Street Capitalist: Event Driven Value Investments

One thing that does not seem to be mentioned much in the usual financial blogs I read is the current global food crisis, the credit crunch seems to be getting more exposure even though this is a pretty big deal. After all, people are killing each other over bread in Egypt.

Agricultural commodities are booming along with most other commodities. Commodities are inherently seen as safer than traditional assets right now because you have to worry about interest rate cuts by the Fed (bad for dollar holders) and then the contagious credit crisis (bad for domestic equity investors). Some people thought emerging markets could provide some kind of safety, but now there’s a lot of arguments against decoupling.

So commodities have seemed like a good choice. I will say that some of the price increase for these agricultural commodities is due to speculation, they are seen as a safe haven from the falling dollar. However, unlike gold, whose value is derived solely from the fear of investors, agricultural commodities are having price hikes because of real concerns. Take a moment to study corn prices. World wide, food prices have gone up 87% in just 3 years. For things like corn, there are other factors driving up demand and prices. Biofuels and increased consumption. With everyone head over heals for ethanol, farmers worldwide are more than willing to grow corn to take advantage of the rising prices. However, if farmers switch towards corn, it means that they are sacrificing another crop. This lowers the supply of those other crops, which ALSO drives up their demand.

via the Financial Times

Soybeans are a good case of this. We have seen protesting in Argentina over export taxes for soybeans. I might be wrong, but I don’t think that soybeans make up a big portion of the average Argentine’s diet. This means that their farmers are growing mainly to export and take advantage of demand elsewhere. When they do this, they reduce the supply of other, more useful crops for home. The export tax is most likely a mechanism to push farmers towards growing for the domestic demand (and also to help reign in the Argentine Peso).

The prices aren’t going unnoticed. Just look at the April 6th strikes in Egypt. 500 people were arrested, over rising food prices. From this kind of outrage, we will definitely see some kind of action from governments. More taxes are a given and there isn’t much to do that will prevent against that. Governments will engage in these kinds of protectionist measures because food is something that affects everyone and food is essential for living. It’s one of those basic needs and any perceived danger of it going away will illicit irrational responses.

I believe that there may be ways to profit from the crisis. Jim Rogers, the famed commodity guru believes that these kinds of bull markets last over a decade. From my research, we’re maybe 3 to 4 years into that commodity bull market. Meaning, we should continue seeing rising prices for agricultural commodities such as corn and soybeans. In addition though, fertilizer could be a good avenue for value.

Here’s a chart of DAP prices:

Governments are inevitably going to try to force farmers to increase food production and the supply is already pretty tight. Production increases really seems like a must in order to fulfill this increased demand. Demand from nations with emerging middle classes like China are taking the already tight supply. The Chinese specially are indirectly affecting the prices because of their meat consumption. If the Chinese are going to want to keep eating meat, we’re going to need more cows and we’ll need more feed for the cows. This means that inevitably, in order to grow more we’ll need more fertilizer.

Here’s a group of fertilizer related companies:

All of these have gone up quite a bit these last couple years, but they still appear to have room to gain. At the very least, they seem like a good spot to counter any of the effects of the credit contagion.I want to make clear that these are not undervalued companies, all of them trade at historical highs and on most metrics that appear overvalued. The trend in rising food prices seems far too difficult to reverse. There’s a fat chance that we’ll see a widespread liberalization of agricultural policy, so production will continue to be inefficient, leading to supply bottlenecks in the midst of soaring demand. The fact that two big global macro investors, George Soros and Jim Rogers are both bullish on China means that the nation will continue to prosper, in spite of the current food problems and fear of global financial turmoil. If China keeps growing their consumption of food commodities will increase as well which would bode well for fertilizer companies.

All this means is that you can probably obtain a profit or at least protect your investment through prudent investments in one of the above companies, or perhaps if you can find one - a global/more off the beaten path fertilizer company (some are out there), or even a passive investment like this agricultural commodity ETF (MOO, DBA, TITN).

Price is what you pay, value is what you get. Those words aren’t mine, they belong to Warren Buffett. For now though, they remain incredibly relevant to the type of investment environment we’re in. With the collapse of Bear Stearns, many commentators took it upon themselves to proclaim that we live in a turbulent period where value can disappear in just a weekend.

This statement is faulty. Value and stock price are not the same thing. If that was the case, value investing would not exist. When Bear Stearns dropped 80%, it was the company’s stock price, not value, which plunged. Stock prices are just what market actors perceive value to be. Value investing works on the basis that what the market actors are perceiving is actually incorrect. This kind of rationale leads many value investors to become major contrarians, where I feel some problems are arising.

I think that by nature, many contrarians utilize a backward looking view at companies. Some funds like to call this “opportunistic” investing. What this boils down to is a hope that a company’s stock price will revert to its mean. But it is precisely this backwards looking perspective which enables investors to make catastrophic missteps. Sometimes the mean is wrong. Sometimes the mean was built on bad levees.

These global investment banks are mostly behemoths with intertwined banking, trading, and private wealth management divisions. Ultimately, easy credit has helped many of these firms soar over the last six years or so. Without easy credit, the foundation for the mean ceases to exist. The banking divisions may have a tougher time underwriting mergers as activity dries up, some trading divisions will undoubtedly suffer from volatile markets or strains in liquidity, and as write downs mount - PWM clients may flee. This can be detrimental to future earnings. Furthermore, many banks are announcing their write downs - these write downs slash book value.

If you were a clever contrarian, thinking you were buying X Financial for 0.5x book, and suddenly the company’s book value is slashed in half because of a write down, you’ll be getting it for 1x book. So, some of the obvious metrics for looking at financials are wrong and should be ignored during your valuation process. There is so much uncertainty in valuing some of these assets that there is a high likelihood for you to be incorrect. So far many sovereign wealth funds, hedge funds, and private equity firms have been hit rather hard by early capital infusion investments in these companies. It might be too early to tell, but I feel like a number of these players bet on a reversion to the mean - without anticipating what kind of impact the credit crisis may have on the future operations of these companies.

Underwriting standards are said to have dwindled in 2005, leading to an excess of loans to be made which helped fuel our real estate bubble. We will see a significant change in these standards which should negatively impact business. The same goes for home equity lines of credit or HELOCs, these were made during a period of rapidly appreciating real estate assets - many homeowners obtained HELOCs with the intention of refinancing as their home climbed in value. If home prices decline (which they have), you should see a decrease in HELOCs as well. This reduced activity will hurt most banks because most banks piled into the mortgage business.

As the pain grows, most financial companies will go through write downs and will need some kind of capital infusion. Usually these capital infusions lead to dilutions in earnings which are detrimental to small stockholders. Just look at Ambac (ABK). If the capital infusions aren’t enough, a “run” on the bank can occur which is even worse. Neither of these cases are pleasant for small investors, yet they are high probability events that you face with financials in the current environment.

I think what has happened is a lot of investors have associated falling prices with cheapness. The two seem like they should go together, but that is not the case. It is really essential for investors take the time to study the level 3 assets held by many of these financial companies, or for them to understand the negative impact that the credit crisis will have on business activities. With complex mark-to-market accounting and poor liquidity, valuing some of these assets becomes just a guess. A probabilistic view on the future of these companies based on their illiquid assets and impacted operations needs to be taken because a backwards view will only make you believe in non-existant value. Things aren’t just going to go back to how they were in 2006.

Some of Michael Lewis’ writings have been questionable as of late, but I feel like this quote is particularly important:

….If the market got the value of Bear Stearns so wrong, how can it possibly believe it knows even the approximate value of any Wall Street firm? And if it doesn’t, how can any responsible investor buy shares in a big Wall Street firm? ….

That’s why I’m steering clear of anything that makes me go long financials right now. If you look, you’ll find better companies that are undervalued in safer sectors (KHD looks interesting, especially after their recent earnings), I’d set my sights on these - after all, you should keep the preservation of capital at the forefront of all your investing.

George Soros has a new book:

http://www.georgesoros.com/creditcrisis08

The cause of the current troubles dates back to 1980, when U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher came to power, Soros said. It was during this time that borrowing ballooned and regulation of banks and financial markets became less stringent. These leaders, Soros said, believed that markets are self-correcting, meaning that if prices get out of whack, they will eventually revert to historical norms. Instead, this laissez-faire attitude created the current housing bubble, which in turn led to the seizing up of credit markets and the demise of Bear Stearns, Soros said.To avoid a super-bubble in the future, Soros said banks must control their own borrowing. They must also curtail lending to clients such as hedge funds by demanding greater collateral and margin requirements on loans. 

via Bloomberg