains undaunted.

“We’ve got one of the most valuable and limited resources in the United States,” he told Forbes last year.

“Over the past five years I’ve seen the potential of investing in this asset and building a business that will have a direct and positive impact on the lives of millions of Americans.”

Investors aren’t so sure. The $US26 billion he owned as the peak of his powers following the sub-prime crash is now down to about $UIS7.5 billion.

Undervalued?

If Falcone is having such as bad trot, why does Charles Mittleman see such promise?

The answer lies in the purchase of two businesses that Harbinger acquired earlier this year: Spectrum Brands and an insurance company called Fidelity & Guaranty Life (formerly known as Old Mutual US Life Holdings).

Mittleman describes Spectrum, which owns Rayovac batteries, Remington personal grooming products and home and garden products like Hot Shot, Cutter and Spectracide, as being “recession proof” and “ridiculously undervalued”.

Looking at the insurance business, he says Falcone is well place to improve the returns on its “massive” $US1.7 billion of assets under management for “huge returns”.

Mittleman is essentially betting that Falcone can replicate Warren Buffett’s ability to unlock value in underperforming companies.

“When exceptional investors and/or business operators take control of otherwise unremarkable public corporations, it’s often a prelude to a lucrative transformation of which outside investors can also take advantage, if they happen to notice what’s going on before Wall Street wakes up to metamorphosis in progress,” he wrote.

Another positive for Mittleman is that the publicly listed Harbinger Group is separate to Falcone’s investments in LightSquared.

At least the New York-based money manager isn’t betting on a quitter.

“You take your lumps and get your bruises. You get knocked down. The key is getting back up,” Falcone told Vanity Fair.

“I’m already standing. I’m 48. It’s not even the second period of my career, and I’ve had a pretty good first period.”

Charles Mittleman will be hoping Falcone’s best is still to come.