Street Capitalist: Event Driven Value Investments

I mentioned Seth Klarman and inflation hedging previously in my post about his talk at the CIMA conference. Here is another quote, this time from a recent article on MarketWatch:

Seth Klarman, a top-performing value investor and head of The Baupost Group LLC, told clients in an Oct. 10 letter that the economic downturn could be “vicious and protracted.”
“The financial market collapse and bailout makes us sick,” he wrote. “There is likely more carnage to come.”

The U.S. dollar will likely weaken and its reign as the world’s reserve currency could end, Klarman predicted. Longer-term, U.S. interest rates may rise as foreigners have to be enticed more to invest in dollar-denominated assets, he added.

The recent Treasury Department bailout has yet to be paid for and should add to inflationary pressures over time, especially when the economy begins to recover, he said.

I still haven’t figured out what his inflation hedge might be, but it’s something worth thinking about. Here’s a line from his book Margin of Safety, which hints a bit at inflation hedges:

…value investing can work very well in an inflationary environment. If for fifty cents you buy a dollar of value in the form of an asset, such as natural resource properties or real estate, which increases in value with inflation, a fifty-cent investment today can result in the realization of value appreciably greater than one dollar.

What might he be looking at? Timberland? Oil and gas properties? Or maybe land itself, domestically or abroad.

As any good investor, many of you are probably searching for bargains right now. With the market rallying, it might appear that there aren’t any bargains out there — or that bargains are becoming less cheap. Never fear! Here are some bargains for you to hunt for:

1. Starbucks – Free small coffee. You merely have to come in and ask for it.

2. Krispy Kreme – Free donut if you have an “I Voted” sticker.

3. Ben & Jerry’s – Free scoop of ice cream between 5-8pm.

4. Chick-fil-a – Free chicken sandwich if you TURN IN your “I Voted” sticker

These aren’t dollars for $0.50 cents, they’re dollars for free.

I’ve always been a huge fan of Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joseph H. Ellis. In the book, Ellis gives us a method for analyzing the economy by using consumer spending as the primary indicator. It really simplifies the problem and as Ellis shows, seems to really have an impact on where our economy goes.

With that in mind, I wanted to re-examine what real personal consumption expenditures have been like over the last few years. To see if anything has fundamentally changed. When I started this blog in September of 2007 I believed that sub-prime would eventually affect consumer spending. Today we got a lot of news that seems to support the idea that consumers are indeed cutting back.

Here’s a chart of spending:

The chart seems to indicate that we’ve seen a sharp decline in spending and the last few times this has happened we’ve seen significant recessions. In addition, today a number of stores were released describing the problems with retailers and spending right now.

First at Circuit City:

Circuit City Stores Inc., the nation’s second-largest consumer-electronics chain, said it is closing and liquidating 155 stores and laying off thousands of employees as it struggles to stay afloat through the holiday selling season.

Citing a deteriorating economy, tightening credit terms by suppliers and reduced borrowing abilities, the Richmond, Va., retailer said it will close more than a fifth of its U.S. stores Tuesday and begin liquidation sales Wednesday.

The moves are designed to slash operating, marketing and payroll expenses while preserving cash needed to stay afloat. Circuit City was down to $92.5 million in cash and equivalents as of Aug. 31. If the effort falls short, industry analysts said, the only remaining options would be to close more stores or seek bankruptcy-court protection.

Circuit City Braces for Dismal Holiday (WSJ)

Then with General Motors, a cornerstone in American industry:

General Motors on Monday reported an incredible 45 percent decline in its sales from the month a year ago, and Chrysler said its sales were down 35 percent. The Ford Motor Company said it sold 30.2 percent fewer cars and trucks.

Toyota Motor said its sales were 23 percent lower, despite offering no-interest financing and large discounts on many models. Sales were down 33 percent at Nissan and 25.2 percent at Honda.

“If you adjust for population growth, this is probably the worst industry sales month in the post-World War II era,” Mark LaNeve, G.M.’s vice president for sales in North America, said in a statement.

Automakers Report Grim October Sales (NYTimes)

Even Whole Foods:

The purveyor of natural and organic foods said in August it would reduce planned store openings for its fiscal 2009, which began Sept. 29, and suspend its quarterly dividend. Chief Executive John Mackey said the environment was “the most challenging I have experienced in my 30 years in retail.”

Economic conditions since have worsened, making it even harder for the company, based in Austin, Texas, to attract customers to the gourmet foods that account for much of its profit, such as $15-a-pound sesame-crusted salmon and $9-a-pound mushroom-leek strudel.

Whole Foods declined to comment, citing a quiet period in advance of its earnings report. But amid the credit crunch and weaker consumer spending, investors have been selling off Whole Foods shares in anticipation of further bad news. The stock was up 15 cents a share in 4 p.m. Nasdaq composite trading Friday, but the shares are down 74% this year.

Slump Threatens to Burn Whole Foods (WSJ)

These stories could just be omens for an oncoming malaise in corporate earnings. So that means we may not have hit the bottom in stocks just yet. However, I think that we shouldn’t let these kinds of considerations explicitly dictate what we’ll invest in. It becomes too hard to time things and you begin trying to forecast not only company specific factors but where the entire economy is going – you can easily make mistakes.

I just like this to provide a little guidance, maybe to find some value investments with potential tailwinds. Trying to find the bottom might be a loser’s game – if you focus on picking stocks large margins of safety though you should be fine and outperform the market.

Today’s New York Times features an awesome article: “Challenging the Crowd in Whispers, Not Shouts” by Robert J. Shiller.

Shiller discusses why the housing bubble was ignored by colleagues. At heart here is the issue of when to be a contrarian. This is a subject I’ve posted about a lot since the start of the blog. As value investors we almost always have to act as contrarians by nature.

The thing I liked about the article is that it discusses a reason for not being a contrarian that I hadn’t have thought of:

The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group…

In addition, it seems that concerns about professional stature may blind us to the possibility that we are witnessing a market bubble. We all want to associate ourselves with dignified people and dignified ideas. Speculative bubbles, and those who study them, have been deemed undignified.

I’ve never thought of contrarianism in these terms — where being a contrarian can affect how your colleagues perceive you and whether or not your professional opportunities are limited by bucking the trend.

When I think of contrarianism, it’s really from a more individualistic perspective. Many investment fund managers are able to achieve a good sense of individuality, managers in the value sector are actually afforded the luxury of being contrarian – it’s part of the job. In other professions, that isn’t the case.

Shiller describes economists working for the federal reserve, but I can think of other places affected by the same problem. A number of people working in the mortgage industry raised questions about the sub-prime loans being made, but were basically told to get back in line. Similarly, recent testimony from the ratings agencies revealed documents detailing questions that were raised regarding certain CDOs.

With economic research councils, like Shiller cites – perhaps something can be done to promote more diverse areas and contrary opinions. I know that some organizations utilize a technique where when someone proposes a plan another employee is given the task of playing devil’s advocate and arguing why the plan should be rejected.

In the other examples, the mortgage lending industry and ratings agencies the problem was a bit different. It was an agency issue. These folks were generally paid based on quantity of work, not quality. That kind of thinking creates a culture of greed and we know how that ends. Tackling that problem is more difficult. You need to adjust the psychological mindset of the people working there. The easiest way would be to alter how compensation works at those firms – so that they have an economic interest in their work, rather than being able to pass the risk off to the next person down the line.

How do you fix something like this, or prevent this kind of thinking?

You need a diverse group of mental models.

Why do professional economists always seem to find that concerns with bubbles are overblown or unsubstantiated? I have wondered about this for years, and still do not quite have an answer. It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing.

Shiller highlights one of the greatest issues with economics, the lack of interdisciplinary thinking. He’s not the first person to bring this up. Warren Buffett’s famous business partner, Charlie Munger has been a huge proponent of interdisciplinary thinking .

From his speech – Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs (PDF)

I think there’s a modern name for this approach that Whitehead didn’t like, and that name is bonkers. This is a perfectly crazy way to behave. Yet economics, like much else in academia, is too insular. The nature of this failure is that it creates what I always call, “man with a hammer syndrome.” And that’s taken from the folk saying: To the man with only a hammer, every problem looks pretty much like a nail. And that works marvelously to gum up all professions, and all departments of academia, and indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man with a hammer syndrome is to have a full kit of tools. You don’t have just a hammer. You’ve got all the tools. And you’ve got to have one more trick. You’ve got to use those tools checklist-style, because you’ll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. But if you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of answers that you won’t
find any other way.

Maybe Shiller will find Munger’s speech. I think he’s enjoy it.

Having these mental models can improve your judgment by getting you to look at problems from non-traditional perspectives. It will get you to question the crowd and might give you the oomph you need to yell instead of whisper amongst your colleagues.

I came across a great interview with Nate Silver of Five Thirty Eight. What I liked most was that Silver highlights how the media is changing for electoral campaigns:

The rise of blogs at the expense of talk-radio could have some interesting financial implications. Media companies are transporters of content. They get paid by putting up advertisements. Think of ads in newspapers and the internet or commercials on the radio and television.

Silver’s proposal is that we’re seeing a coming of age for the internet as a content transporter and that blogs are becoming the new source of viral media. If you think about it, it makes sense. It’s easy now to transport viral media, you can quickly send out youtube videos that link people to videos of events and have millions of views in a few hours. I think that this is a big difference from the last time we saw a lot of internet hype – back in 2000.

Now, internet speeds for the average user are faster. According to the Pew Internet & American Life Project, broadband internet usage is about 57% for American adults. As a result, video content is much more easily accessible than it was in 2000. Video will always be more accessible and in turn more viral than a simple article and sites like YouTube make the transmission of such content extremely easy.

But how does this affect you as an investor? A few ways.

One of the companies I’ve spend a bit of time looking at is CBS (NYSE:CBS) — well really, the media sector all together. We know that traditional forms of media are on the decline, namely radio, TV, and newspapers.

CBS is really a play on radio and TV stations. A decline in usage will hurt their ad revenues, especially in an already distressed economic environment.

For a company like News Corp. (NYSE:NWS), the situation is different. There, investments have been made to keep the company quite competitive as we shift to a more internet heavy world.

Myspace alone averaged 67.7 billion page views for June of 2007. Conversely, collective properties owned by CBS only averaged about 7.3 billion page views in the entire year of 2007, or 10% of the monthly page views for MySpace. As one medium gains momentum, it usually eats away at the other. In this case, the internet versus TV and radio. This hurts CBS more than it does News Corp.

I saw that News Corp was trading at 4.75 EV/EBIT, with cash on hand (great for this environment) but using multiples doesn’t work as well when everything else in the sector is depressed. As a result, valuing media companies becomes tricky, but more exciting too. You have to normalize earnings from from different revenue streams – where some are trending down while others are trending up. It’s the main reason I’ve held off on investing in either of these companies so far, I’m having trouble figuring out how to peg their earnings for the next few years– but maybe one of you out there can give some input.