People far and near have wondered what Seth Klarman's inflation hedge is! In a Columbia Business School conference he said (along with other nibbles n bits), "We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges."
Only a part of his portfolio is disclosed publicly, a lot of his portfolio consists of distressed debt and derivatives which do not have to be disclosed. But from what he has disclosed I think I might have an answer! The popular view is that there will be some deflation, followed by massive inflation (the printing press is in overdrive). Now to be clear, I have no idea what the macro situation would be tomorrow or in 3-5 years (too many variables!), I am just making a humble attempt - trying to analyze his comment.
Energy MLP's, I think is the answer. He owns Linn Energy (LINE), Breitburn Energy (BBEP) and Atlas Pipeline Partners (APL). Why? I will explain the picks later, but the short answer is this: These MLP's have yields of around 20-50% right now and their oil production is hedged 5 years forward at oil prices of around $80/bbl and gas prices of around $8.50/mcf. This means the yield is 'safe' (if its really safe can only be determined by extensive DD) and that if we have any amount of deflation, the yield will more than make up for it. Now in 3-5 years if we have inflation the USD will probably depreciate and oil - priced in USD (and perhaps gold and other commodities) will appreciate as we saw in the last few years. The MLP's will again be able to lock in high oil prices and might increase in value. Again, this is a cheap inflation hedge, not a core strategy! There is a difference. Cheap inflation hedge means that if things don't work out as you expected you will loose, albeit less - the MLP's have a payback period of around 3-5 years because of the yield.
There is a lot of information on MLP's out there, not a lot with investors thou (they've been busy with the crisis). The MLP structure requires a steady and dependable revenue stream. For this reason, MLPs have traditionally been oil and gas pipeline companies. However, in recent years, a number of upstream oil and gas producing MLPs have come to market. These companies use extensive hedging to assure a steady revenue stream from an otherwise unpredictable commodity market. They are income vehicles which avoid both federal and state corporate income taxes by passing through expenses and income to the investor (Canadian energy trusts anyone?). To be sure, these are business and should be analyzed as such, the management, capital structure, finding costs, risks etc. should be thoroughly analyzed. I looked at LINE and BBEP and they looked decent (I have not done extensive DD), Leon Cooperman of Omega Advisors has been pumping the Atlas series of MLPs for a while. During 'normal' times they have yields of around 8-15%.
An interesting factor here (an one that value investors love) is that Lehman Brothers was big in MLPs (As of June, Lehman Brothers Asset Management owned $1.1 billion of MLP equities). So when it went under there was massive selling pressure on these vehicles! To be sure, many small oil and gas MLPs also used Lehman as the counterparty to their oil and natural gas hedges. In addition, Lehman provided lines of credit to some of these companies. But net-net this was a case of broken stocks and not broken companies (LINE terminated the contracts before Lehman bankruptcy) and therefore these MLPs are priced at a discount of around 30% to where Seth Klarman bought. Again, there is a lot of information on MLPs on the internet and if someone thinks they fit their portfolio, please do your due diligence before buying.
Wednesday, December 10, 2008
Friday, December 5, 2008
What were the signs?
I have read about a few booms and bust, but this is my first bust in real time (and what a bust it is). Now going back to my notes, I see a few things coming back. what were the signs? Now I am not saying that I could see all these signs, but the next time I see something similar brewing, I'll know what will follow!
Exhibit A: Housing
This has been talked about in depth, everyone and their dog know now what exactly took place here. But looking back 2-3 years, some of the signs could be: anyone with a pulse getting a loan, 20 year old realtors, 2-4 shows on TV dedicated to flipping houses, flipping houses a 'sure' thing for making money to name a few. Going back to Charlie Mungers's power of incentives, if one just analyzed the incentives in the housing securitization chain, the fallout becomes really easy to predict. No one, and I mean no one had an incentive to keep the quality of the mortgages sane, everyone was concerned about volume (and that is obviously not good!).
Exhibit B: Private equity
Endowment and Pension funds are funny creatures. They employ the best of the best, manage insane amount of capital and serially fall prey to 'glamour' investments. In the late 1970's they lobbied to change the regulations so that they could hold more gold; this time it was Private Equity that took them down. Endowment and pension funds couldn't get enough of their cash in PE funds. Now consider the recent dumping of PE stakes by investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion. Interests in funds managed by KKR, Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent. Now ain't that smart! In addition, when in any field things get large, the likes of which have never been seen before you know that an access is developing. In PE's case the buyouts became larger and larger. In the late 1980's it was RJR Nabisco deal by KKR that signaled the end in that era, and this time it was BCE - the Canadian telecommunications giant that was to be taken over for $52 billion. Furthermore, they say that when you cant determine who the sucker on the table is, it is usually you. This was the case with the various Private Equity/Hedge Fund IPO's. When Stephen Schwartzman is selling, buying would be a bad idea! This was in my opinion the most obvious sign that the party is coming to an end.
Exhibit C: Risk..What Risk?
Yes, unfortunately that was what the world had come to believe. This was not just true this time, but every time people are feeling joyous. The spread between the treasuries and the junk bonds becomes smaller and smaller, the covenants become looser (pik toggles anyone) and investors just need yield, any yield as long as it higher than the treasuries (and they don't care how much more risk they are taking!).
Exhibit D: Net-Nets
Now method this is proprietary I must say, and is one that roughly works. One just needs to look at the number of net-nets available in the market and its as simple as that. You don't have to buy them, but as a rule when there are a few (or no) net-nets available in the market, you know some excesses have developed and its time to be cautious.
Now I can't (and no one can) tell you exactly when the kindgom will come, or what the catalyst would be, and none of the things mentioned above is precise but I rather be roughly right and be cautious than be precisely wrong and do nothing (or short it all).
Wednesday, November 26, 2008
BCE: Risky Arbitrage
John Paulson's, the founder of Paulson & Co. (huge subprime bets) started his career as a investment banker and then worked as a risk arbitrager with Gruss Partners. He learned a very important lesson here that I'd like to reiterate: "Watch the downside, the upside will take care of itself". He also wrote a paper titled, "The 'Risk' in Risk Arbitrage", and its a must read! A caveat here is in order, risk arbitrage is very risky and should not be tried at home (as Joel Greenblatt would put it). The BCE buyout deal has been a non-stop soap opera for anyone who's watching. Today it was announced that the deal might be in jeopardy and the stock dropped 40% from around $37 to $24; the buyout price is $42.75/share. Arbitrage spreads in general have been very very wide over the last 3-6 months and for a good reason as deals have imploded left and right. While I am not going to talk specifically about the BCE deal, but will talk about arbitrage at the tail end of the buyout boom (and its common sense!).
But first, all this reminds me of something I read in the 1988 Berkshire Hathaway shareholder letter (which is also a must read for risk arbitrage). In that letter Warren Buffett explains arbitrage and his approach with relevant examples. Here's a synopsis: "To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?"
He goes on to explain a couple of transactions and but in the end the thing that I remember is, "Even if we had a lot of cash we probably would do little in arbitrage in 1989. Some extraordinary excesses have developed in the takeover field." He goes on further to talk about how he 'doesn't know' and 'no one knows', "We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders."
And this is the essence of it. Simply, do not engage in arbitrage at the tail end of the buyout boom. The ratio of collapsed deals to total deals has been very high this past year. It usually is when the buyout boom takes a form of its own, and the market values everything at private market valuations, exactly as WB said. It was high in 1988 and it was high in 2007 (read: Blackstone IPO). Michael Price once said that the folks who do risk arbitrage are the same ones that do distressed debt when the cycle turns, and this rings true today when a lot of hedge funds are unloading the risk arbitrage staff and beefing up their distressed debt teams (but just a little too late). If an investor as a rule refuses to participates in risk arbitrage during these times, a lot of pain and suffering can be avoided. When you are picking pennies (or dollars) in front of a road roller you really want to have the odds on your side.
But first, all this reminds me of something I read in the 1988 Berkshire Hathaway shareholder letter (which is also a must read for risk arbitrage). In that letter Warren Buffett explains arbitrage and his approach with relevant examples. Here's a synopsis: "To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?"
He goes on to explain a couple of transactions and but in the end the thing that I remember is, "Even if we had a lot of cash we probably would do little in arbitrage in 1989. Some extraordinary excesses have developed in the takeover field." He goes on further to talk about how he 'doesn't know' and 'no one knows', "We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders."
And this is the essence of it. Simply, do not engage in arbitrage at the tail end of the buyout boom. The ratio of collapsed deals to total deals has been very high this past year. It usually is when the buyout boom takes a form of its own, and the market values everything at private market valuations, exactly as WB said. It was high in 1988 and it was high in 2007 (read: Blackstone IPO). Michael Price once said that the folks who do risk arbitrage are the same ones that do distressed debt when the cycle turns, and this rings true today when a lot of hedge funds are unloading the risk arbitrage staff and beefing up their distressed debt teams (but just a little too late). If an investor as a rule refuses to participates in risk arbitrage during these times, a lot of pain and suffering can be avoided. When you are picking pennies (or dollars) in front of a road roller you really want to have the odds on your side.
Tuesday, November 25, 2008
Stock Idea: CBS Corporation
Although it is a monkey and a dartboard (stockboard?) market right now, you always hope you can beat the market. CBS Corp. (CBS), in my opinion is a safe and extremely cheap investment and if bought at these prices ($6.50/share) will beat the market and then some.
(1) Television - 66% of revenues, 60% of EBIT with 18% op margins;
(2) Radio - 12-14% of revenues, 24% of EBIT with 35% op margins;
(3) Outdoor - 16% of revenues, 14% of EBIT with 18% op margins;
(4) Publishing - 6% of revenues, 3% EBIT with 8% op margins.
CBS right now has a market cap of $4.5B and Long term debt ( 4.625% – 8.875% due 2010 – 2056) is $ 7.1B for a $11.1B in EV. With a TTM EBITDA of $2.9B the company is trading at a EV/EBITDA (ttm) multiple of 3.7x and a dividend yield of 16%. CBS is not a growth story, but a cash flow story and comes close to a Private Equity type investment. The company is a very stable cash generator and has generated, over the years on average around $2.6 billion in operating earnings (FCFF) and after $550 million in debt service around $2B in FCFE (not including growth capex) per year. So for a $4.5 B equity investment CBS is producing around $2 B in cash flow for a yield of 50%! The bull case is trivial, I will present the bear case here and try to refute the arguments.
Sumner Redstone: The CBS shares collapsed over the last few weeks and their collapse was made worse by the fact the company’s chairman and controlling shareholder, 85-year-old Sumner Redstone, was forced by lenders to sell a fifth of his family’s holdings in CBS to meet loan covenants for his holding company (NAI). He controls around 80% of the voting shares and therefore this company cannot be sold, unless he sells. I will not value CBS at a private market valuation. There is a concern that Sumner Redstone will take CBS private, but with margin calls n all, and the current debt refinancing environment, I don't think so! There is also an issue between Sumner Redstone and his daughter Shari Redstone. But really do I care? A part of the bid price today is because of 'forced selling', so this is a case of a broken stock not a broken company. I like I like.
Debt Maturity: $1,585.5 million in long term debt is due June 2010 and another $950 million is due 2011. CBS generates around $400-500 million of FCF every quarter and there are seven quarters left till the June 2010 maturity. With $500 million in cash and potential $2.8 B in FCF they should be more than able to pay the debt. One caveat thou: the dividend will have to be cut! The company is paying around $700 in dividends every year and that will need some cutting going forward (the market has already priced this in). This is all assuming the company cannot refinance at favorable terms in 2010.
Advertising environment: CBS is heavily dependent on advertising and this is supposed to be the worst advertising environment over the last 40 years (and the world is ending). CBS operates in segments that give advertisers the greatest bang for their buck and the stronger companies will advertise more in order to gain market share so net-net the effect would be minimal. These networks are like toll roads, where will the companies go? Even if I assume a 40% cut to the operating earnings (way too rich, management is expecting mid teens decline) the company will produce $1.56 B in FCFF and $1B in FCFE per year, and even this will be good enough to take care of the debt maturity and then some. The management is good, has good incentives to execute and is experienced and they know whats coming and have been and will manage the business accordingly. The loans seem covenant lite and I could not find anything in the 10K.
Pension Liabilities: This is a bummer, CBS has around $1.7 B in unfunded pension liabilities. The point here is that these are not loans and do not have a bullet payment. CBS is assuming a 7% long term return with 5.9% discount rate and has more than 80% of the assets in fixed income securities. I am not saying it does not matter, but this issue existed before the current decline. There is around $200-300 million that CBS will need to contribute to the plan every year, I've looked at the footnote and there is nothing that overly concerns me (esp. looking at the kind of cash flows they are producing).
I am sure there is something else, but net-net CBS is the number 1 rated network, is a strong cash flow generator which has produced strong returns on invested capital. Media companies have traditionally traded for around 10-12x EBITDA, have private market values of around 12-14x and after discounting the control by Sumner Redstone I am comfortable valuing CBS around 9x. In around 3-5 years, at 9x, the EV would be $27 B, and after debt and residual corporate costs (pension, operating liabilities) of around $11B (assuming moderate cash payments over 5 years) gives me an an equity value of around $16B - $18B or $22-25/share. The media sector is trading at very depressed valuations and these companies are cash flow cows. Prem Watsa recently increased his investment in Canwest Global, which is a similar investment but more levered. So in essence, more than the upside the important thing to consider in this type of an investment is what can impair your capital (and the upside will take care of itself)? In CBS's case I found no scenario (or only very low probability scenarios) that that could 'kill my investment'.
Disclosure: Long CBS
(1) Television - 66% of revenues, 60% of EBIT with 18% op margins;
(2) Radio - 12-14% of revenues, 24% of EBIT with 35% op margins;
(3) Outdoor - 16% of revenues, 14% of EBIT with 18% op margins;
(4) Publishing - 6% of revenues, 3% EBIT with 8% op margins.
CBS right now has a market cap of $4.5B and Long term debt ( 4.625% – 8.875% due 2010 – 2056) is $ 7.1B for a $11.1B in EV. With a TTM EBITDA of $2.9B the company is trading at a EV/EBITDA (ttm) multiple of 3.7x and a dividend yield of 16%. CBS is not a growth story, but a cash flow story and comes close to a Private Equity type investment. The company is a very stable cash generator and has generated, over the years on average around $2.6 billion in operating earnings (FCFF) and after $550 million in debt service around $2B in FCFE (not including growth capex) per year. So for a $4.5 B equity investment CBS is producing around $2 B in cash flow for a yield of 50%! The bull case is trivial, I will present the bear case here and try to refute the arguments.
Sumner Redstone: The CBS shares collapsed over the last few weeks and their collapse was made worse by the fact the company’s chairman and controlling shareholder, 85-year-old Sumner Redstone, was forced by lenders to sell a fifth of his family’s holdings in CBS to meet loan covenants for his holding company (NAI). He controls around 80% of the voting shares and therefore this company cannot be sold, unless he sells. I will not value CBS at a private market valuation. There is a concern that Sumner Redstone will take CBS private, but with margin calls n all, and the current debt refinancing environment, I don't think so! There is also an issue between Sumner Redstone and his daughter Shari Redstone. But really do I care? A part of the bid price today is because of 'forced selling', so this is a case of a broken stock not a broken company. I like I like.
Debt Maturity: $1,585.5 million in long term debt is due June 2010 and another $950 million is due 2011. CBS generates around $400-500 million of FCF every quarter and there are seven quarters left till the June 2010 maturity. With $500 million in cash and potential $2.8 B in FCF they should be more than able to pay the debt. One caveat thou: the dividend will have to be cut! The company is paying around $700 in dividends every year and that will need some cutting going forward (the market has already priced this in). This is all assuming the company cannot refinance at favorable terms in 2010.
Advertising environment: CBS is heavily dependent on advertising and this is supposed to be the worst advertising environment over the last 40 years (and the world is ending). CBS operates in segments that give advertisers the greatest bang for their buck and the stronger companies will advertise more in order to gain market share so net-net the effect would be minimal. These networks are like toll roads, where will the companies go? Even if I assume a 40% cut to the operating earnings (way too rich, management is expecting mid teens decline) the company will produce $1.56 B in FCFF and $1B in FCFE per year, and even this will be good enough to take care of the debt maturity and then some. The management is good, has good incentives to execute and is experienced and they know whats coming and have been and will manage the business accordingly. The loans seem covenant lite and I could not find anything in the 10K.
Pension Liabilities: This is a bummer, CBS has around $1.7 B in unfunded pension liabilities. The point here is that these are not loans and do not have a bullet payment. CBS is assuming a 7% long term return with 5.9% discount rate and has more than 80% of the assets in fixed income securities. I am not saying it does not matter, but this issue existed before the current decline. There is around $200-300 million that CBS will need to contribute to the plan every year, I've looked at the footnote and there is nothing that overly concerns me (esp. looking at the kind of cash flows they are producing).
I am sure there is something else, but net-net CBS is the number 1 rated network, is a strong cash flow generator which has produced strong returns on invested capital. Media companies have traditionally traded for around 10-12x EBITDA, have private market values of around 12-14x and after discounting the control by Sumner Redstone I am comfortable valuing CBS around 9x. In around 3-5 years, at 9x, the EV would be $27 B, and after debt and residual corporate costs (pension, operating liabilities) of around $11B (assuming moderate cash payments over 5 years) gives me an an equity value of around $16B - $18B or $22-25/share. The media sector is trading at very depressed valuations and these companies are cash flow cows. Prem Watsa recently increased his investment in Canwest Global, which is a similar investment but more levered. So in essence, more than the upside the important thing to consider in this type of an investment is what can impair your capital (and the upside will take care of itself)? In CBS's case I found no scenario (or only very low probability scenarios) that that could 'kill my investment'.
Disclosure: Long CBS
Monday, November 17, 2008
Bonds: Here's the Glory
There is a lot to be said about these instruments. They are 'safer' than equity no doubt, but do not offer the glory of equity returns (ok I admit that you have to look at more than a 10 year period). Distressed Debt investing however has its own charms, it offers 'lower' risk than equities but equity type returns. Looking at the quarterly filings by some of the gurus, there's one common element: distressed bonds.
I will not explain how bonds work here or the different types of bonds, but offer a few examples of distressed investing and pepper it with my comments. The 2000-2002 period was also good for distressed debt investing. Warren Buffett bought bonds in L3 communications and Enron among others. Here's how Enron went, "in 2002-2003 we spent about $82 million buying – of all things – Enron bonds, some of which were denominated in Euros. Already we’ve received distributions of $179 million from these bonds, and our remaining stake is worth $173 million." (Some of the gain was due to the appreciation of the Euro)
Seth Klarman of the Baupost Group in September initiated a position on WAMU (again of all cos) covered bonds (a special type of bond secured by an over-collateralized pool of good quality mortgages) for 74 cents on the dollar. If WAMU survived they would have earned 15.4% yield to maturity in 2011. If however WAMU failed, the bonds were backed by good quality mortgages and could either be acquired by a buyer, become backed by cash placed in a trust or the bond holders would come to own the mortgages. Its really a win-win situation.
Today, Marty Whitman, one of the best (he was right there when Eddy Lampert was buying Kmart), is buying distressed bonds. This is what he bought: GMAC 7 3/4 Senior Unsecured Notes, Maturing 1/19/2010, Recent Price: $62, Yield to Maturity 53.42%, Current Yield 12.50%. In addition, he bought bonds in MBIA and Forest City and gives a lesson on distressed debt investing in his quarterly letter. Here is an expert, "It is important to understand that no one can take away a creditor’s right to a money payment unless he, she or it consents, or Chapter 11 relief is granted. What does this mean for a distress investor? If a company is going to avoid Chapter 11, a short-term maturity date gives the distress investor de facto seniority. If a company is to be granted Chapter 11 relief, seniority lies in the loan covenants; maturity dates for unsecured lenders become irrelevant." He explains his GMAC buy in the letter and assigns probabilities to the bonds remaining performing and the company defaulting. In any of the scenarios Whitman could not point out to a case which would lead him to take a loss on this investment.
In addition to the above mentioned managers, Francis Chou and Tim McElvaine are also bidding for distressed bonds. You can get your price by - A) forced seller willing to dump at any price B) genuine deterioration where the company is closing in on a covenant. Option A could be a no-brainer as long as you have done your DD (you will see a 'buy me' sign), but with option B there is a chance of Chapter 11. I am no expert at distressed investing, but from the little I know its bad to buy bonds of 'buggy-whip' manufacturers, but OK to buy bonds of companies that have a viable product but are in distress due to the debt burden. And again from my limited knowledge the Chapter 11 dynamics look like this: say a company has an enterprise value (EV) of $1.5 billion, with $1 billion in debt (at 6%) and $500 million in equity. The company needs $60 million every year to service the debt. Now lets say the economy deteriorated and the company can only service $50 million in debt. The creditors will force the company in Chapter 11, the equity holders will be wiped out and the debt will be restructured. The way debt would be restructured is the debt holders will now get say $700 million in newly issued notes (the company can comfortably service its debt now) and $300 million in newly issued equity. So if you paid 60-70 cents on the dollar for this bonds, you will be made whole and given an addition equity kicker. There are myriad scenarios and the process is very complicated.
Option A - the company doesn't default and the loans remain performing you get paid in full; Option B - the company defaults, you get debt and equity in bankruptcy and the price you paid ensures the safety of capital.
I will not explain how bonds work here or the different types of bonds, but offer a few examples of distressed investing and pepper it with my comments. The 2000-2002 period was also good for distressed debt investing. Warren Buffett bought bonds in L3 communications and Enron among others. Here's how Enron went, "in 2002-2003 we spent about $82 million buying – of all things – Enron bonds, some of which were denominated in Euros. Already we’ve received distributions of $179 million from these bonds, and our remaining stake is worth $173 million." (Some of the gain was due to the appreciation of the Euro)
Seth Klarman of the Baupost Group in September initiated a position on WAMU (again of all cos) covered bonds (a special type of bond secured by an over-collateralized pool of good quality mortgages) for 74 cents on the dollar. If WAMU survived they would have earned 15.4% yield to maturity in 2011. If however WAMU failed, the bonds were backed by good quality mortgages and could either be acquired by a buyer, become backed by cash placed in a trust or the bond holders would come to own the mortgages. Its really a win-win situation.
Today, Marty Whitman, one of the best (he was right there when Eddy Lampert was buying Kmart), is buying distressed bonds. This is what he bought: GMAC 7 3/4 Senior Unsecured Notes, Maturing 1/19/2010, Recent Price: $62, Yield to Maturity 53.42%, Current Yield 12.50%. In addition, he bought bonds in MBIA and Forest City and gives a lesson on distressed debt investing in his quarterly letter. Here is an expert, "It is important to understand that no one can take away a creditor’s right to a money payment unless he, she or it consents, or Chapter 11 relief is granted. What does this mean for a distress investor? If a company is going to avoid Chapter 11, a short-term maturity date gives the distress investor de facto seniority. If a company is to be granted Chapter 11 relief, seniority lies in the loan covenants; maturity dates for unsecured lenders become irrelevant." He explains his GMAC buy in the letter and assigns probabilities to the bonds remaining performing and the company defaulting. In any of the scenarios Whitman could not point out to a case which would lead him to take a loss on this investment.
In addition to the above mentioned managers, Francis Chou and Tim McElvaine are also bidding for distressed bonds. You can get your price by - A) forced seller willing to dump at any price B) genuine deterioration where the company is closing in on a covenant. Option A could be a no-brainer as long as you have done your DD (you will see a 'buy me' sign), but with option B there is a chance of Chapter 11. I am no expert at distressed investing, but from the little I know its bad to buy bonds of 'buggy-whip' manufacturers, but OK to buy bonds of companies that have a viable product but are in distress due to the debt burden. And again from my limited knowledge the Chapter 11 dynamics look like this: say a company has an enterprise value (EV) of $1.5 billion, with $1 billion in debt (at 6%) and $500 million in equity. The company needs $60 million every year to service the debt. Now lets say the economy deteriorated and the company can only service $50 million in debt. The creditors will force the company in Chapter 11, the equity holders will be wiped out and the debt will be restructured. The way debt would be restructured is the debt holders will now get say $700 million in newly issued notes (the company can comfortably service its debt now) and $300 million in newly issued equity. So if you paid 60-70 cents on the dollar for this bonds, you will be made whole and given an addition equity kicker. There are myriad scenarios and the process is very complicated.
Option A - the company doesn't default and the loans remain performing you get paid in full; Option B - the company defaults, you get debt and equity in bankruptcy and the price you paid ensures the safety of capital.
Friday, October 24, 2008
Lets use some WMFD's
Derivatives or Weapons of Mass Financial Destruction as they have been fondly called by Warren Buffet (WB). He talked about this back in 2002-2003 right at the same time Alan Greenspan was talking about less regulation. We are lucky that WB was just half right, because I cannot fathom where we would be if he was fully right (mushroom cloud type stuff). Having said all this, he has used derivatives where he found mispricing. It is not in the use of the derivatives that he has a problem with, its the unchecked use, the wild wild west type of environment (read: CDS).
Lets see what he did and what we can learn/use in this environment. First in March we heard news that WB sold puts on the S&P 500 and 3 foreign indexes. These puts expire in 15-20 years and gave him $4.5 billion in premiums. What this essentially means is that WB is betting that the markets in 15-20 years will be higher than what they were in March, 2008. Again in October 2008 he sold Puts (~5 million shares) on Burlington Northern Santa Fe (BNI), with a strike price of $76-$80 and collected premiums of around $7/put. His index Put selling strategy might be more of a play on collecting premiums, but the BNI purchase seems to be more geared towards him wanting more stock in the company (he already has a large stake). Now if BNI trades at $74 in the future he would have the option of buying the stock at $76, but he has already collected $7 for the put, so he is essentially buying the stock at $69 - selling Puts is another way of buying a stock.
Call and Put option pricing depends on a lot of things, but one of the major determinants is Vega (volatility). This is a time of unprecedented volatility where the VIX is at historical heights, and therefore these options are priced accordingly - high (and this is where an opportunistic value investor comes in). One of the strategies (derived from WB options activity) could be to sell Puts on indexs/stocks that you want to buy, make some money on premiums and if the they fall to your sweet spot, well then good for you!
Let me give you an example: the S&P 500 (SPY) is trading at around the $88.0 area; you sell $75.0 strike put options on SPY expiring Jan 2009 and collect $4.7 in premiums. If the index falls to that level or below you can essentially buy SPY for around the $70.0 level. If it doesen't then you still get to keep the $4.7 in premiums (but don't get to buy the index, which is a downside if that is what your sole aim was). If you think that S&P at 880 is not the bottom, would you be comfortable buying at the 700 levels? The market would be more than 50% off its highs, and the P/S, P/E ratios would be more in line with previous bear markets troughs. Another example could be Goldman Sachs (GS), the stock is trading at around $100, you can sell the $65 strike puts expiring Jan 2009 and collect $5 in premium, how would you like to buy GS for $60? or keep $5? There are myriad things that you can do with options, but selling options is something that can work well when the volatility is high. Also exactly which strike/time to buy depends on the situation and the goals..
Update: GS is trading at $55 today (19th November), so if you had sold the put option on GS you would have been forced to buy the stock. Again, selling options just for the premiums is a risky strategy, however if you want to own the stock after selling puts or are writing covered calls, that's a different story..
Lets see what he did and what we can learn/use in this environment. First in March we heard news that WB sold puts on the S&P 500 and 3 foreign indexes. These puts expire in 15-20 years and gave him $4.5 billion in premiums. What this essentially means is that WB is betting that the markets in 15-20 years will be higher than what they were in March, 2008. Again in October 2008 he sold Puts (~5 million shares) on Burlington Northern Santa Fe (BNI), with a strike price of $76-$80 and collected premiums of around $7/put. His index Put selling strategy might be more of a play on collecting premiums, but the BNI purchase seems to be more geared towards him wanting more stock in the company (he already has a large stake). Now if BNI trades at $74 in the future he would have the option of buying the stock at $76, but he has already collected $7 for the put, so he is essentially buying the stock at $69 - selling Puts is another way of buying a stock.
Call and Put option pricing depends on a lot of things, but one of the major determinants is Vega (volatility). This is a time of unprecedented volatility where the VIX is at historical heights, and therefore these options are priced accordingly - high (and this is where an opportunistic value investor comes in). One of the strategies (derived from WB options activity) could be to sell Puts on indexs/stocks that you want to buy, make some money on premiums and if the they fall to your sweet spot, well then good for you!
Let me give you an example: the S&P 500 (SPY) is trading at around the $88.0 area; you sell $75.0 strike put options on SPY expiring Jan 2009 and collect $4.7 in premiums. If the index falls to that level or below you can essentially buy SPY for around the $70.0 level. If it doesen't then you still get to keep the $4.7 in premiums (but don't get to buy the index, which is a downside if that is what your sole aim was). If you think that S&P at 880 is not the bottom, would you be comfortable buying at the 700 levels? The market would be more than 50% off its highs, and the P/S, P/E ratios would be more in line with previous bear markets troughs. Another example could be Goldman Sachs (GS), the stock is trading at around $100, you can sell the $65 strike puts expiring Jan 2009 and collect $5 in premium, how would you like to buy GS for $60? or keep $5? There are myriad things that you can do with options, but selling options is something that can work well when the volatility is high. Also exactly which strike/time to buy depends on the situation and the goals..
Update: GS is trading at $55 today (19th November), so if you had sold the put option on GS you would have been forced to buy the stock. Again, selling options just for the premiums is a risky strategy, however if you want to own the stock after selling puts or are writing covered calls, that's a different story..
Wednesday, October 22, 2008
Stock Idea: Contango Oil and Gas
Contango (AMEX: MCF) runs on two principles:
(1) The only competitive advantage in the natural gas and oil business is to be among the lowest cost producers
(2) Virtually all the exploration and production industry’s value creation occurs through the drilling of successful exploratory wells
Kenneth Peak, the founder and CEO of Contango is the largest shareholder in the company, has never sold a share and is a very good capital allocator (Buffett type). He has 6 full time employees, all focusing on the highest ROI part of the E&P value chain – exploration. Every other service in the chain is contracted out to an expert that can provide better value for that part of the chain than MCF can. They work with some of the brightest and most successful oil and gas finders in the business. Contango collaborates with a network of about 10 geoscientists with four small, privately held alliance partners. In all their deals, the alliance partners have capital at risk and the deals are structured so that the partners do not make money before Contango makes money. This strategy has paid off - Contango made the largest Natural Gas find (Dutch and Mary Rose) in the Gulf of Mexico (GOM) in the last 2 decades, combing through old publically available data. Contango has the best balance sheet in the E&P sector, with approximately $50 million cash, another $50 million line of credit and $18 million in debt. They have 369bcf in proven reserves and 70 undrilled GOM leases. The Dutch and Mary Rose wells, when operating at full capacity, generate approximately $20 million per month in after-tax cash flow at $7 natural gas and $70 oil prices. The firm has also carved out some properties before and sold them for 10-15x their initial investments, all without paying tax (capital allocation).
The current stock price of approximately $43/share buys 22 mcf of Natural Gas and contemplates $4 natural gas prices and $50 dollar oil. I believe it is not possible for the price of natural gas to remain below $6 for a long period of time (I am not saying it will go up, but below $6 econ 101 will kick in) due to the high cost of marginal supply. MCF can purchase after-tax reserves on the open market, in the form of share repurchases, for approximately $1.75/mcf, which is about half of the cost of developing new reserves through drilling. The company has recently done some buybacks (again capital allocation) but any further buybacks will substantially increase the value of the company.
Warren Buffet has talked about the 'finding costs' as the most important factor in valuing Oil and Gas companies. Contango has total costs (including finding) of $2.18/mcf and is one of the lowest cost explorers in the GOM. The company’s PV-10 valuation with $7.00/mcf of natural gas and $70.00/bbl oil, NYMEX prices flat forever after 35% for projected federal income taxes is approximately $1.3 billion or $78.00 per share. The firm recently got an offer between $75-85/share just for the Dutch and Mary Rose fields (there are other fields, leases and a computer system worth around $10-20/share), but it fell through because of financing. Reserves in the GOM area have traditionally gone for $3.50-$5/mcf; with all these valuation metrics Contango is worth somewhere between $80 - $ 110/share. I am not saying this is the best deal in town (there are E&P companies which have 3-5x potential, but there's more risk) but that there is high visibility and therefore low risk. They have a tangible asset value that can be realized easily and the assets can be easily converted into cash without discounting them.
Mark Sellers has talked about this idea in the Value Investing Congress conferences many times. I researched it and always liked it but Contango never had the margin of safety before, now it does.
Friday, October 17, 2008
Where is the consumer?
This is unprecedented. The fact is that we have never seen a consumer lead recession in our lifetimes. The previous recessions in 73/74 – Oil; 80/81 – Interest Rates; 90/91 - S&L crisis; 2001 - Dot-Com collapse and 9/11 were all exogenous shocks to the economy that resulted in a contraction in business, but were not consumer lead. Every facet of the economy has enjoyed the pearls of leverage over the last 20 years. We were all operating at levels that were not warranted, levels that were sustained only by leverage on the household balance sheet. In order to pay this debt and get the household balance sheet in order, people have to work more jobs, spend less, and save more. Also, the unemployment rate after bottoming early last year at 4.4% is now close to 6.1%; this can easily go to 8-11% if history is any guide. Personal income drives consumption and with unemployment rising, personal consumption will go down. Furthermore, in all likelihood Senator Obama will become President of the United States; and he has talked about ‘taking responsibility’ and ‘saving’ etc. This is in stark contrast to the current administration’s message of ‘spend, it’s the American way’.
The US consumer on average has a disposable income of $10 trillion/year and the saving rate over the last few years has been negative. If we look at the 25 years ending in 1985, the saving rate was 10%. I believe the savings rate would go up substantially; maybe not 10%, but something like 5% over the next 5-10 years and factor in the absent leverage – the consumer (75% of GDP) will be a huge drag on the US economy. I believe that were will be smaller engines in the form of Asian economies (slowing down) but the net result will still be negative - via a negative feedback loop. Now the economy either needs: 1) A Large War 2) Major Technology breakthrough. I place a very low probability of any one of them occurring. In essence, this will be a consumer led recession, is unique, will by all accounts severe and last a long (3-4 years) time. We know that the economy and the stock market are rarely in sync, but as an investor this matters because it is crucial to know where the consumer is when valuing a company.
Warren Buffett in a Fortune magazine article once argued that if there is one indicator he looks at, it is the ratio of the market capitalization of the market to the GNP (I am using revenues). The current P/S ratio of the S&P 500 is 1.22. The current ratio sits above the long-term average of 1.14 since 1975 and the median of 1.10; and is substantially higher than the ratio reached in the 1990 bear market of 0.77 and in the early 1980's of 0.50. There has been however, a permanent upward shift in the level of profitability (although the profit margins of 2006-2007 are unsustainable) in the economy, and the S&P 500 should be able to maintain a relatively higher price to sales ratio. S&P 500's median P/E ratio now is at 13.5 and has fallen to just below its long-term average of 14 and below its median of 15. It's near the valuation levels reached in 2002, but remains noticeably above the levels reached in 1991 - 11, in 1982 - 7 and in 1974 - 5. Taking the P/E and the P/S ratios into consideration the market has further to fall - S&P around 750-800; and might trade flat to down over the next few years with a few bear rallies. There are no predictions, only probabilities. I believe in buying stocks and not markets. Balance sheet strength is as important as ever, and investors should buy stakes in stocks they are prepared to average down on. Although I strongly believe in fundamental bottom up analysis (90%), I think it is essential to have a perspective on the relative valuations (10%).
Update: GMO's Jeremy Grantham has completed the first part of this Quarterly Letter, very interesting commentary. He essentially said that they are nibbling right now, they might be early and that there is risk of a 20% overrun to the downside.
The US consumer on average has a disposable income of $10 trillion/year and the saving rate over the last few years has been negative. If we look at the 25 years ending in 1985, the saving rate was 10%. I believe the savings rate would go up substantially; maybe not 10%, but something like 5% over the next 5-10 years and factor in the absent leverage – the consumer (75% of GDP) will be a huge drag on the US economy. I believe that were will be smaller engines in the form of Asian economies (slowing down) but the net result will still be negative - via a negative feedback loop. Now the economy either needs: 1) A Large War 2) Major Technology breakthrough. I place a very low probability of any one of them occurring. In essence, this will be a consumer led recession, is unique, will by all accounts severe and last a long (3-4 years) time. We know that the economy and the stock market are rarely in sync, but as an investor this matters because it is crucial to know where the consumer is when valuing a company.
Warren Buffett in a Fortune magazine article once argued that if there is one indicator he looks at, it is the ratio of the market capitalization of the market to the GNP (I am using revenues). The current P/S ratio of the S&P 500 is 1.22. The current ratio sits above the long-term average of 1.14 since 1975 and the median of 1.10; and is substantially higher than the ratio reached in the 1990 bear market of 0.77 and in the early 1980's of 0.50. There has been however, a permanent upward shift in the level of profitability (although the profit margins of 2006-2007 are unsustainable) in the economy, and the S&P 500 should be able to maintain a relatively higher price to sales ratio. S&P 500's median P/E ratio now is at 13.5 and has fallen to just below its long-term average of 14 and below its median of 15. It's near the valuation levels reached in 2002, but remains noticeably above the levels reached in 1991 - 11, in 1982 - 7 and in 1974 - 5. Taking the P/E and the P/S ratios into consideration the market has further to fall - S&P around 750-800; and might trade flat to down over the next few years with a few bear rallies. There are no predictions, only probabilities. I believe in buying stocks and not markets. Balance sheet strength is as important as ever, and investors should buy stakes in stocks they are prepared to average down on. Although I strongly believe in fundamental bottom up analysis (90%), I think it is essential to have a perspective on the relative valuations (10%).
Update: GMO's Jeremy Grantham has completed the first part of this Quarterly Letter, very interesting commentary. He essentially said that they are nibbling right now, they might be early and that there is risk of a 20% overrun to the downside.
Wednesday, October 15, 2008
Margin of Safety: Three Most Important Words
when it comes to investing! But what is it? What does it exactly mean? What we essentially hear is that it is buying $1.00 for $0.50, fair enough; but thinking about it over the last few days, I think there are two forms of margin of safety..
Form#1: This is the pure Graham version, where he determines that ABC Corp. is trading for $0.50 while the Book Value of the company is $1.00, the book value is solid. Mr. Market then recognizes that the Book Value is solid and sends the stock price up to reflect that fact. Now IF the company grew by 10% in that year the new Book Value would be $1.10, so we can buy this company for $0.50 and sell it for $1.10, remember most of the money has been made because of the value differential.
Form#2: And this is the modern form. When the US economy moved to a service based economy, there were fewer assets required to produce cash flow. Value investors could not really reply on Book Value's and with the times had to move on to Discounted Cash Flow (DCF) models. The intrinsic value of a business is the Present Value of its future cash flows (P/E and other relative valuation ratios are basically derived from a DCF). Now XYZ Corp.'s is growing at 20%, according to a DCF and has a fair value of $1.20 and the company is trading for $1.00. A value investor will only pay $0.60 for this company while a growth investor might pay around $1.00-1.20 (i really don't know what they would pay!). The value investor is banking that the valuation gap between the fair value (his) and the market will decrease and the growth investor is relying on future growth. This is all fine and dandy but will Benjamin Graham do it this way?
I think not! Remember in our DCF we are implicitly factoring in growth in the cash flows. And this comes down to how value investor's today value securities (and there is nothing wrong with this). We mortals like to label the different type of investing methods, some are value some are growth and so on n so forth. Warren Buffett has said that value and growth are joined at the hip, the only different in the price, and by price we mean margin of safety. Anyways, If we were to use Form#1 in modern day valuation what we would do is value this business factoring in a zero growth rate or a GDP plus (5%) growth rate and then demand a price which is 50% lower than what we figured. If the firm does grow 20% good for us, but we are not making money banking on the growth; we are making the money as the valuation gap seizes. Just something to ponder..
Form#1: This is the pure Graham version, where he determines that ABC Corp. is trading for $0.50 while the Book Value of the company is $1.00, the book value is solid. Mr. Market then recognizes that the Book Value is solid and sends the stock price up to reflect that fact. Now IF the company grew by 10% in that year the new Book Value would be $1.10, so we can buy this company for $0.50 and sell it for $1.10, remember most of the money has been made because of the value differential.
Form#2: And this is the modern form. When the US economy moved to a service based economy, there were fewer assets required to produce cash flow. Value investors could not really reply on Book Value's and with the times had to move on to Discounted Cash Flow (DCF) models. The intrinsic value of a business is the Present Value of its future cash flows (P/E and other relative valuation ratios are basically derived from a DCF). Now XYZ Corp.'s is growing at 20%, according to a DCF and has a fair value of $1.20 and the company is trading for $1.00. A value investor will only pay $0.60 for this company while a growth investor might pay around $1.00-1.20 (i really don't know what they would pay!). The value investor is banking that the valuation gap between the fair value (his) and the market will decrease and the growth investor is relying on future growth. This is all fine and dandy but will Benjamin Graham do it this way?
I think not! Remember in our DCF we are implicitly factoring in growth in the cash flows. And this comes down to how value investor's today value securities (and there is nothing wrong with this). We mortals like to label the different type of investing methods, some are value some are growth and so on n so forth. Warren Buffett has said that value and growth are joined at the hip, the only different in the price, and by price we mean margin of safety. Anyways, If we were to use Form#1 in modern day valuation what we would do is value this business factoring in a zero growth rate or a GDP plus (5%) growth rate and then demand a price which is 50% lower than what we figured. If the firm does grow 20% good for us, but we are not making money banking on the growth; we are making the money as the valuation gap seizes. Just something to ponder..
Monday, October 13, 2008
Arbitrage and Market Turmoil
Seth Klarman and Joel Greenblatt have made careers correctly monetizing on the dislocations in the capital markets. They look for forced sellers where the stock price is depressed not because of the fundamentals but because of the stakeholders who are selling in bulk for one reason or the other. In spinoffs it could be the the holder do not want to or cannot hold on spinco, in additions and deletions from indexes there is opportunity for the astute investor. I am finding now there are opportunities where a deal does not go through and most of the float is held by the arbitragers.
Now suppose a stock is to be taken out at $30/share and was trading at $25/share, which seems to be its intrinsic value as determined by the market. The stock will trade close to $30 and most of the investors holding the shares would have sold their shares to the arbs in the $29 range. Now further suppose that this merger falls apart, for whatever reason (other than a material change in the business suppressing the intrinsic value). Ideally, the stock should go down to around $25/share (in a normal market), but the opportunity arises because it usually does not! The arbs are not in the business of buy and hold, they are in the business of 'buy at 58 sell at 60'. So they will sell their holdings, and because they are levered (to juice the returns) they will sell fast. The stock will have undue downward pressure in these situations and will come way below its $25 intrinsic value. The more it comes down the better it is for investor looking to scoop up a company for cheap. To be sure the window of opportunity here is narrow, the investor would need to do his HW before.
Let me give you an example, after Genesco terminated the merger with Finish Line the stock came down to around $2/share (while the merger was around $15). The price had come down to a fraction of book value for a profitable retailer, and this is mainly because of the forced sales by the arbs. An opportunistic investor could have loaded up and 6 months later sold the position at around $10/share for a 5x return!!
Another example could be the Cerberus-United Rentals buyout. The company went to court but the judge ruled in favor of Cerberus, there was no buyout but Cerberus agreed to pay $100 million termination fee. The buyout was at around $35/share and and URI shares fell to as low as $16/share in the following weeks. Again a opportunistic investor could see that this is way undervaluing the company. The company itself realized that its share price was too low and initiated a tender offer between $22-$25/share for around 20% of its float! The shares traded around $22/share in the ensuing weeks a which seemed to be its value prior to the buyout news.
Now suppose a stock is to be taken out at $30/share and was trading at $25/share, which seems to be its intrinsic value as determined by the market. The stock will trade close to $30 and most of the investors holding the shares would have sold their shares to the arbs in the $29 range. Now further suppose that this merger falls apart, for whatever reason (other than a material change in the business suppressing the intrinsic value). Ideally, the stock should go down to around $25/share (in a normal market), but the opportunity arises because it usually does not! The arbs are not in the business of buy and hold, they are in the business of 'buy at 58 sell at 60'. So they will sell their holdings, and because they are levered (to juice the returns) they will sell fast. The stock will have undue downward pressure in these situations and will come way below its $25 intrinsic value. The more it comes down the better it is for investor looking to scoop up a company for cheap. To be sure the window of opportunity here is narrow, the investor would need to do his HW before.
Let me give you an example, after Genesco terminated the merger with Finish Line the stock came down to around $2/share (while the merger was around $15). The price had come down to a fraction of book value for a profitable retailer, and this is mainly because of the forced sales by the arbs. An opportunistic investor could have loaded up and 6 months later sold the position at around $10/share for a 5x return!!
Another example could be the Cerberus-United Rentals buyout. The company went to court but the judge ruled in favor of Cerberus, there was no buyout but Cerberus agreed to pay $100 million termination fee. The buyout was at around $35/share and and URI shares fell to as low as $16/share in the following weeks. Again a opportunistic investor could see that this is way undervaluing the company. The company itself realized that its share price was too low and initiated a tender offer between $22-$25/share for around 20% of its float! The shares traded around $22/share in the ensuing weeks a which seemed to be its value prior to the buyout news.
Sunday, October 12, 2008
Whats wrong with CA$H?
People sometime have a problem sitting on cash. They might feel like they are not working if they are not deploying cash and that cash if not deployed is not really working for them. An investor would usually keep a portion of his portfolio in cash just in case he/she is confronted with a fat pitch. But how much cash should one keep in the portfolio? The answer is..it depends! Here, I will address the time when the investor is usually feeling pessimistic about the markets prospects or when the markets seem high. There are usually two positions people take when confronted with this:
(1) Increase their Cash holdings(2) Speculate with Gold.
Let me get the gold issue out of the way first and let me tell you why I said speculate. Benjamin Graham said, "An investor calculates what a stock is worth based on the value of its business. A speculator gambles that a stock will go up in price because somebody else will pay more for it". Do you know what the intrinsic value of gold is? I sure don't! A lot of value investors including Jean-Marie Eveillard of the First Eagle funds have large positions in gold. Now on the other hand Warren Buffett has talked about gold as having no use, no utility. According to him we dig a hole to take it out, and then dig another hole to store it! Gold in the markets trades as other commodities trade - supply and demand. Gold however, is different from other commodities as gold is seen as money; more specifically the ultimate form of money. The demand for gold is mostly psychological and comes from the perceptions of investors depending on their views on the macroeconomic conditions at that time and in the future. Since the gold standard was ended on August 15, 1971, the U.S. government has been free to print as much money as they choose, and recently they have been printing a lot of it (M3 supply has risen to 9,873 billion in 2005 from 288 billion in 1959). So when the world around you is getting bubbly, the argument goes buy gold, as it is the only sure thing.
Now cash. The problem here is that when there is uncertainty in the markets (as is the case now), government bonds yield too little, they don't even yield enough to dampen the dilutive effects of inflation! Here my answer to that, so what? Warren Buffett sat on his cash reserves for most of 2002-2007 (and many other periods), he did take stakes in some rail stocks and bought a few companies, but he sure did not go on a spending spree. Now, look at his Goldman Sachs and General Electric purchases, he is getting some of the best deals of his life! I think the underperformance of his cash holdings would be more than offset by the performance of his investments going forward. We must not look a year ahead and think that the yield is not high enough, we should think about the opportunities we can have if we have 103% of the money we started with as opposed to 50%! As Jessy Livermore said, "Big money is made in the waiting". Charlie Munger has talked about sitting on 10-20 million at a time in T-Bills just waiting. He further elaborated, "It takes character to sit there with all that cash and do nothing. I didn't get to where I am by going after mediocre opportunities".
Coming back to Benjamin Graham's point, the problem with gold is that it can be too psychological dependent! I don't know what the "real" value is! I don't know if I bought too soon, too late or when I should sell. I rather have my money in T-Bills, just sitting there so that when Mr. Market throws a fat pitch in a security I really understand, I have enough power to swing hard and let that fat pitch take care of the underperforming years.
Friday, October 10, 2008
Down down down down...
Wow, what a sell off. The market is down around 20% in the last week alone. This is the same as the 1987 crash except that it took a week as opposed to a single day (and the fundamentals then were better). So again coming back to the million dollar question..Is it buying time yet? I addressed capitulation before and determined there's still time, plenty of time. Really? But oil and gas sector is down around 60-80%, quality companies are selling for 1/6th the value they were selling at before and the market is factoring in $60 oil. Well there might be some bargains in this market but lets go through a quiz first; this is courtesy of Prof. Sanjay Bakshi of the Fundoo Professor fame, he teaches Behavioral finance (as important as knowing the numbers) and manages a hedge fund.
So here goes. You go to a store too buy a cell phone and its retailing for $500. The store clerk tells you that if you walk 10 blocks you can get the same phone for $400 (the clerks incentive structure is suspect!). Would you walk 10 blocks to save $100? 90% people would say yes (the rest are just plain old lazy)!
Now that you have a phone, you want to go buy a car and the car is retailing for $20,000. The salesman again tells you that if you walk 10 blocks you can get the same car for $19,900! Save yourself a $100. Would walk 10 blocks to save $100? Very few people here would say yes even though its the same $100. You are buying things that cost very different amounts, but the change to your net worth is the same $100. So rationally, it makes sense to walk and get your car cheaper!!
Professor Baskhi explains it as follows, "The brain, operating at the subconscious level, is often influenced by the presence of false “anchors”. Anchors are pieces of information to which a mind tends to latch on to while making a decision. And the human mind will often latch on to false anchors created by various influences like availability or contrast."
A stock many have fallen and fallen hard, but that does not mean we should look at where the stock was trading just a few months ago and 'anchor' our expectations! That would be a wrong way to look at it. The crash has indeed produced bargains, but these bargains are only to be had after a lot of research and due diligence. It should be determined that the stock is 'safe', has a strong balance sheet and can weather the downturn, if extended. Cheapness can take two forms: (1) Is the stock cheap because its market cap is way below its Book Value (the real book value as determined by you, and don't count the banks here) (2) Is the stock cheap as determined by the future cash flows it will produce. I believe, that in these environments, you can find both, cheap (both type) and safe. Some stocks in the oil and gas sector may have come down so that it is easily determinable that their assets (ignore them if their cost/bbl are high) are worth more than their market cap (after debt). These things take a lot of work and effort. So dig away and find these gems, demand a greater margin of safety but anchoring to the highs, well....
So here goes. You go to a store too buy a cell phone and its retailing for $500. The store clerk tells you that if you walk 10 blocks you can get the same phone for $400 (the clerks incentive structure is suspect!). Would you walk 10 blocks to save $100? 90% people would say yes (the rest are just plain old lazy)!
Now that you have a phone, you want to go buy a car and the car is retailing for $20,000. The salesman again tells you that if you walk 10 blocks you can get the same car for $19,900! Save yourself a $100. Would walk 10 blocks to save $100? Very few people here would say yes even though its the same $100. You are buying things that cost very different amounts, but the change to your net worth is the same $100. So rationally, it makes sense to walk and get your car cheaper!!
Professor Baskhi explains it as follows, "The brain, operating at the subconscious level, is often influenced by the presence of false “anchors”. Anchors are pieces of information to which a mind tends to latch on to while making a decision. And the human mind will often latch on to false anchors created by various influences like availability or contrast."
A stock many have fallen and fallen hard, but that does not mean we should look at where the stock was trading just a few months ago and 'anchor' our expectations! That would be a wrong way to look at it. The crash has indeed produced bargains, but these bargains are only to be had after a lot of research and due diligence. It should be determined that the stock is 'safe', has a strong balance sheet and can weather the downturn, if extended. Cheapness can take two forms: (1) Is the stock cheap because its market cap is way below its Book Value (the real book value as determined by you, and don't count the banks here) (2) Is the stock cheap as determined by the future cash flows it will produce. I believe, that in these environments, you can find both, cheap (both type) and safe. Some stocks in the oil and gas sector may have come down so that it is easily determinable that their assets (ignore them if their cost/bbl are high) are worth more than their market cap (after debt). These things take a lot of work and effort. So dig away and find these gems, demand a greater margin of safety but anchoring to the highs, well....
Thursday, October 9, 2008
Book Review: The Little Book of Value Investing
This is a book by Christopher Browne of the Tweedy Browne fame. They originally used to buy and sell illiquid stocks and then started money management. They have been value investors since Benjamin Graham's time (Walter Schloss worked in their offices), infact he was one of their regular clients. While this was a good read, it is for someone who does not know much about value investing and is a begineer to investing in general. They are the very old school type of value investors and focus on P/B, P/E metrics and are not afraid to go around the world to find value. There were some examples that Chris Browne cited which were useful in forming a prospective.
An example could be the Japanese insurers are selling for 1/3 BV, because the securities in their books are marked at cost and the stock market has had a big run up. They buy these insurers, the regulators change the rules and they can mark the securities at market now and they made some good money. Although, this sounds like a good value investment, but there are a lot of 'if's' in this case, because you are levered to the stock market. What if the market fell? A recent example of this could that Bill Ackman bought Wachovia right after the IRS announced a big change in how the firms can carry the tax losses. Wachovia now has $21 billion of these losses and consequently Wells Fargo announced made a big to acquire it for $15 billion (trumping Citi's FDIC brokered bid)! So knowing these things helps, but now you really need to be very very fast than back in the 1980's when Tweedy Browne bought the shares.
I read this book a couple of weeks ago; he in general about what to look for in a Balance Sheet and the Income Statement. He also presents some research on value stocks vs. other strategies over the long term. There are many other examples of European stocks and relative valuations and how in Europe they don't pay as much attention to the stock market as the US does; the various crises including the Russian debt default, Mexican Peso Collapse, the Asian defaults and the opportunities that arose. A good book, an easy read; buy it if you are starting out and want to get a good introduction to value investing.
An example could be the Japanese insurers are selling for 1/3 BV, because the securities in their books are marked at cost and the stock market has had a big run up. They buy these insurers, the regulators change the rules and they can mark the securities at market now and they made some good money. Although, this sounds like a good value investment, but there are a lot of 'if's' in this case, because you are levered to the stock market. What if the market fell? A recent example of this could that Bill Ackman bought Wachovia right after the IRS announced a big change in how the firms can carry the tax losses. Wachovia now has $21 billion of these losses and consequently Wells Fargo announced made a big to acquire it for $15 billion (trumping Citi's FDIC brokered bid)! So knowing these things helps, but now you really need to be very very fast than back in the 1980's when Tweedy Browne bought the shares.
I read this book a couple of weeks ago; he in general about what to look for in a Balance Sheet and the Income Statement. He also presents some research on value stocks vs. other strategies over the long term. There are many other examples of European stocks and relative valuations and how in Europe they don't pay as much attention to the stock market as the US does; the various crises including the Russian debt default, Mexican Peso Collapse, the Asian defaults and the opportunities that arose. A good book, an easy read; buy it if you are starting out and want to get a good introduction to value investing.
Events and Valuations
One of the recurring themes that many value investors use is to buy companies which have been battered by bad 'events'. The market thinks the sky is falling, and the value investor determines that the event is temporary and places a bet on 'reversion to the mean'.
The most famous examples of this has been Warren Buffett (WB) buying American Express after the salad oil scandal (he actually put around 40% of the partnerships assets in AXP!). Another example could be again WB buying Washington Post in the early 1970's after the Watergate scandal. He determined that these were solid businesses with deep moats and the events were temporary. A recent example could be Sanderson Farms (SAFM), they are a poultry processing company and were hammered after the constant bird flu scares in 2005-06. What did the market think? People will stop eating chicken? Usually what happens after an 'event' is that the company focuses on PR and people either forget (we all know we have short memories) or find safety in the fact that this happened, now the company is more careful (because the PR told them they instituted these state of the art QA process). Anyways during the ensuing few months people resumed eating chicken and the stock went up around 50%.
Now, after the pet food recalls hit (anyone remember?) the firms that produced pet food got severely beaten down. The pet food industry has GDP plus type growth (4-5%) and is fairly recession resilient. The future also seems to be bright for this industry as baby boomers buy pets to accompany them during their waning years. I read the 10K for Menu Foods, and determined the following, (1) Customers which accounted for 40% of the sales no longer would order from Menu (2) A lawsuit was filed (which is almost resolved with minimal damage to menu) (3) The restructuring cost Menu around $55 million (4) The existing customers have increased demand, so their sales are down around 20-30% on average.
This did effect Menu's intrinsic value, the question is by how much? Is the market too negative on Menu's prospects? I believe it is, menu produces an essential product and has its sales down and hence the profits are down (although it did turn positive last qtr). The company is taking the right steps in terms of reining in the expenses and assuring customers that it has put processes in place to make sure this does not happen again. Mr. market has hammered the stock around 80%, while I believe the value should be down around 30%. Running numbers on the company my model predicts that the firm should be valued at around $2.50/share while it is trading at $1/share today. Having said that, there are better buys avaliable in this market and Menu's debt level is higher than what I am comfortable with. This is a case study in value investing and not a buying opportunity.
The most famous examples of this has been Warren Buffett (WB) buying American Express after the salad oil scandal (he actually put around 40% of the partnerships assets in AXP!). Another example could be again WB buying Washington Post in the early 1970's after the Watergate scandal. He determined that these were solid businesses with deep moats and the events were temporary. A recent example could be Sanderson Farms (SAFM), they are a poultry processing company and were hammered after the constant bird flu scares in 2005-06. What did the market think? People will stop eating chicken? Usually what happens after an 'event' is that the company focuses on PR and people either forget (we all know we have short memories) or find safety in the fact that this happened, now the company is more careful (because the PR told them they instituted these state of the art QA process). Anyways during the ensuing few months people resumed eating chicken and the stock went up around 50%.
Now, after the pet food recalls hit (anyone remember?) the firms that produced pet food got severely beaten down. The pet food industry has GDP plus type growth (4-5%) and is fairly recession resilient. The future also seems to be bright for this industry as baby boomers buy pets to accompany them during their waning years. I read the 10K for Menu Foods, and determined the following, (1) Customers which accounted for 40% of the sales no longer would order from Menu (2) A lawsuit was filed (which is almost resolved with minimal damage to menu) (3) The restructuring cost Menu around $55 million (4) The existing customers have increased demand, so their sales are down around 20-30% on average.
This did effect Menu's intrinsic value, the question is by how much? Is the market too negative on Menu's prospects? I believe it is, menu produces an essential product and has its sales down and hence the profits are down (although it did turn positive last qtr). The company is taking the right steps in terms of reining in the expenses and assuring customers that it has put processes in place to make sure this does not happen again. Mr. market has hammered the stock around 80%, while I believe the value should be down around 30%. Running numbers on the company my model predicts that the firm should be valued at around $2.50/share while it is trading at $1/share today. Having said that, there are better buys avaliable in this market and Menu's debt level is higher than what I am comfortable with. This is a case study in value investing and not a buying opportunity.
Capitulation? What Capitulation?
The markets have been ruthless over the last few days. Anything and everything is being sold. The major indices are down around 30% from their all time highs, and are dropping further as I write this. The emerging markets are down around 60% on average. Everyone is looking for a buying opportunity. Is this the time where a value investor should feel like a kid in the candy store? Prem Watsa doesen't think so and he's putting his money where his mouth is (70% of his portfolio is in government bonds). He is expecting markets go to down at least 50% from their all time highs (this will put the S&P in the 750 range!) which is akin to the 1974 market declines. According to him there's a significant recession coming, long and deep. It's going to spread all across the world; It's very difficult to not be caught by it and it'll will be difficult for the Fed to do too much now as they are running out of ammo. As George Soros and Warren Buffett have said, this is the unwinding of the great credit bubble of the last two decades, and something that takes decades to build up is not dismantled in a few months; this will be a prolonged recession perhaps lasting many years.
So when will there be capitulation?
Prem Watsa further clarifies the definition: You'll know about it when no one here is optimistic. You'll know when there's no expectation of a turn. In September, there were resumptions, significant redemption; but history shows you've got to have months of resumptions. That's an indication that people are losing their confidence and want to be out of the market. You'll see the average pension fund going down to 30 per cent, 40 per cent equity allocation. ‘Stock' will be a bad word. This is akin to the 1980's when gold was at its highest and Barron's printed an article recommending gold and shunning stocks. Pension funds got the rules changed so that they could hoard more gold, and we all know what happened to gold and equities in the decades that followed.
Now just to be clear, there is a difference between the economic cycle and the stock market cycle. They lag/lead each other and seldom are in tandem. I do not expect the stock market to go down for years. What will likely happen now is that the analyst estimates will come down, and then the companies will show earnings; as long as the earnings are not beating estimates the market will keep going down. When however, the analysts are very very bearish (this is after the company goes bankrupt usually) and have very low expectations, this is when the stocks are really crushed and even the slightest earnings beat will provide substantial upside. This is the game wall street plays and knowing this a value investor can be careful and can adjust his buying and selling accordingly. So stocks are beaten down at the expectation that it will not beat expectation and then traded up or down with the actual expectations accordingly.
So when will there be capitulation?
Prem Watsa further clarifies the definition: You'll know about it when no one here is optimistic. You'll know when there's no expectation of a turn. In September, there were resumptions, significant redemption; but history shows you've got to have months of resumptions. That's an indication that people are losing their confidence and want to be out of the market. You'll see the average pension fund going down to 30 per cent, 40 per cent equity allocation. ‘Stock' will be a bad word. This is akin to the 1980's when gold was at its highest and Barron's printed an article recommending gold and shunning stocks. Pension funds got the rules changed so that they could hoard more gold, and we all know what happened to gold and equities in the decades that followed.
Now just to be clear, there is a difference between the economic cycle and the stock market cycle. They lag/lead each other and seldom are in tandem. I do not expect the stock market to go down for years. What will likely happen now is that the analyst estimates will come down, and then the companies will show earnings; as long as the earnings are not beating estimates the market will keep going down. When however, the analysts are very very bearish (this is after the company goes bankrupt usually) and have very low expectations, this is when the stocks are really crushed and even the slightest earnings beat will provide substantial upside. This is the game wall street plays and knowing this a value investor can be careful and can adjust his buying and selling accordingly. So stocks are beaten down at the expectation that it will not beat expectation and then traded up or down with the actual expectations accordingly.
Update (21st November): Prem is buying. He essentially said that while the recession might be long and deep, the equity markets have discounted much of it.
Wednesday, October 8, 2008
Paulson, CEO of the US and A
Paulson and his performance as the CEO of the $50 trillion behemoth called the USA. Looking at if the privatized profits and socialized gains theory holds!
Bear Stearns:
Bear came way before the current crisis, and at that time was thought of as a bad apple which would impact the whole system. The stockholders lost their shirts, the only people who were saved were the employees (as many) and the bondholders (which I agree is not ideal). The fed did backstop $30 billion worth of looses, which some of this I think the fed would never see again! Again, the reason they saved Bear was so that they could restore confidence and be like there there, its been taken care of, get on with your business..
Stockholder 0; Bondholder 1; Taxpayer 0
GSE's:
FRE/FNM bondholders HAD to be protected, what did the stockholders get? nothing! Now the good thing about this is that he might be able to make the taxpayer money on that too, these GSE's have huge earning power. The problem here were that they were too levered, and the stockholders loved it until the music stopped. Now the GSE's under the government will be operating at moderate leverage, the government has the holding power to ride the storm and this should ultimately end up making money for the taxpayer.
Stockholders 0; Bondholders 1; Taxpayer 1
Lehman Brothers:
I believe, Paulson did exactly the right thing with LEH, making sure the moral hazard side of the equation is being taken care of. The stockholders were wiped out and the bondholders will be getting pennies on the dollar. The stockholders and bondholders going forward will demand more from their companies, expect better disclosure and not just expect a government put. It is a shame that LEH had to go, but now going forward firms will know and investors will know that the downside is zero. This is akin to a professor who only asks 2 big questions on a final exam, so you have to study everything..Its good that people are aware of RISK
Stockholders 0; Bondholders 0; Taxpayer 1
AIG:
Wow what a deal! Paulson is a loan shark!! AIG is a wonderful company and was solvent (given that there is a very fine line between liquidity and solvency in these markets). Paulson wrote a $85 billion check and got 80% of the company with a 8.5%+3 month LIBOR interest rate (8.5% on the unused portion)! The loan is secured by all the assets of the firm. Warren Buffet himself said that he wants to know who made the deal, he wants people like that at Berkshire.
Stockholders 0; Bondholders 0; Taxpayer 1
Bailout:
And now the 'bailout', and the word bailout is in quotes because its not really a bailout; and because this is one mistake (if you can call it that) that Paulson made - He dint sell it properly! Warren Buffet, Bill Gross and Larry Fink have all come out and said it will be a fantastic deal for the government IF the securities are bought at market. Warren Buffet said he'll personally buy 1% of what the government buys (and he does not swing unless he sees a really fat pitch). Again, theres a big IF here, if they start buying these things at inflated prices, then there are bound to be losses. But prudent buying of these securities would again help the taxpayer.
Taxpayer 1, Economy 1
Paulson is an investment banker, a really top notch investment banker and the US taxpayer is his client. I believe, he is doing exactly what he should be doing. The financial system is so convoluted and intertwined (derivatives of derivatives anyone?) that it is the perfect example of a real world domino. In all this there is one risk, the risk of executives who absolutely made the worst decisions and were grossly incompetent still have their jobs. Yes, their stock options are way under water, but they'll find ways to issue themselves cheaper options as soon as the clouds clear. I just hope the shareholders can see through all this. The other con is that everyone from the auto industry to the governments of California are asking for a bailout! Furthermore, although the government is not in the business of owning enterprises and making money (at least not in the US) this might set a bad precedent. But in summary, Paulson is absolutely doing the best he can with the cards hes been dealt!
Bear Stearns:
Bear came way before the current crisis, and at that time was thought of as a bad apple which would impact the whole system. The stockholders lost their shirts, the only people who were saved were the employees (as many) and the bondholders (which I agree is not ideal). The fed did backstop $30 billion worth of looses, which some of this I think the fed would never see again! Again, the reason they saved Bear was so that they could restore confidence and be like there there, its been taken care of, get on with your business..
Stockholder 0; Bondholder 1; Taxpayer 0
GSE's:
FRE/FNM bondholders HAD to be protected, what did the stockholders get? nothing! Now the good thing about this is that he might be able to make the taxpayer money on that too, these GSE's have huge earning power. The problem here were that they were too levered, and the stockholders loved it until the music stopped. Now the GSE's under the government will be operating at moderate leverage, the government has the holding power to ride the storm and this should ultimately end up making money for the taxpayer.
Stockholders 0; Bondholders 1; Taxpayer 1
Lehman Brothers:
I believe, Paulson did exactly the right thing with LEH, making sure the moral hazard side of the equation is being taken care of. The stockholders were wiped out and the bondholders will be getting pennies on the dollar. The stockholders and bondholders going forward will demand more from their companies, expect better disclosure and not just expect a government put. It is a shame that LEH had to go, but now going forward firms will know and investors will know that the downside is zero. This is akin to a professor who only asks 2 big questions on a final exam, so you have to study everything..Its good that people are aware of RISK
Stockholders 0; Bondholders 0; Taxpayer 1
AIG:
Wow what a deal! Paulson is a loan shark!! AIG is a wonderful company and was solvent (given that there is a very fine line between liquidity and solvency in these markets). Paulson wrote a $85 billion check and got 80% of the company with a 8.5%+3 month LIBOR interest rate (8.5% on the unused portion)! The loan is secured by all the assets of the firm. Warren Buffet himself said that he wants to know who made the deal, he wants people like that at Berkshire.
Stockholders 0; Bondholders 0; Taxpayer 1
Bailout:
And now the 'bailout', and the word bailout is in quotes because its not really a bailout; and because this is one mistake (if you can call it that) that Paulson made - He dint sell it properly! Warren Buffet, Bill Gross and Larry Fink have all come out and said it will be a fantastic deal for the government IF the securities are bought at market. Warren Buffet said he'll personally buy 1% of what the government buys (and he does not swing unless he sees a really fat pitch). Again, theres a big IF here, if they start buying these things at inflated prices, then there are bound to be losses. But prudent buying of these securities would again help the taxpayer.
Taxpayer 1, Economy 1
Paulson is an investment banker, a really top notch investment banker and the US taxpayer is his client. I believe, he is doing exactly what he should be doing. The financial system is so convoluted and intertwined (derivatives of derivatives anyone?) that it is the perfect example of a real world domino. In all this there is one risk, the risk of executives who absolutely made the worst decisions and were grossly incompetent still have their jobs. Yes, their stock options are way under water, but they'll find ways to issue themselves cheaper options as soon as the clouds clear. I just hope the shareholders can see through all this. The other con is that everyone from the auto industry to the governments of California are asking for a bailout! Furthermore, although the government is not in the business of owning enterprises and making money (at least not in the US) this might set a bad precedent. But in summary, Paulson is absolutely doing the best he can with the cards hes been dealt!
Tuesday, October 7, 2008
Why?
Hello and Welcome. I am passionate about value investing and over the years have read the works of several value investors including Benjamin Graham, Warren Buffett, Marty Whitman, and Joel Greenblatt to name a few. I am also enrolled in the Chartered Financial Analyst (CFA) program and have passed Level 2 of the curriculum. The ultimate aim is to work under a reputed value investor in the hope that something rubs off. I've also had the opportunity to learn from several blogs, where authors have selflessly shared their ideas and thesis on various subjects. Why Safe and Cheap? Well there are two rules of investing 1) Don't loose money 2) Don't forget rule number 1. Safe because I believe it is absolutely essential to have a strong balance sheet so that the company can survive the downturns and the capital invested is not permanently impaired - the downside is protected. Cheap is just another way of saying margin of safety, where I'll be looking to buy dollar bills for 50 cents - there is minimal upside. On this blog, I will be presenting thesis on various securities that I analyze, study the activities of the 'gurus' and evaluate general market events from the perspective of a value investor.
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