Street Capitalist: Event Driven Value Investments

Aubrey K. McClendon, CEO of Chesapeake Energy (NYSE:CHK) recently had a major margin call and was forced to sell his entire stake (rumored to be around 5%) in his company. McClendon’s margin call made me think – does having a margin call mark the sign of a bad CEO?

To answer that, first we’ve got to understand what kind of factors make for a good CEO, or jockey as Warren Buffett likes to sometimes refer to them. Many companies become undervalued because of missteps by the company itself. Usually, the mistake is small but the market overreacts. However, if you’ve got a poor jockey, you risk having mistakes occur repeatedly and have intrinsic value decline.

The following interview is with Larry Pitkowsky of the Fairholme Fund. The track record for the Fairholme Fund is awesome and what I really like is the fact that they place a good deal of importance on the jockeys of the companies they invest in. In this interview, Pitkowsky outlines the characteristics they look for in a manager for the businesses that they invest in.

So what do the people at Fairholme look for in a jockey?

First, they enjoy owning businesses where the manager owns a lot of stock that makes up a big percentage of their net worth. It must be someone who lives for business and is a true fanatic for their work, this makes me think of people like Tom Murphy or Rose Blumkin. When you have people like this, they will be working hard every day to make sure that your company’s value is maximized and your competitive moats stay in tact.

More importantly though, they want someone who is risk averse. This is harder to figure out, I suggest reading as many news stories as you can on a company and also their annual reports to get a feel for how the company acts in terms of risk. An aversion to risk helps companies as it forces them to think about unforeseen black swan-like events. Managers who do this typically keep a lot of cash on hand so that they have ability to react and take advantage of market turmoil. Conversely, businesses that are over levered and whipsawed by black swan events usually free fall into bankruptcy.

These points made me think of a think of a misstep by a prominent CEO, Aubrey McClendon of Chesapeake Energy. If you remember, Chesapeake soared as high as $74 a share this year but crashed to $11 as natural gas prices fell. One of the more interesting stories here is McClendon’s margin call:

Aubrey K. McClendon, the billionaire chief executive of Chesapeake Energy Corp., has sold “substantially all” of his stock in the company over the past three days in order to meet margin loan calls, the company said Friday.

Chesapeake Energy did not disclose the size of the stock sale, pending the filing of documents with the Securities and Exchange Commission, but media reports have placed the number of shares at more than 33 million, making him the Oklahoma City-based company’s third largest shareholder…

“I have been the company’s largest individual shareholder for the past three years and frequently purchased additional shares of stock on margin as an expression of my complete confidence in the value of the company’s strategy and assets.”

Chesapeake Energy CEO forced to sell company stock ( AP )

So is McClendon a bad jockey? Yes, I think so. While it’s great that McClendon had so much faith in his company, he still exercised poor judgment when it came to the use of leverage. He did not plan for the worst nor demonstrate an aversion to risk. Rather, he fully embraced risk. He broke a lot of rules described in the Morningstar video because he didn’t foresee the possibility of extreme events, like those which we have encountered for the last few months, and was caught off guard and extremely over levered.

Investors are lucky that McClendon did not employ this blatant gambler-like thinking with the company itself. However, we can’t ignore the fact that McClendon was capable of such thinking. On the managers of companies, Warren Buffett likes to say that “You need a guy at the top whose DNA is very, very much programmed against risk.”

It seems like McClendon lacks that aversion to risk gene and that means that potential investors will need to see if Chesapeake’s economic moat protects against that. Maybe it does, maybe it does not. As investors search through the companies that have been beaten down by Mr. Market, they need to take a good long look at the people managing them. If they don’t, they risk blindly putting their money in the hands of people who may be seduced by leverage and open to excessive risks.

In the end, unless you’re able to win control of the company that you’re investing in, you’re at the mercy of management. As we can see from the current destruction of value on Wall Street, the managers of companies can sometimes make grave mistakes by misusing leverage. It pays to take the time to study the people that will be allocating capital and making the strategic decisions that may unlock the value you’re looking for.