Street Capitalist: Event Driven Value Investments

In the news we’ve heard a lot of mixed accounts that always seem to push oil higher, at least for a day. Lately it’s been Turkey wanting to invade northern Iraq. One of the things I dislike about these stories is they never seem to really dig deep enough into the groups involved.

Who are the PKK? What about those Nigerian rebels? You hear about them all the time too, but you never get a sense of who these groups are or why they’re causing a ruckus.

So let’s try to get to the bottom of it.

Turkey’s issue is with the PKK (Partiya Karkerên Kurdistan or Kurdistan Workers Party). The PKK is a Marxist terrorist group whose goal is to create an independent Turkish state by stealing territory from Turkey, Iraq, Iran, and Syria.

The catalyst we’re seeing right now is the PKK’s relentless attacks the Turkish military and citizens. Recent PKK attacks killed 12 civilians in a bus ambush, and another clash killed 13 Turkish soldiers. The PKK’s campaign of violence really does not seem to be letting up; they carried these attacks out despite the Turkey’s promise of a swift military retaliation.

The Turkish people are extremely prideful, and malicious attacks such as these aren’t going to go unanswered. We saw a hint of this with some air strikes Turkey executed on the northern end of Iraq. What remains to be seen is whether the country will mount a full scale incursion with ground troops into Iraqi territory. Most analysts seem to be thinking that this won’t be the case, simply because the terrain is unfamiliar and hard to navigate. A comparison has been made with how Israeli soldiers were bogged down as they tried to invade Lebanon the summer before last.

What I believe is that Turkey will enter northern Iraq with ground troops if another attack occurs. Nationalism is at an all time high in Turkey and the nation’s citizens will not stand by idly while the PKK takes shots at them. 100,000 troops are already stationed at Turkey’s Iraqi border, ready to move in swiftly in response to any new attacks.

The Effect on Oil

Most of this is psychological. The fact of the matter is that an all out conflict is unlikely, but let’s look at the situation anyway.

100,000 bpd are exported via the Kirkuk-Ceyhan pipeline. An increase in attacks by Kurdish militants/ Collateral damage from a Turkey-PKK conflict would hinder the amount exported. This number is not enough to significantly impair the world’s supply of oil, meaning any conflicts would lead to short term psychological spikes in prices but not long term fundamental price changes. If PKK attacks crossed over from the Kirkuk-Ceyhan pipeline to the Kurdish regions of southern Turkey where the Baku-Tbilisi-Ceyhan crosses, significant damage could occur. The BTC pipeline is expected to start pumping 1,000,000 bpd in 2008, meaning that any hint of conflict would have a tremendous psychological effect on the price of oil, but also a material effect on the world’s oil supply.

This will be an event to watch carefully, a flash point here would be what’s needed to spike oil’s price to $100 a barrel but at the moment I’m not holding my breath.

Over the next two days I’ll have posts regarding the supply/demand side of things.

Apologies to all IE6 users. A friend gave me a heads up today that there was a problem with the blockquotes, after each quote the left margin would distort the page. I believe I fixed the issue, but if anyone still notices it, or anything else, feel free to e-mail me / leave a comment

One of the most talked about value investors today is Eddie Lampert, of ESL Investments and Sears Holdings Corporation. He successfully rescued Kmart from bankruptcy and then later used it to acquire Sears. Along the way he’s demonstrated an extremely disciplined approach to investing, often taking large stakes, holding them for years, and realizing huge gains (~29% annualized since inception).

I have been doing more research on Lampert by looking through some old newspaper articles. Below is what I have gleaned from reading a few older articles on Eddie Lampert, specifically a 1995 Washington Post article.

I could spend this post discussing Lampert’s investment in SHLD, but I don’t think it would be worthwhile. It’s still an ongoing situation and would not make for a complete study. Rather, I think it would be more helpful to learn a bit about the early Eddie Lampert and see how he came to where he is today. First, one of the best pieces of advice I’ve been given is to learn value investing through case studies. Lampert has done this himself, he says that he has studied many of Buffett’s greatest investments by reverse engineering former deals and asking himself questions like this:

If I was looking at The Washington Post in 1973 or ‘74, could I have made the investment Buffett made? Can I understand what he saw?

While highly successful at Goldman Sachs’ risk arbitrage desk, Lampert says this on investing:

I liked the idea of buying something at $ 30 if it’s worth $ 60 as opposed to buying it at $ 59 to sell at $ 60… Goldman was not in that business. We were in the business of buying at $ 59 to be worth $ 60 in a short time.

A long term approach is vital, because it forces you to make sure that the businesses you are investing in are high quality and possess strong moats, capable of weathering temporary downturns and new competition. He puts it best here:

…we have always invested on the basis that whatever we buy, if the stock market was shut down tomorrow, we’d be happy owning the position for the next five years.

Lampert is also keen on investing in restructuring situations. One of his first experiences with this was with Saatchi & Saatchi, but he also used his analytical prowess when evaluating American Express. In the 1980s and early 1990s, missteps by former CEO James D. Robinson III severely hindered earnings. Poor strategy initiatives lead to raising credit card fees on stores and restaurants while also missing out on frequent flyer mile tie-ins.
Eddie chose to study American Express when he saw management work on turning things around by selling off nonessential businesses and refocusing on the credit card business. One of the catalysts leading Eddie to load up on American Express stock was the fact that Robinson was ousted in ’93. He was able to load up at prices around $ 20 to $ 22.50 a share for most of ESL’s position in American Express. At the time of the article, the stock traded upwards to $41.50 a share. In addition, for each of its shares in American Express, ESL also received about $ 3 in dividends and another $ 4 to $5 worth of shares in Lehman Brothers Inc.
(more…)

The credit market is extremely important for investors in the event driven space because easy access to credit fuels private equity acquisitions and leveraged recapitalizations. These have been easy ways to create value for investors but have slowed down over the past couple months. This in conjunction with the J.C. Flowers uttering “MAC” against SLM, the abandoned buyout of Acxiom, and the fat arbitrage spread on the Tribune Company all seems to affirm the certainty of a PE slowdown.

Today we saw the CreditForecast.com release numbers. The following graph is a measure of credit quality, measured on a YoY basis:

As you can see, credit quality is diving. To make matters worse, mortgage delinquencies are on the rise. We’ve seen a steady rise in delinquencies from 2% in Q4 of 2005 to 3.3% in Q3 of 2007. Additionally, with house prices falling, variable rate mortgages resetting from teasers, and poor employment prospects the problem continues to pose a threat. Delinquency rates rise carried over into two other credit sectors, a 0.2% delinquency rate rise for auto loans and a 0.5% rise in consumer finance. These measures are at their highest levels for the past 2 years, and I believe that we’ll see a slow but sure rise in both of them.

What does that mean for event driven investments? If you read the Wall Street Journal, you know that deals are still happening. I don’t think that there will be a standstill. What I suggest is looking for plays that point towards industry consolidation. Normally value investors shy away from drug company stocks, but Daniel Loeb and Carl Icahn have made some great moves here. It seems like the idea is to go after smaller companies that own good patents / have a good portfolio of drugs, and agitate for larger industry players to come in and acquire them. The strategy benefit is easy to see, many of the existing drug patents from the larger players have expired, leading to a wave of generics. They need new drugs to fuel their margins, and the pipeline from companies like Biogen and PDLI seems to fit the bill perfectly. Other areas with strategic acquisition potential would be the IT sector, Oracle is already going after BEA Systems (another Icahn pick) and SAP announced a planned takeover of Business Object.

Most of the IT companies I’ve looked at are holding tremendous amounts of cash on their balance sheet and now that they don’t have to compete with private equity funds on buyouts, they should be ready to open their wallets and start spending. When looking through these companies, I’d be cautious on ones domiciled in India. Not because of governance concerns but currency risk. The rupee’s rapid appreciation will definitely take a toll on these companies’ US business and justifies their lower stock prices right now.

Last week we saw the release of the employment numbers, on a month over month basis, they exceeded expectations and the market exhibited jubilation. However, when we alter this data, to go from month-to-month, to YoY, we see a different trend. One of the reasons that I prefer YoY is that it reduces the noise, these numbers are often heavily revised and seasonality tends to influence the numbers. When we look YoY, seasonality and noise is reduced, we can see a longer term trend of where things are going.

Here’s the employment numbers, graphed YoY:

What’s interesting to not here is that the numbers are trending downward. This is extremely important! Employment is what fuels the checks of Americans, allowing them to go into our economy and spend their money. A reduction in employment leads to a reduction in personal consumption. I’ve addressed my long term views on consumption before, that I believe it will decline to a positive but sub-par level. The same seems to be happening with employment, which should give us slower growth in the economy.

We also saw the release of the import price data yesterday. These continued to display one of my older beliefs, that inflationary problems in China would carry over to the US. Again, import prices from China rose(YoY 1.6%), but as a whole import prices rose.

Below is the graph, YoY:

Overall, it’s my view that we’re going to see a slower economy than what we had last year. Some people are saying that the credit market problems are over, but if you read the Wall Street Journal’s story The United States of Subprime, you might decide that there’s still room for trouble.

Trades

The CAD/USD is at a record high right now, having only touched this level 30 years ago in 1976 (Coincidentially, Canadian unemployment has fallen to a record level of 5.9%, its lowest since 1979). One of the issues with Canada is that the CAD is driven based on the movements of commodities and the US economy. The negativity towards the US pushed oil to record levels, which seems to have propelled the CAD upward as well. At the same time though, we’re also seeing positive news releases for the US economy (although long-term these do not seem to be the case) which also fuels the CAD’s bullish move since a positive US economy would be able to consume more Canadian goods. Canada’s economy is strong, commodities still have some room to grow over the long term, and the United States’ demand for Canadian exports should remain stable over the next year. This makes me feel like the CAD/USD still has room to rise.