Street Capitalist: Event Driven Value Investments

A market that’s bit more explosive than our own:

I’ve heard some things regarding whether or not Buffett is allowed to release the letter on Saturday. I’ve heard that it might be as early as friday at 5 PM (about the same time as last year). But just in case:

Via the Associated Press

OMAHA, Neb. (AP) — Billionaire Warren Buffett will release his annual letter to Berkshire Hathaway Inc. shareholders on Saturday morning.

Buffett’s shareholder letters are one of the best-read business documents released each year, and many companies use quotes from Buffett’s writings in their own reports.

Spokeswoman Carrie Kizer said Monday that Buffett’s letter and Berkshire’s 2008 annual report will be posted online.

Investors will be interested to learn more about long-term derivatives Berkshire holds that are tied to the value of stock market indexes.

Berkshire owns furniture, carpet, jewelry and candy companies, restaurants, natural gas and corporate jet firms and has major investments in such companies as Coca-Cola and Wells Fargo & Co.

Check out Tunku Varadarajan’s interview with Nouriel Roubini in the WSJ. A few couple quotes:

Mr. Roubini tells me that bank nationalization “is something the partisans would have regarded as anathema a few weeks ago. But when I and others put it in the context of the Swedish approach [of the 1990s] — i.e. you take banks over, you clean them up, and you sell them in rapid order to the private sector — it’s clear that it’s temporary. No one’s in favor of a permanent government takeover of the financial system.”

There’s another reason why the concept should appeal to (fiscal) conservatives, he explains. “The idea that government will fork out trillions of dollars to try to rescue financial institutions, and throw more money after bad dollars, is not appealing because then the fiscal cost is much larger. So rather than being seen as something Bolshevik, nationalization is seen as pragmatic. Paradoxically, the proposal is more market-friendly than the alternative of zombie banks.”

One of the things I encounter with conservatives is the utter disgust for anything that sounds like nationalization. But I think that until the bad assets are flushed out, we’re going to keep seeing financial bloodbaths like what happened on friday. Nationalization may be the only way to bring about the kind of confidence that you need for banks to regain their strength.

I know that some investors have crept into financial institutions over the last quarter, by building stakes in companies like GE and Wells Fargo (both of which hit multi-year lows on friday), but I hesitate. For me, I’ve always preferred non-financial businesses in the sense that if they end up failing, they can liquidate and you’ll extract some kind of value. With financials, it’s much trickier. If this panic keeps up, you might see runs on banks and when deposits flee any of these behemoths can be quickly cut down.

Nationalization at the very least could take the banks away from Mr. Market’s glaring eyes and give management there some time to really make proactive changes without having to worry about their daily stock price. These decisions would be made for creating and preserving value, rather than defending the company from whatever psychological assaults that the market throws at them.

In reading about the Swedish model, the one thing I’ve noticed is that the government there still has somewhat of a controlling stake in their formerly nationalized banks. But over all, the effect of such action was quite positive. Here though I think we’d see a lot of investors who would love to jump into any of these financial institutions after they’ve been stripped of the bad assets so the government stake would likely be sold off after a short period of time.

Roubini brings up another worry though:

…Yet another reason why bank nationalization is a good idea, Mr. Roubini continues, is that “we started with banks that were too big to fail, but what has happened, in the process, is that these banks have become even-bigger-to-fail. J.P. Morgan took over Bear Stearns and WaMu. BofA took over Countrywide and then Merrill. Wells Fargo took over Wachovia. It doesn’t work! You can’t take two zombie banks, put them together, and make a strong bank. It’s like having two drunks trying to keep each other standing.

“So if you took over a big bank, and you split the assets in three or four pieces, maybe you create three or four regional or national banks, and they’re stronger! Nationalization — or ‘temporary receivership,’ if you like, if the N-word is a political liability — is an occasion to undo the sort of consolidation that has created an even bigger systemic problem. And the only way to do it is by essentially taking them over and breaking them up.”

If you think about it, he’s correct. Our policy at the start of the crisis was one where the government essentially financed or at least backstopped consolidation transactions. Rather than fix the dreaded “too big to fail banks” we had banks that were even larger come in and swallow them up. This does little else than create a problem for the future. Until these are broken apart, any issue with these banks would impose a huge systemic risk.

One of my biggest questions right now is what kinds of effects government intervention will have on equity holders. The fact is, it’s a little ridiculous for these guys to get a free ride while taxpayer money is guaranteeing their businesses. There needs to be a re-alignment of risks and rewards here, in order to prevent moral hazard from ensuing. The way I could envision it is sort of an application of the stress-testing that everyone seems to be talking about right now. The banks with a greater degree of bad assets will see higher rates of common equity holders wiped out, while the banks with less will see less of a reduction.

My guess is that such a policy will be difficult to implement, but something like it should happen. Until it does, you should expect the roller coaster equity markets to continue.

I’m going to try to catch this tonight and have a review up tomorrow. I’ve been a big fan of the programs that come out of Frontline and recommend that you guys try to catch it. It should be on at 9 PM EST:

Max Olson of FutureBlind puts together a really great presentation on the financial crisis:

You know, normally value investors aren’t thought of to be… “aesthetically” inclined (just look at Berkshire Hathaway’s website) but Max’s presentation manages to look really good while being very informative!

I’ve only recently been turned on to Howard Marks of Oaktree Capital, but so far I like a lot of what he says. You can find his latest memo The Long View here. Today’s NYTimes features an article about the inclusion of private capital allocators in Geithner’s bailout plan:

Mr. Marks is a former banker who became a pioneer in the graveyard of Wall Street. He is one of the biggest players in distressed investing — putting money into risky investments that few others will touch.

But he and other potential investors are wary of the risk in this case.

With its plan to shore up banks that was announced on Tuesday, the Obama administration hopes to entice investors like Mr. Marks, who has $55 billion at his command, to buy troubled assets from the nation’s banks and enable them to make the loans needed to jump-start the economy…

But Mr. Marks and other investors like him said they were in no hurry to wade into this mess. Distressed investors — “vultures” is the Wall Street term for them — aim to buy investments on the cheap in hopes of reaping big returns.

Yet even for the vultures, the risks — political as well as financial — seem daunting. Some worry about being seen as profiteers who benefit at taxpayers’ expense, even though the economy could get worse unless they swoop in.

“You have to ask whether this is an attractive deal,” said Mr. Marks, the chairman of Oaktree Capital Management, a big money management firm in Los Angeles. It all depends on the price, the terms and the risks, he said. Wall Street, of course, wants what it always wants: a lot of potential profit on the upside, and not much risk of losses on the downside. But as Treasury Secretary Timothy F. Geithner outlined his sweeping rescue plan on Tuesday, the questions kept piling up.

What kind of assets would the banks sell, and at what price? What role would the government play? And, of course, the big one: what are these investments really worth? The banks themselves are struggling to place values on them.

Washington Hopes ‘Vulture’ Investors Will Buy Bad Assets (NYTimes)

I think the main sticking point of the plan has to do with the pricing of assets. Geithner’s terse presentation yesterday did little to remedy that aspect and we saw markets fall. This makes me think that maybe they still haven’t figured out how to do it, and until they do there will be some hesitancy by private market participants. Michael J. de la Merced and Zachery Kouwe do bring up the IndyMac plan, where the government basically offered to step in and take on losses after a 20% decline.

While this plan may appear good on paper, it still poses an issue for institutional fund managers. In order to get paid, these managers need to have positive returns. A loss of 20%, which may seem like only a little, can actually be a lot when you realize that many of these guys were down 30 to 50% for 2008. Losing 20% would only increase that gap and make it more difficult to earn fees.

I’d like to point you all to a recent interview with Marks (LA Business Journal):

Q: You recently sent out a memo called “The Long View” with your thoughts on the turmoil in the financial markets. What do you think was the cause?
A: If you have to single out one thing, (leverage) was probably the greatest part. There’s an old saying in Las Vegas that the more you bet, the more you win when you win. But they always leave out the part about the more you lose when you lose. That’s what leverage is. Leverage does not add value to an investment – it doesn’t make it a better investment; it only magnifies the outcomes.

Q: And the long view?
A: These things never change. It will always be the case that when borrowed money is too easily available and people do not concern themselves with the downside, they will leverage their activities to levels where if something goes wrong they won’t survive. One of my favorite quotes in the world is from John Kenneth Galbraith. He says that one of the outstanding characteristics of financial markets is “the extreme brevity of the financial memory.”

Q: Why did you decide to stay in Los Angeles? Is there a benefit to being away from a financial center like New York?
A: The main reason that I stayed is because this is a great place to live. But we often theorize, especially at times of chaos, that it’s a help to be outside New York because you can see the real outline of things better from the outside than from the inside. New York is so overwhelmingly an investment community that I think it’s easier to have a broad perspective if you’re observing it rather than in the middle of it.

Q: What does it take to excel in investment management?
A: You obviously need to be to some degree numerically facile. You have to have a certain perceptiveness and an ability to look at a picture and see more than the average person sees. It’s so easy to see that the average person will do average. And if a client wanted to do average, they can put their money in an index fund. You just can’t swallow the same story that the average investor swallows and expect to be above average.

Q: Like what?
A: For one example, there’s an article by Charlie Ellis that I think was called “Winning the Loser’s Game.” What I took from that article was the way to succeed in investing – just like the way to succeed at being a B-level tennis player, which I am – is to not make mistakes. The champs win by hitting winners; the B player at a country club wins by not hitting losers. So that resonated with me and that’s one of the things we do. Oaktree’s motto is that if we avoid the losers, the winners take care of themselves.

Pay attention to that last answer, I think it tells us a lot about how to think successfully when looking at opportunities right now. When I discussed Geithner’s new plan, I noted that even a 20% loss may be too much. Marks seems to affirm that with his tennis player analogy, the idea is to dodge losers all together rather than simply limit how much damage the losers can do to your portfolio. I’m also reminded of Warren Buffett’s rule: Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. That’s likely to be the main reason that there’s still a high level of skepticism being offered by investors right now of these new bailout plan. Until more information is released, it’s likely that we’ll continue to be in an environment with shaky confidence and little involvement from private investors.

When I began this blog, I was under the impression that we’d see a difficult period for retailers and consumer spending in general. I had looked at data that showed many consumers leveraged their spending by using the easy credit provided by their home equity loans. My thinking was that if house prices declined, these guys would start feeling the hit and we might see a broader downturn. It was one of the drivers for me to invest in Fairfax Financial (NYSE:FFH).

The deterioration did not move at the pace I expected, but it seems to be picking up now. Tara Siegel Bernard at the NYTimes has a great piece on increased losses with private label credit cards:

Losses on the cards are rising at a faster pace than the broader credit card market — reaching a three-year high of 10.51 percent in January, according to Fitch Ratings, up 44 percent from a year ago. That compares with general credit card losses of 7.5 percent, up 40 percent from the year before.

While private label cards account for only about 11 percent of all credit card loans outstanding, their troubles offer a window into the deteriorating finances of some of the most distressed Americans. And the losses may prove to be a warning of deeper problems ahead for general cards as the economy weakens and unemployment climbs.

“The higher rate of charge-offs on private label reflects the impact that the economic downturn is having on all customer classes, with a particular strain on lower and middle-class income households,” said John Grund, a partner at First Annapolis, an advisory firm focused on the payments industry. “The next 12 months, 2009 into 2010, just doesn’t look real pretty as the jobless figures escalate.”

And this may affect retail sales:

The troubles in the private label card business may also further affect sales at retailers, which have already been reeling as consumers have cut back. Mr. Grund estimated that 30 to 40 percent of department store sales went on private label cards.

“Credit-tightening will shrink the amount of private label credit outstanding over time, but it will have an immediate impact on retail sales,” he added. “Consumers need financing to buy merchandise, especially big-ticket items, and issuers can cut too far to reduce loss exposure, making the recession even more problematic.”

Of course, some retailers, especially those that cater to more affluent consumers, are experiencing fewer losses, Nordstrom among them. And while some retailers continue to offer the cards at their registers in exchange for a same-day discount, the lenders have made it more difficult to qualify, much as they have done with traditional credit cards.

Fitch, which tracks $72 billion in receivables issued by banks on behalf of retailers, expects private label card losses to surpass 12 percent by midyear and losses on general cardholders with solid credit to reach 8 percent.

Losses Mount on Credit Cards for Retailers (NYTimes)

I think that the likelihood of this issue affecting retail sales will be pretty big. I walk through stores all the time and see them peddling their store cards and see people sign up for them particularly during increased spending periods (Christmas, Back to School shopping, Black Friday). These are times when buyers may be doing more than their usual purchasing and may lack the cash to make the purchase on that particular day. They go ahead anyway with the hopes of paying it off later with the store’s card.

If stores stop extending these cards, they’ll surely see a contraction in spending which should continue to have a negative effect on retailers and the sectors that are affected by them. Some people are expecting consumer spending to revert back to its historical mean (about a 10% contraction). Right now, I think that one of the best ways of trying to figure out how much this is happening and to what degree, is by paying attention to its drivers. These private label cards are at least one of them.