Street Capitalist: Event Driven Value Investments

Jeffrey Goldberg of The Atlantic has this great article which asks what the average investor is supposed to do right now. I often discuss investing with everyone I meet, it’s a passion — but I’m often shocked by the preconceptions that people have about it. The ordinary investor has really been misinformed which unfortunately leads to bad decisions and negative returns. Goldberg’s article sets a lot of things straight and would be good reading for anyone you know who is interested in investing but knows little about it. What I liked most about Goldberg’s article was the quotes from Seth Klarman:

Klarman is an acolyte of Ben Graham, the original value investor. Value investors—Warren Buffett is the most famous—seek out distressed, underappreciated assets, buy them, and wait until the rest of the world realizes that they’re worth something.

“The overwhelming majority of people are comfortable with consensus, but successful investors tend to have a contrarian bent,” Klarman said over lunch one day in an empty Boston restaurant. “Successful investors like stocks better when they’re going down. When you go to a department store or a supermarket, you like to buy merchandise on sale, but it doesn’t work that way in the stock market. In the stock market, people panic when stocks are going down, so they like them less when they should like them more. When prices go down, you shouldn’t panic, but it’s hard to control your emotions when you’re overextended, when you see your net worth drop in half and you worry that you won’t have enough money to pay for your kids’ college.”

One theme of Margin of Safety is that people like me aren’t equipped to be investors. “No one knows what he’s doing unless he’s a full-time professional,” he said. “As in many professions, full-time experts have an enormous advantage. Investing is highly sophisticated and nuanced. The average person would have an incredibly hard time competing.”

On the troubles of the small investor:

He agreed with Robert Soros that the financial-services industry treats the small investor not as a client but as a source of ready cash. “The average person can’t really trust anybody. They can’t trust a broker, because the broker is interested in churning commissions. They can’t trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now it’s even worse because even the most sophisticated people have no idea what’s going on.”

After 15 years of pabulum, I was enjoying, in a perverse sort of way, receiving straight talk from masters of finance.

“Everybody these days is a just-in-time investor. People say, ‘I’m going to leave my money in the market as long as possible, and then pull it out of the market just before I have to write the tuition check.’ But I think we’re seeing that the day you need to pull it out of the market, the market might be down 50 percent. It’s critical not to be greedy. Avoid leverage and don’t invest money that you can’t stand to lose.”

“I haven’t leveraged myself,” I said.

He asked me if I had a mortgage. Yes. He then asked me if the amount of money I had invested in the stock market was greater than the amount I owed on my mortgage—could I liquidate what remained of my portfolio to pay off my mortgage? I could.

“So you are leveraged. Why are you keeping your money in the market?”

“Because—”

“It’s because you think you’re going to make more money in the market than you’re paying in interest on your mortgage.”

“Yup.”

“Well, are you?”

“Uhh, no. But I’m getting the mortgage-interest deduction.”

“Yes, the interest is deductible. But if you had capital gains in the market, you’d pay taxes on those. In the aftermath of this financial crisis, I think everyone needs to look deep within themselves and ask how they want to live their lives. Do they want to live close to the edge, or do they want stability? In my view, people should have a year or two of living expenses in cash if possible, and they shouldn’t use leverage anywhere in their lives.”

“But if I dump my portfolio now, I make my losses real.”

“How are you going to feel if the market drops another 50 percent?”

Klarman brings up an interesting argument. I feel like when people decide they want to invest, they do not properly weigh their actions in the context of their overall financial situation. I have a feeling that many people invest simply to say that they’re invested. As a result, they usually make poor or mediocre decisions. At the very least, they end up investing money in the market when they may have been better suited by paying down debt. The kind of arbitrage practiced, where someone takes out a mortgage but invests in the market is highly risky. But I don’t think many people weigh investing in the market versus their mortgage.

Finally, Klarman’s question to ask anyone who is interested in investing:

“Here’s how to know if you have the makeup to be an investor. How would you handle the following situation? Let’s say you own a Procter & Gamble in your portfolio and the stock price goes down by half. Do you like it better? If it falls in half, do you reinvest dividends? Do you take cash out of savings to buy more? If you have the confidence to do that, then you’re an investor. If you don’t, you’re not an investor, you’re a speculator, and you shouldn’t be in the stock market in the first place.”

Be sure to read the entire article, there are excellent insights from Bill Ackman and Robert Soros among others.

Prem Watsa recently gave a talk at the University of Waterloo about some of Fairfax Financial’s guiding principles in terms of organizing and managing its subsidiaries. I’m sure a lot of interested investors could not make it to the event, but luck for us Rose Simone of The Record has a great article that covers the event:

Fairfax is short for “fair, friendly acquisitions,” Watsa said, adding the company will never consider a hostile takeover.

Furthermore, Fairfax doesn’t believe in selling its companies for a quick profit. “We say our companies are not for sale,” he said.

That may upset some shareholders, but “the advantage is that you can build a company over the long term,” Watsa said. “You can’t replace people or a culture,” he added.

Fairfax believes in “full disclosure,” to shareholders, taking great pains to stress the potential risks of decisions.

“If they want to buy, they can buy. If they want to sell, they can sell. But they cannot say we didn’t tell them,” Watsa said.

The company follows conservative financial practices. The primary goal is “not losing money,” and long-term returns, Watsa added.

That also applies to the company as a whole, Watsa added. “We will never bet the whole company on any acquisition.”

Fairfax has a decentralized structure, giving its executives a great deal of freedom. “Fairfax itself is a small holding company, not an operating company,” he said.

The result is that Fairfax has “never lost a president who has performed well,” and those presidents operate as if the companies are their own, Watsa added.

Most important is the principle of “honesty and integrity in all relationships,” Watsa said.

The company wants its employees and executives to be hard working, “but not at the expense of families,” he added.

After growing Fairfax into a multibillion-dollar company, Watsa cited one his favourite quotes, from the Bible’s Matthew 16:26: “For what is a man profited, if he shall gain the whole world, and lose his own soul?”

Investor advocates honesty, fairness (The Record)

Elsewhere, I saw it reported that Watsa recommended My Years with General Motors by Alfred Sloan which certainly seems interesting when you consider the current troubles at GM. The book seems to primarily be about Sloan’s time at GM and how the company changed its management structure in favor of decentralizing certain decision making roles. When you consider what Watsa says above, it’s likely that the book had an influence on the way Fairfax is run today.

Adam Lashinsky of Fortune Magazine has a pretty awesome interview with Warren Buffett on Wells Fargo (NYSE:WFC) and banks in general. I’ve increasingly looked into financials, as the sector has been hit hard and it’s one where I want to expand my circle of competence. This interview has plenty of good insights:

What about all the smart analysts who think no big bank can survive in its present form, including Wells Fargo?

Almost 20 years ago they were saying the same thing. In the end banking is a very good business unless you do dumb things. You get your money extraordinarily cheap and you don’t have to do dumb things. But periodically banks do it, and they do it as a flock, like international loans in the 80s. You don’t have to be a rocket scientist when your raw material cost is less than 1-1/2%. So I know that you can have a model that works fine and Wells has come closer to doing that right than any other big bank by some margin. They get their money cheaper than anybody else. We’re the low-cost producer at Geico in auto insurance among big companies. And when you’re the low-cost producer – whether it’s copper, or in banking – it’s huge.

Then on top of that, they’re smart on the asset size. They stayed out of most of the big trouble areas. Now, even if you’re getting 20% down payments on houses, if the other guy did enough dumb things, the house prices can fall to where you get hurt some. But they were not out there doing option ARMs and all these crazy things. They’re going to have plenty of credit losses. But they will have, after a couple of quarters of getting Wachovia the way want it, $40 billion of pre-provision income.

And they do not have all kinds of time bombs around. Wells will lose some money. There’s no question about that. And they’ll lose more than the normal amount of money. Now, if they were getting their money at a percentage point higher, that would be $10 billion of difference there. But they’ve got the secret to both growth, low-cost deposits and a lot of ancillary income coming in from their customer base.

Dick Kovacevich specifically told me to ask you your views on tangible common equity.

What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they’ve got huge earning power. And Wells … you can’t take away Wells’ customer base. It grows quarter by quarter. And what you make money off of is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that’s what they do.

Incidentally, they won’t lend Berkshire money. They’re not interested in national credits or any of that stuff where the spreads are narrow. We did a big deal about six or seven years ago on Finova, which we did jointly with Leucadia. And what was then the old First National of Boston sort of headed the deal up, and people would come in for $500 million or $200 million. Wells wasn’t interested. There wasn’t enough money in it, basically. I got a big kick out of that because that was exactly how they should think. Everybody else wanted to be in it, and they were doing it for 20 basis points or something of the sort. And they’d make commitments for all kinds of credit for 6 or 8 basis points, and the ones that were in the underwriting business, they would do it just get the underwriting.

But back to tangible common equity…

You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that’s where people get all mixed up incidentally on things like the TARP. They say, ‘Well, where’d the 5 billion go or where’d the 10 billion go that was put in?’ That isn’t what you make money on. You make money on that deposit base of $800 billion that they’ve got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they’ll put out the money differently.

They’ll have to work through a lot of this stuff that they inherited from Wachovia. Those option ARMs, they explained exactly how they break them down, and in the end they may lose 3 or 4 billion more. Nobody knows exactly. But I would say that California residential real estate is not deteriorating. It hasn’t moved up. But it has flattened out with good volume recently. So my guess is that the option ARMs will work out about as they guessed.

How is Wells differentiated from the banks you own and the ones you don’t?

Wells just has a whole different attitude. That’s why Kovacevich calls them retail stores. He doesn’t even like the word banking. I mean, he is looking to have a maximum enduring relationship with many, many millions of people. Tens of millions. And at the base of it involves getting money in very cheap. When you do that that’s a helluva start in the business. The difference between getting your money at 1-1/2 % and 2-1/2% on a trillion-dollar asset base is $10 billion a year. It’s hard to overemphasize that. He thinks more like Sam Walton than he thinks like J.P. Morgan. I’m talking about the individual there. He’s a retailer. He’s not trying to influence Washington or be the most important guy on the scene or anything like that. He’s just trying to do business with millions of people every day and make a few bucks off of them.

Now that you mention it, Kovacevich has done a pretty good job of annoying Washington, wouldn’t you say?

That’s hard to tell. There’s an advantage to being that way too. He’s not going to cozy up or be sycophantic toward his regulator, and I would say most bankers probably are now. They need to be. But his strong point is retailing not diplomacy. I kind of like that. It’s hard for a guy that knows his institution forward and backwards to have somebody come in that really may be working off a check list or something and is telling him what to do. And I’m sure that Dick gets antagonized by that sometimes. In the end, he’s got the record. And he’s got the business to back up what he’s doing.

To the extent that his tangible common equity is low, a) nobody was even talking about that a year ago. And b) they should be talking about earning power. But it comes about in part because he saved the FDIC’s bacon on Wachovia. I mean they had a deal on Citigroup (C, Fortune 500) that had big assistance involved in it, and the FDIC moved about what would have been about 5% of the deposits in the United States without a dime of expense to the taxpayer or the FDIC to Wells. And Wells took it over. And if they’d gone to Citigroup a) they would have looked like idiots, and within a very short period considering what happened to Citi. So to penalize them because they solved the FDIC’s problem without cost to the FDIC would be a little crazy. And I imagine that’s what gets Dick a little riled up.

So what is your metric for valuing a bank?

It’s earnings on assets, as long as they’re being achieved in a conservative way. But you can’t say earnings on assets, because you’ll get some guy who’s taking all kinds of risks and will look terrific for a while. And you can have off-balance sheet stuff that contributes to earnings but doesn’t show up in the assets denominator. So it has to be an intelligent view of the quality of the earnings on assets as well as the quantity of the earnings on assets. But if you’re doing it in a sound way, that’s what I look at.

I don’t own Wells Fargo, but seeing the way Buffett views these banks (paying attention to earnings power more so than book-value metrics) gives me some idea on how to view these companies. I think that this may be one of the reasons he’s stuck with some of the simpler banks like USB and WFC as opposed to others. It seems to involve picking a manager who is great in the sector, so that you can have trust in the company’s book value and focus on analyzing the bank’s earnings power.

Found this video, via McKinsey:

Nice interview here with Prem Watsa of Fairfax Financial — I haven’t been able to dig up too much regarding the annual meeting, but I’ll try to stay on top of it.

(click the image below)

Tara Perkins has out one of the first articles that discusses Fairfax Financial’s annual meeting. It’s short, but it provides answers to a few questions bugging investors, mainly the company’s newspaper investments:

The largest mistake that Fairfax Financial Holdings Ltd. made in the past year was underestimating the effect of the recession on the newspaper industry, chief executive officer Prem Watsa suggested.

Mr. Watsa was responding to a shareholder, at the company’s annual meeting in Toronto on Wednesday, who asked what the biggest mistake of the past year had been.

Fairfax took a 90-per-cent hit on its stake in AbitibiBowater Inc., and also lost money on its investment in CanWest Global Communications Corp. , Mr. Watsa noted.

And on removing the portfolio’s equity hedges:

Mr. Watsa also suggested that, in retrospect, he might have waited a few extra months before removing the hedges that Fairfax had in place on its stock exposure.

The company’s stock portfolio was fully hedged last year, but it recently chose to remove the hedges given how far markets had tumbled. “The fact that we hedged covered up a lot of our sins,” Mr. Watsa said.

He added that roughly three-quarters of Fairfax’s equity investments are in big companies such as Johnson & Johnson and Kraft Foods, and he believes that this is a “time of opportunity” for investors who will be in the market for the long term. Markets will not turn on a dime, but the next five to 10 years will be good to value-oriented investors, he suggested.

Fairfax regrets Abitibi, CanWest deals (Globe Investor)

Its funny, a few months back I looked at the newspaper sector myself (specifically the Sun Times Media Group) but couldn’t figure out what kind of cash flow to normalize my valuation estimates with. I never invested as a result. I guess I got a bit lucky on that end. Then there was also a post I wrote a while back on the NYTimes, I saw what appeared to be declining YoY cash flow numbers combined with difficult industry headwinds and issues with the Class A and B share listing. Since then, the company has fallen considerably.

On the bright side, Prem mentioned that the investment portfolio had two big positions in JNJ and Kraft. Interestingly enough, Kraft looks like they’re trading near a 52-week low. Given the company’s moats I’m going to start digging into them. The predictability there is much better than in the rest of the financial sector.

Western Sizzlin (NASDAQ:WEST) is an interesting company for investors to study. Many of us would love the opportunity to invest in the next Berkshire Hathaway. There will never be another Berkshire, but it does not mean that there won’t be companies that come to embody a similar philosophy. Some seem to think that Western Sizzlin, run by Sardar Biglari, is shaping up to be just that. I don’t currently own WEST, but I think that it’s certainly worth looking at.

Sardar Biglari’s Lion Fund (a value-based hedge fund) took control of Western Sizzlin a couple years back and so far has tried to implement the same kinds of value practices at the company. Western Sizzlin really started as simply a restaurant operation; currently the company owns 5 restaurants, 104 franchise restaurants, and a joint venture in a buffet-concept. Under Biglari the company has expanded quite by acquiring significant stakes in public companies, operating a real estate investment partnership, and picking up an investment advisory business.

To value a business like WEST, which contains a number of different parts and moving elements, you should try to break the business down into pieces and figure out a value for each. The best approach is to value as much as possible using net asset values and then applying other methods for the restaurant and investment advisory operations.

Public Investments

Common stock investments in ITEX Corporation (OTC:ITEX) and the Steak N Shake Company (NYSE:SNS) are probably the two biggest drivers in WEST stock. What you want to do is figure out how much of each company does 1 share of WEST control. Here’s how to do this:

Company stock owned / Shares of WEST outstanding

SNS: 1,322,222.15*/2,822,785 = 0.47 shares of SNS per share of WEST.
(*Western Investments owns 85.11% of Western Acquisitions, which owns underlying shares in SNS)

ITEX: 1,704,201/2,822,785 =0.60 shares of ITEX per share of WEST.
Now you can start doing the math of figuring out how much a price movement in ITEX or SNS affects your WEST stock.

Simply take (.6*Current Price of ITEX)+(.47*Current Price of SNS) or, using today’s numbers:
((.47*8.93)+(.6*.57))= $4.54 per share

Real Estate

In 2007, Biglari established a new subsidiary called Western Real Estate LP, to serve as a vehicle for investing in real estate. In December of 2007, the company purchased 23 acres of land in Bexar County (San Antonio – where Biglari is from). With the inclusion of Kenneth R. Cooper (a lawyer who specializes in real estate transactions) on Western Sizzlin’s board of directors its likely that Western Real Estate will see more transactions in the near future.

I tried to do some due diligence work on the land transaction. Going onto the Bexar County clerk’s page, I was able to obtain the public records for the purchase (PDF:Land Transaction). Unfortunately, the descriptions inside these documents will only give a person indirect information of the parcel’s actual location. You’re not given absolute coordinates, so I was unsure about how to plot this out. But, if you look at the report here, it seems as if real estate prices in San Antonio are rather stable, meaning that it may be valid to record the real estate transaction’s impact on net asset value based on its cost.

WEST assigns the land owned by Western Real Estate LP a value based on the cost of $3.75 million. $3.75 million / 2,822,785 = $1.33 per share

Net Cash

I’m simply taking cash & cash equivalents – (total liabilities)
330,998-6,651,590 = -2,584,771/2,822,785 = -2.24 per share

Business Operations

1. Restaurant

WEST owns 5 company-operated restaurants, a joint venture in the Wood Grill Buffet concept, and finally a franchising operation for 104 restaurants. To figure out its per-share commitments, we have to deviate a bit from the previous methods. I believe that figuring out this segment’s free cash flow and then assigning a multiple to it will be an adequate means of obtaining its value.

Free cash flow from restaurant operations is about $2.2 million. To get this number you have to take the company’s meager reported net income for 2008 ($175K) and add back a series of one time charges while also deducting (-$34K) for maintenance capex. You’ll peg this number at $2.2 million of FCF for 2008. At this point, I think a multiple of 8X is quite fair. The number of restaurants franchised by WEST has declined over time from 123 (2006) to the current 104, it might be a stretch to project any growth to come out of this area. I’m using a multiple of 8X as opposed to 10X because of the decline in franchised restaurants over the past 2 years. The restaurant operation’s contribution to WEST common stock comes out to $6.30 per share.

2. Mustang Capital

The fees generated from Mustang Capital’s advisory fees come out to approximately $240.5K. With a business of this nature, I think that net income actually approximates free cash flow, as typical with most financial businesses. Mustang Capital operates as an advisory firm where fees are derived from a percentage of assets managed. Since this was during 2008, I would say that its certainly not a peak number, so assigning a 9X multiple works. This contributes $0.77 cents per share.

You might argue for a higher multiple, but I think that because there are so many uncertainties about the asset management business, we should err to the side of caution. We don’t quite know what the composition of assets are (if they’re mostly one person, evenly divided, and so on) so 9X should be fair.

Sum of the parts valuation

6.30 (Restaurant ops) + 0.77 (Mustang Capital) + 1.33 (Real Estate) + 4.54 (Equity Investments) – 2.24 (net cash) = $10.7 estimated value

Current trading price: $11

This implies that WEST is actually slightly overvalued, nota screaming bargain. But if you go ahead and take a look at the per share impact of ITEX and SNS, you’ll see that a $1 increase in either’s stock price would add $0.60 and $0.47 to the company’s estimated NAV. This means that estimated NAV will be moving up and down every day. As a result, one should think like an owner when investing in WEST. I consider it to be blind investing if you simply look at the investments in aggregate and assign growth rate multiple and assume that is what their contributions will be to the company’s valuation. That is what I would consider to be too much faith put in Biglari’s hands. Not that his hands aren’t good at investing, but the sheer fact that there is so much concentration in two securities makes it essential for you to go out and calculate the intrinsic values of Steak N Shake and ITEX.

Western Sizzlin has the potential to be a really attractive investment, and a few days ago when I was working on this write up the valuation spread was wider, at 22%. Still, for me personally, I see little reason for investing in WEST while owning shares of SNS. For others, especially those who believe that ITEX shares are undervalued, Western Sizzlin could be a way to play both while having one portfolio position. I also see the company as a jockey stock. I know a few investors who will only invest in “Buffett”-like managers, such as Prem Watsa, the partners and Leucadia, the Tisch family at Loews, and so on. From what I understand, its a strategy that works pretty well.

For me though, I would rather stick with just SNS, where I see there being less moving parts and a simpler situation to value — than wading through Western Sizzlin with its various subsidiaries and operations.