Street Capitalist: Event Driven Value Investments

Diya Gullapalli at the WSJ is running a good story today on Ken Heebner and his bullish stance of financials:

This fall, Mr. Heebner built a more than $1 billion combined position in Citigroup Inc. and Bank of America Corp. He has put $780 million in two Brazilian banks, Banco Bradesco SA and Banco Itau Holding Financiera SA, counting on U.S. actions to help lending abroad. CGM Focus’s biggest holding through September was $552 million in Wells Fargo & Co.

About 40% of his $4.3 billion CGM Focus was in financial stocks as of Sept. 30, according to its portfolio report.

In determining which ones to buy, Mr. Heebner is leery of certain traditional earnings multiples that don’t always best gauge affordability. So for banks he uses two other measures, which suggest they are at historically cheap levels and, because he feels strong rebounds are assured, are ripe for plucking.

One such metric is “price-to-tangible book value.” For 20 big lenders, including Citigroup, Bank of America and Wells Fargo, this runs about 1.1 times, compared with 2.7 on average since 1990, according to a Goldman Sachs report. Tangible book value is the net worth of a company after stripping out intangible assets such as goodwill and patents. A lower ratio suggests a bank’s stock is undervalued but can also suggest assets are overstated…

His second measure is the “price-to-preprovision earnings” ratio. For these 20 banks, it is 5.4 times compared with 12.2 times on average. Preprovision earnings exclude provision expenses for loan losses and measure banks’ earnings power. A relatively low ratio can mean the market is underestimating the value of a bank’s potential for profits. But a low ratio also can be warranted if the market believes a company hasn’t provisioned enough for such losses.

Heebner the Contrarian (WSJ)

Heebner is an interesting investor to look at, at the end of 2007 he was routinely awarded as fund manager of the year. I think that the main issue with Heebner, which Gullapalli does indeed address, is the fact that he’s largely a momentum player. His fund has a pretty high turnover rate, basically from my perspective it looks like this – he takes a number of concentrated positions in a particular macro-investment theme and looks to see if they play out over the course of that quarter. If they don’t, he sells.

Most amateur investors like to look at 13F-HR filings to see what a particular fund manager is doing, but with a guy like Heebner this can be a recipe for disaster. The quarterly filings are always for what was bought last quarter. If you have a fund manager who has a turnover rate of 4 times a year, like Heebner does, you risk purchasing securities that he’s already sold. So I don’t really see Heebner as a guy you can study in this sense, or piggyback off of. If you’d like to invest alongside him, your best bet would be through his CGM Focus Fund.

You can still learn from an investor like Heebner in other ways. Try reading some of the past articles that include interviews with him, so you can figure out what his thought process is like when he’s looking at the market. That could be helpful with finding which trends you might want to pick up on when looking for cheap stocks.

Here’s a few good articles:

How Three Managers Turned Back a Tide (NY Times)
Three Strategies That Kept Sizzling (NY Times)
America’s Hottest Investor (Fortune)

Sorry for the thin posting recently, I’ve been going through final exams. This morning I had a chance to watch Charlie Rose’s interview with Nassim Taleb. Like always with Charlie Rose, the interview was top notch:

One of the things that struck me as interesting in the interview was the fact that the prospect of deflation. Nassim Taleb seems to think that that’s where our economy is heading:

CHARLIE ROSE: But let me go — you mentioned Nouriel Roubini, who has been here and who has become well-known as someone who has predicted this and saw it coming, and scares the hell out of people when he comes and sits where you do, because he sees it as getting worse, and even suggests sometimes it may mark the decline of America. How bad do you think…

NASSIM NICHOLAS TALEB: I think it is worse than Roubini thinks.

No, I — I had the same story, haven’t changed my story since — and what convinced me of this is that we switched from an environment of inflation, hyperinflation, where people are afraid of commodity prices rising, to a total deflation in no time. Look at inflation bonds…

… I know that we are going have massive deflation. The overhang of debt, massive deflation. Debt needs to be reduced. And I think Paulson seems to be doing a good job, particularly that they were part of the cause of what happened, you know, it is quite commendable.

That got me wondering – what is the best way to invest when you think that deflation is coming? When we, as value investors, invest we look for margins of safety. But if asset prices are falling, the margin of safety quickly contracts. So what are we to do?

Seth Klarman of the Baupost Group touches of this in his book, Margin of Safety. We’re lucky because the book was written only a few years after the junk bond craze, these kinds of topics were on the mind of investors. Here is what Klarman had to say on deflation:

In a deflationary environment assets tend to decline in value. Buying a dollar at 50 cents may not be a bargain if the asset value is dropping. Historically, investors have found attractive opportunities in companies with substantial “hidden assets,” such as an overfunded pension, real estate carried on the balance sheet below market value, or a profitable finance subsidiary that could be sold at a significant gain. Amidst a broad-based decline in business and asset values, however, some hidden assets become less value and in case may become hidden liabilities. A decline in the stock market will reduce the value of pension fund assets; previously overfunded plans may become underfunded. Real estate, carried on companies’ balance sheets at a historical cost, may no longer be undervalued. Overlooked subsidiaries that were once hidden jewels may lose their luster…

The possibility of sustained decreases in business value is a dagger in the heart of value investing (and is not a barrel of laughs for the other investment approaches either).

Which is really the heart of the problem with deflation, especially for value investors. We have to be cautious and not forget the fact that underlying values can indeed decline. This may have been one of the mistakes that some fund managers made when investing in banks while using book value to approximate business value. Book value was simply written down each quarter, ruining whatever margin of safety existed.

Klarman gives us three ways to invest if we think that business value may decline:

First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.

Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or hold current positions. This means that normally selected investors would probably let even more pitches than usual go by.

Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or not you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause to diminish become moot.

These rules are telling us that we need to be even more conservative if we wish to protect against deflation. That means increasing our margin of safety to compensate, and sticking with areas we’re more certain about. Sometimes value investors like to relax their standards so that they can join in the action of the market. They end up buying dollars for 70 or 80 cents and dip their toes in industries outside of their circle of competence. Maybe they’ll invest an an industry where the asset values are much harder to determine, they may make the error of overestimating and skewing their valuations as a whole. So we must become more conservative as the market becomes more turbulent.

With respect to the third factor, I really see this from a special situations perspective. Workouts like risk arbitrage, odd-lot tenders, and so on may be helpful because the price changes should be independent of the market’s precise movements and determined more by the transaction itself usually with a fixed time interval. This gives you the luxury of figuring out when the transaction will be completed so that you can compare it against what the market is doing.

Maybe you’re thinking about investing in an arbitrage situation but you think that asset values will decline over the course of the year. This could affect debt covenants or trigger a material adverse clause and kill the transaction. So you have to keep time in mind. The longer a transaction is supposed to take, the more you risk your capital, especially if you think the value of businesses will be declining.

Investing with macro issues in mind is always a tough thing, especially because its practically impossible to predict exactly what the economy will do. I don’t think that we need to study or spend too much time focusing on the economy though. We simply need to stick close to our principles and maybe exercise more caution that usual. If we do this, our returns should reward us well.

A few days ago, one of the best financial bloggers passed away: Doris Dungey, better known by her nom de guerre “Tanta”.

Take a moment to visit this post at Calculated Risk.

One of the greatest contributions of Tanta to the financial blogosphere can be found here, at her list of Compleat UberNerd posts, these made the esoteric world of mortgages and mortgage backed securities understandable for everyone – as the financial system started to unravel.

And personally, I always liked her posts where she pointed out the flaws in Gretchen Morgenson’s reporting at the New York Times. It’s a great service to everyone when a journalist is kept on their toes, so that we can make sure the truth is being properly disseminated to the public.