Street Capitalist: Event Driven Value Investments

Guy Spier of Aquamarine Capital Management is someone I’ve been wanting to read more about and learn from. He doesn’t appear in the news as much as other value investors, so I was really surprised to see an article written by him in Time magazine today:

Buffett has always made a point of doing business with integrity — and of working only with people who share his values. As we learned at lunch, he credits his father with teaching him early on to rely on his own sense of what’s right, rather than looking for affirmation from others. “It’s very important to live your life by an internal yardstick,” he told us, noting that one way to gauge whether or not you do so is to ask the following question: “Would you rather be considered the best lover in the world and know privately that you’re the worst — or would you prefer to know privately that you’re the best lover in the world, but be considered the worst?”
When it comes to investing, nothing is more important than the ability to think clear-headedly for oneself — and Buffett is unsurpassed on this front. In the late-90s, he was widely criticized for his refusal to invest in booming tech and Internet stocks, a decision that was richly vindicated when the bubble burst. Buffett has made a fine art of keeping this kind of distracting noise at bay: for example, he said he even limits his contact with the managers of businesses in which he invests, preferring to assess them by studying their companies’ financial records —a more neutral source of information.

My $650,100 Lunch with Warren Buffett (Time)

The whole article is worth reading and I think it shows us one of the reasons Buffett is such an interesting character to study and learn from. The fact that he takes such a hands off approach to is businesses is pretty remarkable. He really has an uncanny ability for picking CEOs to operate businesses who are truly passionate about their work which is a quality that you can’t pluck out of an MBA.

To contrast this, look at Edward Lampert of Sears. He gets a lot of comparisons to Buffett, but when it comes to attracting talent they’re worlds apart. Lampert has been unable to find the right managers to run the businesses and brands within Sears and I think it’s one of the key factors that is holding down the company’s turn around. Maybe in that situation the “people” input is simply not being given the weight it deserves.

Guy Spier’s account seems to show us that the real wisdom that can be gleaned by Warren Buffett is how to measure and judge character and people, something that is a product of decades worth of relationships and experiences. That seems to make a $650,100 lunch or even $2.11 million lunch worth the expense if you get just some of the insights of a lifetime in just a lunch at Smith and Wollensky’s!

A few hours ago, Zhao Danyang won the Glide Foundation’s auction for lunch with Warren Buffett. The lunch auction is always an interesting thing to watch because of the eclectic groups of people who bid. The 2007 lunch, which actually took place a couple days ago, was won by value investors Mohnish Pabrai (Pabrai Funds) and Guy Spier (Aquamarine Capital Management). Here is what Mohnish Pabrai had to say about his lunch:

Becky Quick:

$650,100 is what you two paid to have a 2-1/2 hour lunch with Mr. Buffett. Was it worth it?

Mohnish Pabrai: Every penny. I think we would have been willing to pay a lot more than that. Well worth it. We were here with our families and it was just fantastic.

Lunch With Warren Buffett “Worth Every Penny” at $650,100 (CNBC)

It looks like Pabrai was not the only person who seemed to think a lunch with Buffett would be worth in excess of the $650,000, since Zhao Danyang bid a record $2.11 million. So far the news on him is a little sparse, but from what I’ve been able to dig up, he sounds like a very value oriented investor from China.

According to Terrapin he began his investing career in 1996 and took the lead in promoting the philosophy of “selecting security investment from the view of an industrial investor.” To shed some more light on this philosophy I took a look at the website of his fund, the Pureheart China Growth Investment Fund:

We do not follow stock index and price-volume analysis. We rarely use individual stock charts as the basis for investment decisions. We only partly agree to fundamental analysis. By taking a long-term view, we believe that the share price of a (well managed) enterprise will undoubtedly reflect its intrinsic value over time. Our selection criteria are quite simple. We seek enterprises that can survive. These enterprises have been established usually for a decade or more and have relatively high success track records. We strongly believe that if we own part or most shares of these enterprises, our investment will grow and breed success together with the companies.

The themes described here are very inline with some of the ideas preached by Warren Buffett and Charlie Munger. Rather than simply looking for cheap companies, the fund seems very oriented towards investing in industry leaders and businesses with wide moats to give them long term competitive advantages.

The fund also aggressively utilizes a margin of safety:

Based on quantitative benchmarks, we input data into our evaluation model to calculate its intrinsic value. The market price is then compared with the intrinsic value of the companies. If the market price is traded below to the fair intrinsic values—that is half of the value or even lower—only with sufficient safety margins would we consider taking a position. We continue to monitor all businesses conditions faced by the business and adjust the parameters every quarter according to the real market environment.

We do not invest rashly. We value patience and aim for an ideal price. We would rather lose the opportunity rather than take on un-necessary risks. In the capital market, we believe that survival should always be the first consideration. Controlling risk is the key to smart investing.

This means that Zhao holds the preservation of capital at the utmost importance and I think it’s nicely reflected in this Asia Times article that discusses the liquidation of his funds.

“We would rather miss an opportunity than blindly take a reckless move under whatever [market] circumstances,” Zhao wrote in a letter to his clients before the liquidation. “To survive in each investment decision is always our priority.”

“So far, the A-share and H-share markets are beyond our understanding.” Zhao wrote in his letter, with H-shares referring to Hong Kong-listed mainland-related stocks. “The bottom and peak of the indexes are always a riddle. Now, we can’t find any proper investment targets which meet our investment criteria and have enough margin of safety as well.”

It takes a lot of courage to liquidate funds during a bull market period (the funds were liquidated on January 2, 2008). Not only do you struggle with having to dissent and break from the herd, but you also have to cope with operating in an environment with few investment opportunities while being responsible for the capital of others. The fact that Zhao did not compromise with his investing philosophy tells us a lot about his character as a fund manager and makes him someone we should keep on our radar screens.

Today, Abnormal Returns asks us what role it should have in the future of the investment blogosphere. This question brings to mind some of my own thoughts on investment blogging and some ideas I’ve had in my head for a while. Before addressing what Abnormal Returns should be, I’d like to go over some of the ideas in that post.

Quality Control by Blog Type

Quality control is the most important problem facing investment blogs today. The metrics for assessing quality are dependent upon the type of blog. In the investment blogosphere, blogs generally come down to two sides:

1. Commentator types, like Paul Kedrosky who mainly focus as a central source for news he thinks is important and an outlet for his comments on current events. Going to Kedrosky’s site will keep one informed, but is probably not the best place for learning investing.

Quality control with these blogs is hard to peg. There might not even be a need for quality control. These sites are more like opinion pieces in the newspaper and in that case, they don’t have to be correct. They only need to serve as a place to get a specific type of perspective.

2. Trader/investor sites. These sometimes overlap with the previous topic. They’re written from a trader or investor’s point of view, and often you will see posts that actively go over new investment strategies or even ideas.

It’s my belief that quality control here is vastly more important, there are actual investment ideas being generated here. The best thing that these sites can offer to their readers is a level of transparency in their posts. For my blog, I list the positions I hold and make posts that note my entry date in these positions, and update a few times a year with how they’re doing. If I propose an investment idea i’ll also address whether or not I actually hold a position in the company myself. Both of these are important aspects that I believe should be adhered to.

A while back, I took part in an academic study on the investment blogosphere by a prominent university where I was asked questions on how I know what blogs to read and how I rate them. I specifically mentioned that I look at the track record of these bloggers in order to see whether or not they’re worth reading. A track record does not have to solely be your actual performance, it can also be the way you research, the way you summarize and explain your methodologies for how you invest/trade. All of these are sources that actually teach us and probably teach us more than a simple performance number — this is the key to monitoring the quality of trader/investor blogs.

Gatekeepers, Traffic, and Quality Control

I look at Abnormal Returns as the Drudge Report for investors. Often, I’ve discovered new sites by just visiting AR and they get added to my RSS Feed list. AR seems to take an active approach to showing a variety perspectives on one of its daily themes which makes it worth reading. A key difference between Matt Drudge and AR is that they at least appear to have different motives. Drudge pushes a certain ideology, while AR pushes themes of the day.

One thing I want to point out is that “gatekeepers” like AR can actually help in quality control. Linkfests like Abnormal Return push traffic to us which can help start discussions and create discourse.

If you compare us (financial bloggers) to our older second-cousins (political bloggers) there are some big differences. The political blogosphere is vastly greater than our own. Looking at some of the latest traffic numbers, you’ll see that sites like the Drudge Report (which does not actually report but showcase) and the Daily Kos or Huffington Post actually receive more hits than many newspapers.

Nielsen Online Names Top 30 News Sites

With such huge numbers in traffic, these groups are able to bring together larger debates than we can, which can uncover shoddy analysis and perform fact checking.

Look at the traffic numbers of major financial media outlets: the Wall Street Journal, the Financial Times, the Economist (or FMSM- the financial mainstream media). They generally perform better than the closest “independent” blogger driven competitor available - Seeking Alpha. Part of this is because we’re thinking strategically when we conceive our blogs. Most bloggers realize that there is little chance of them competing with the financial press establishment in general reporting.

The other part is because the FMSM typically have strong brand names and are associated with quality. In financial journalism, quality is an important factor, and I think this is primarily why the financial press is an oligopoly of sort. The barriers to entry - earning the recognition that you’re a worthwhile voice to listen to is difficult.

Some of us fight the war of the flea. We (initially) write about niche areas in finance that are not served by the FMSM.

To give you a few examples, look at Equity Private, Tanta (Calculated Risk), or Macro Man. Each brings a perspective that simply could not come from your run of the mill financial journalist. Unfortunately, what ends up happening is that these blogs become valued by industry professionals but typically lack a broader appeal.

Calculated Risk is probably an exception tot his, but part of that is probably because of the constant news about sub-prime mortgages in the news. I’ve been wondering if the broader audience will keep reading sites like Calculated Risk, after the credit mess blows over.

The future for Abnormal Returns and the investment blogosphere?

I can’t help but wonder about the future of the investment blogosphere and the FMSM. Will a blogger driven site ever match the traffic of the WSJ? To do so would be tough. First, content would have to be aggregated. This alone puts up a host of issues. Many bloggers have their own advertising and feel that aggregators take their content for free, without contributing traffic to add meaningful revenue to their blogs.

Then, somehow content would have to be screened. Seeking Alpha is just a mass glutton for content, they end up carrying some trashy contributors. The Huffington Post and Breitbart both supply the news, but also offer contrasting perspectives. The Breitbart blog network is mostly comprised of conservatives while Huffington Post offers a liberal perspectives. Maybe new investment aggregators could come onto the scene that provide different perspectives on the market. Some contrarian, some more mainstream. The fact that these aggregators would have content written by investors and traders, or commentators with professional backgrounds would help differentiate themselves from the typical financial journalists.

Finally, there would be the issue of the financial press broadening its scope. The FT and WSJ feature extensive coverage on current events, foreign and domestic. An aggregator would have to feature that content as well to match and be a true competitor.

With respect to Abnormal Returns though, they should stick with what they’re doing - making a good daily linkfest. I’m actually pretty glad that they have not taken a Digg or Reddit approach. Some sites are trying to become the Digg for financial news, but the problem with this model is that it thrives on mob mentality. Contrarian perspectives can get ignored by these sites and makes the editorial nature of AR’s linkfest advantageous. As for pursuing profit, as long as it is tasteful, I don’t see how a few ads here and there could hurt.

Today I’m starting a new weekly (hopefully) feature at Street Capitalist called the Investor Book Club. Every week or so, I will post a “book club” entry introducing one or several of the books and articles that have influenced my thinking on investing.

The first book club selection is a bit off the beaten path, Richard Branson’s Losing My Virginity.

You might be wondering, what does Richard Branson have to do with investing? Richard Branson the billionaire who competes in death defying races around the world, launched a failed competitor for Donald Trump’s The Apprentice, runs an airline, and is even working on a space travel company. This does not sound risk averse, this does not sound like value investing. In reality, Branson is actually quite risk averse, he has been able to become a successful entrepreneur by taking minimal risks, similar to the Dhando-like low risk/high uncertainty method coined by Mohnish Pabrai.

The idea of value investing, or at least successful investing is the preservation of capital. We see the preservation of capital kept in mind at the beginning of the book when Branson applies it to his first real business. In 1968 Richard Branson launched a magazine called The Student, a publication that would cater towards the protest movement in London and cover topics that appealed to students of his age. The publishing industry is fiercely competitive, but Branson brought a margin of safety to The Student. Before even publishing its first issue, he made sure to sell out of advertising.

Most of them [advertisers] rejected the idea of paying for advertising in an unpublished magazine, but gradually I began to see ways of attracting their attention.

Even if the magazine failed to sell any issues, his losses would be minimal since the actual costs of the magazine had been paid for through advertising that had been sold beforehand.

Eventually though, competitive headwinds changed and Branson had to adapt. With the protest movement fading away, Branson sought to evolve his magazine into a new business.

I began to think of ways to develop the magazine and the “Student” name in other directions: a Student conference, a Student travel company, a Student accommodation agency. I didn’t see the Student just as an end in itself, a noun.

Branson realized that he could use his brand to sell music records to other students and shifted from using the Student as a brand and instead created Virgin, which would go on to christen railroad trains, airplanes, and even bottles of cola. One of the ingenious aspects of this whole endeavor is the fact that he sold the records through a mail order catalogue. By doing this, Branson could obtain fees up front in order to create a floor for his business venture’s value. The other benefit of a mail order catalogue was that Branson was always able to shop around for the best deal on records (sometimes taking advantage of arbitrage situations based on European taxes) while also giving him the benefit of not having to worry about managing large amounts of inventory. He was able to buy records more precisely to cater to his customer’s needs which helped keep costs down and allow him to undercut his more established rivals in the retail business.

Branson dedicates some of the book to a period when Virgin was a publicly listed company. While shares were floated at 140p, they fell during the year as England descended into a recession. Always the rebel, Branson chose to look the other way as the market panicked. He set his sights on Virgin’s rival, Thorn EMI and began to acquire shares because he thought they were undervalued. he says:

And since I was focusing more on the profits and cash flow from EMI, I began to see the stock market crash as a golden opportunity to buy the company… It simply cannot be true that Thorn is now worth only two-thirds of its value on Friday. We know the cash which we can earn from its back catalog, so in terms of straight cash to us it’s a bargain

Branson focused his attention on the actual financials of Thorn EMI instead of its stock price. With respect to Virgin’s own price at the same time he questions the logic of the market:

When we announced that Virgin’s profits for the year ended July 1987 had doubled, from 14 million to 32 million… our share price did not move upwards — anything but. It was difficult to understand how Virgin could have floated with a share price of 140p last year and to see our share price halved on the back of doubled profits.

These are lessons that still apply today, especially right now. In our negative economic environment, investors must keep in mind cash-flows and how the business is actually operating, not just a stock price. Branson basically figured out how inaccurate the stock market could be when assessing value and took advantage of it by building a stake in his undervalued competitor and taking Virgin private through a management lead buyout and then sold a portion of shares to the Japanese company Pony Canyon at a 52% premium above Virgin’s original IPO price.

With Branson, even an airline can provide an excellent margin of safety. A famous investor has said that: The quickest way to become a millionaire is to be a billionaire and buy an airline. Branson figured out how to prevent that. The airline business is one with huge capital expenditures, planes cost large sums of money after all. In order to start Virgin Atlantic while minimizing costs and cash outlays, Branson figured out that he could lease air-crafts from Boeing. This effectively capped the airline’s maximum loss at $3 million while leaving the sky as the limit for Virgin’s value. In an industry riddled with bankruptcies, companies like Virgin are hard to come by.

The second half of the book is mostly devoted to Branson’s battle with British Airways. It is an exciting read because we see the kinds of underhanded business practices British Airways employed as it tried to squash Virgin during their “dirty tricks” campaign. I found this section particularly interesting because British Airways used media disinformation campaigns and private investigators– tactics that we’ve seen in recent books and news stories. This section could be particularly useful for investors and managers who may one day find themselves in the same situation.

For me, the biggest lesson from Losing My Virginity is that starting a business does not have to be a high risk affair. Branson’s companies serve as a testament that this isn’t the case and that you can apply value investor principles to entrepreneurship and still obtain success. Benjamin Graham said that investing is best when it is most business like, but I’ve found that most investors (me included) have had little or no personal entrepreneurship experience. This book might provide some of the lessons and ideas that are needed to start changing that.

There are many oil bears who are expecting that Saudi Arabia’s new production plans will save us from the $150 oil plaguing our markets today. This is just wishful thinking. The Saudi plans are bold, there is no doubt about that. They are calling for 12.5 million bpd by next year and I believe they have the capacity for it. Even with such bold estimates, it wont be enough to bring oil back down to the $60 per barrel prices that the bears are longing for.The latest issue of The Economist sheds some light on why a production increase may not be enough:

The trouble is that it cannot manipulate markets as before. The kingdom has a fifth of known reserves. It supplies an eighth of the world’s oil and remains, crucially, the only producer with at least some spare capacity. A huge investment plan under way should raise its capacity from 11.3m barrels a day in 2007 to 12.5m by next year. Noting pleas from George Bush and Ban Ki-moon, the UN’s secretary-general, the Saudis have upped actual production twice in the past month, raising it by 500,000 barrels a day to its present level of 9.5m.

But much of that new output, and most of the reserve capacity, is in the form of heavier oils that are costlier to refine and for which there is less thirst. The Saudis are unlikely to bring new, lighter crude, or bigger refining capacity for their heavier oils, onto world markets until next year. Even then the incremental rise may not offset demand. So energy watchers hope the Jeddah conference will reveal something bolder than promises of more oil.

The puzzle of oil production (The Economist)

Currently, the excess capacity that the Saudis bring to the market will only serve to fill in the gaps left by decreases elsewhere. Specifically, in African nations like Nigeria and Angola where rebel activity is driving oil production down to 25 year lows. Recent attacks on a Chevron pipeline will be cutting its oil output by 120,000 bpd while Royal Dutch Shell is saying that they wont be able to make their previous 250,000 bpd delivery after a raid on their Bonga field.

Why are the Saudis even bothering to raise production? What do they really gain from more supply being brought to the market? There is a general worry that high oil prices will end up hampering economic growth and stem global demand for crude. Many emerging market nations employ fuel subsidies which drive their citizen’s consumption of crude upwards. China recently announced that they will be cutting some of their subsidies on gasoline and diesel, this will raise its public costs by 17% for gasoline and 18% for diesel which should help a little. If other nations follow suit, we should see a fall in the price of oil - but that hasn’t happened so far. Such a fall would be disastrous for Saudi Arabia because it would cut the value of their oil holdings by billions. This money is necessary to fund the kingdom’s bold economic city projects.

One possibility, that may drive prices down somewhat is if other OPEC nations follow suit and pump more oil as well. The problem with this is similar to the Saudi problem though. Iran has been trying to flood the market with heavy crude that it has kept in storage since mid-may, but this typically contains more metal and is harder to refine. The demand is less for this kind of crude partly because of a lack of refineries globally. Other nations are on the fence, debating whether or not our current oil troubles are a result of demand or speculation - this squabbling slows any kind of collective action by OPEC to address the problem that we’re facing right now.

My current belief has always been that speculation is not the cause of the price increases that we’re seeing. I will concede that there may be a slight speculative premium to oil, but not a large one. We wont go back to the $10 oil of 1999 by simply reducing the amount of speculation. As a result, lawmakers would be better off focusing on ways to promote the production of alternatives to oil so that crude is less of a problem to begin with. This kind of action has a definite future value, while conversely, the speculator witch hunts we’re seeing seem to be less based in facts and more grounded in manias and panics.