Street Capitalist: Event Driven Value Investments

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Take a moment to watch the following video:

Guy Spier is a value investor that I think we can learn a lot from. I think that while the idea of value investing can be pretty general, it’s always extremely interesting to see how practitioners actually employ Benjamin Graham and Warren Buffett’s principles. Spier for example takes a much more global approach than most value investors I’ve seen before. Be sure to check out his blog.

So far the lunch auction with Buffett has steadily moved up from the initial bid. At the moment it’s at $810,100 with 4 hours and 15 minutes left. You can keep yourself updated by refreshing the eBay page.

I’m sure you all remember that Zhao Danyang of Hong Kong’s Pureheart Asset Management won the Glide Foundation’s auction for lunch with Warren Buffett. Reuters has an article detailing the lunch:

SHANGHAI (Reuters) – When Zhao Danyang agreed to pay more than $2 million a year ago for lunch with Warren Buffett, the Chinese hedge fund manager was plagued by puzzles he hoped the Oracle of Omaha could help unravel.

But Zhao spent most of Wednesday’s three-hour New York steakhouse lunch listening to the world’s most celebrated investor to see if their two minds think alike.

“Buffett told me: ‘you’re lucky to be in China’” Zhao said.

“China has so many clever people, there’s no doubt that someone will stand out in the game of investing.”

Zhao’s bid for the lunch was three times the previous record, and the largest ever for the charity auction sponsored by eBay Inc. It was also a sign of how Chinese fund managers want to share the limelight with top investors as its economy takes center stage in a global recovery.

The expensive lunch was an inexpensive advertising campaign for Zhao, 37, whose Hong Kong-based Pureheart Asset Management Co had a 600 percent return during the past six years.

He brought a 10-year-old copy of Buffett’s book with him as he and six friends lunched with the Berkshire Hathaway Inc BRK.B chairman at the Smith & Wollensky’s steakhouse in Manhattan.

“Buffett to me is what Benjamin Graham is to Buffett,” Zhao said, referring to the economist and investor considered the first proponent of value investing.

“I thank him and I respect him. But I don’t adore him, because we’re all human beings…”

“…After witnessing this economic cycle, and the bubble bursting, I now have a better understanding of many economic issues,” Zhao told Reuters by phone from New York.

“Buffett agreed with some of my views, which emboldens me to make some big bets in the future.”

Zhao said he adopted Buffett’s value investing philosophy after reading a book about him a decade ago.

“The lunch was really worthwhile. It’s priceless,” said Zhao.

“Unlike Buffett, I’m still young and haven’t witnessed many cycles. His views will benefit my whole life.”

In an expression of gratitude, Zhao gave Buffett a bottle of Moutai, a fiery Chinese liquor, and some Chinese medicine.

He also presented several annual reports of Beijing-based retailer Wumart (8277.HK), which Zhao said is heavily weighted in Pureheart’s portfolio. “I like this company very much, and I hope Buffett can give it his thoughts.”

Fund manager Zhao aspires to be “China’s Buffett” (Reuters)

It will definitely be interesting to see who wins this year especially with all the talk of Buffett losing his luster. I wouldn’t pay too much attention to that kind of talk though, it seems to happen every 10 years or so and Buffett always manages to be vindicated afterwards.

Intellectually, start ups have always been an area of interest for me. What I often wonder is if start ups can mesh with the kind of Warren Buffett-style practices I use to look at businesses. Right off the bat, the two ideas appear to be pretty incompatible. After all, start ups are typically focused on new technologies that are unproven, often without moats around them. But Max Chafkin over at Inc.com has a great article (“The Start-up Guru: Y Combinator’s Paul Graham”) that details the methods employed by Y Combinator when investing in start ups.

Y Combinator is unique in that its investments are relatively small, they do not sink millions of dollars into any one company. The businesses they invest in are often intended to be disruptive, their goals are to eat away at the moats of competitors. A while back I remember reading about Walmart and Sam Walton. One of the things that he addressed was the fact that you did not have to try to copy Walmart to compete with Walmart. Instead, you had to find holes in its moat, products that they could not deliver to their customers. I look at these Y Combinator start ups in some of the same light. They’re not trying to beat a company like Google, they’re just trying to take a sliver of Google’s giant moat.

Y Combinator’s strategy of limiting the liabilities side of their start ups reminded me of Mohnish Pabrai’s belief that often you need to find low risk high uncertainty businesses. For example:

Tonight’s feast consists of mountains of white rice and a ketchup-hued chili served out of several large electric Crock-Pots. The founders eat standing up or hunched over laptop screens. A quick scan of the Y Combinator pantry, which includes six gallon-size cans of pinto beans, seven large cans of sloppy joe sauce, and a copious amount of canned tomatoes, confirms that the meal is typical. “Goop on rice — the same every week,” Graham says with a smile, as he shovels the stuff into his mouth. He used to cook the meals himself but recently ceded that duty to a professional cook.

Cheap meals are, in a strange way, part of Y Combinator’s formula for start-up success. Graham wants founders to spend as little money as possible. Live cheaply enough, he believes, and you can become cash-flow positive without going on a lot of sales calls or spending too much time talking to investors. Graham calls this “ramen profitability” and says it allows companies to say no to bad investment terms and forces them to think about long-term viability. It also ensures that most Y Combinator founders are in their 20s — or, for the few who happen to be older, that they are capable of living in dormlike conditions. “That culture of frugality and discipline is really important for the Y Combinator mindset,” says Sam Altman, founder of Loopt, a graduate of Y Combinator’s first class. “The start-ups that do well are the ones that are working all the time.”

…The pitch was straightforward: $6,000 for a company with one founder, $12,000 if the company had two founders, and $18,000 if the company had three. In exchange, Y Combinator would get roughly 6 percent in common stock. (Exact ownership stakes vary. The most Y Combinator has taken is 10 percent; the least is 1.4 percent.)

Graham promoted the program with an essay that he posted on his website and that quickly found its way to many college students’ e-mail inboxes. “We give you enough money to live on for a summer, as with a regular summer job,” he wrote. “But instead of working for an existing company, you’ll be working for your own; instead of showing up at some office building at 9 a.m., you can work when and where you like; and instead of salary, the money you get will be seed funding.”

From the start, the businesses funded by Y Combinator seem to be infused by a mantra of doing less with more and living frugal lifestyles. By keeping these costs ultra-low and controlled, the team at Y Combinator seems poised to keep their losses relatively low while keeping their upside high. Graham himself seems like a bit of a renaissance man:

Like many software entrepreneurs, Graham has been writing code since his teenage years, but he also has a range of interests not common among computer geeks. He was an aspiring short-story writer as a high school student and majored in philosophy at Cornell as an undergraduate. After deciding that he found philosophy incomprehensible, Graham landed in a computer science Ph.D. program at Harvard. He excelled as a programmer, but about halfway through graduate school, he started taking classes in Harvard’s art department. After receiving his doctorate, he enrolled at the Rhode Island School of Design with a plan to become a painter. He took classes at RISD that summer and in the fall enrolled at Florence’s Accademia di Belle Arti, a nearly 500-year-old art school founded during the Renaissance. When I suggest to Graham that this was a weird life plan for someone with a computer science degree from Harvard, he says simply, “I never cared about the official rules.”

Such a multidisciplinary approach reminds me of investors like Benjamin Graham or Charlie Munger. One thing I wanted to point out is that I think their approach of building a fairly diversified portfolio of investments is interesting. It reminds me a lot of Ben Graham’s net-net approach, where capital was deployed in many different securities. The same kind of thinking happened with Buffett’s investments in South Korea and more recently in the Pharma-sector. In these cases, there was a considerable amount of uncertainty and while the investors knew some of these companies would be immensely profitable investments, others would be less so. It would be too difficult to only pick the winners, so a diversified approach was employed.

Be sure to read the full article: The Start-up Guru: Y Combinator’s Paul Graham (Inc.com) I feel like we can always learn by looking at areas that we normally designate to be outside of our circle of competence. Most value investors try to shun technology, but as we all know, both Buffett and Munger spoke highly of Google’s moat at the annual meeting this year so it’s likely an area worth studying.

With value investors, I’ve always looked up to Joel Greenblatt. His book You Can Be a Stock Market Genius was actually my very first investing book. Since then I’ve tried to read everything I could about him, from transcripts of interviews he gave on television, and his course material from Columbia.

I stumbled across a really interesting paper, penned by Greenblatt and noted value investor Richard Pzena published in the 1981 Summer issue of the Journal of Portfolio Management. Their paper is titled “How the Small Investor Can Beat the Market”.

I think that sometimes as value investors we spend too much time trying to emulate our idols, rather than take advantage of the opportunities that are available to us because of our small size. Greenblatt and Pzena’s article affirms the idea that small investors do have an advantage, mainly in the area of net-nets where most securities are small, under followed, and often mispriced. The authors say:

…Wall Street research houses limit their coverage to fewer than 500 actively traded issues (Merrill Lynch being the exeption with approximately 1100 stocks closely studied). Meanwhile, the NYSE trades 2000 stocks, the Amex trades 1000 companies, and the OTC market trades another 7000 issues that are required to provide relatively full disclosure to the SEC. Under these circumstances, the individual may in fact be able to locate unrecognized values in the nearly 9000-stock second tier not closely followed by “experts.”

Now this was written about 28 years ago, so maybe research has changed. Still, certain companies will always be under followed or receive scarce research coverage. I’ve always noticed that there indeed are bargains in the net-nets area. Finding liquidations for example (often the result of a net-net where management realizes their operations are doomed) requires a little extra leg work on the part of the investor. Some enterprising online communities have sprung up that are dedicated to uncovering these bargains. The extra work required to find such bargains makes them less likely to be uncovered by the rest of the investing universe, allowing you, the small investor, to take advantage.

So Greenblatt and Pzena (G&P from now on) set out a methodology for what they define as Graham’s rough calculation of liqudiation value:

Curent assets (cash, accounts receivable, inventory, etc.).

less

Current Liabilities (short term debt, accounts parable, etc.),

less

Long Term Liabilities (long term debt, capitalized leases, etc.),

less

Preferred Stock (claim on corporate assets before common stock),

divided by

Number of shares outstanding,

equals

Liquidating Value Per Share.

G&P didn’t just test this method during a bull market. They say:

…we selected 15 segments of 4 months each over a six-year period in which the over-the-counter (NASDAQ) averages halved and then doubled. (Approximately 60% of our selected stocks were traded in the OTC market.) The period under study ran from April 1972 to April 1978; it included the great market plunge of 1974 and the subsequent strong recovery. The obvious advantage of such a volatile period is that we were able to observe the performance of our selected stocks during extreme market conditions.

G&P look at three factors when designing their portfolio test.

1. Price to liquidation value
2. Price to earnings ratio
3. Dividend yield.

The authors included in the simulations that a security would be sold after a 100% gain or after 2 years, whichever came first.

Here are the portfolios:

Portfolio 1
Price / liquduation value: <= 1.0;
P/E: floating with bond yields;
Dividends: no dividend requirements
Return (After tax/comm): +11.3%

Portfolio 2
Price / liquidation value: <= 0.85;
P/E: floating with bond yields
Dividends: no dividend requirements.
Return (After tax/comm): +16.5%

Portfolio 3
Price/liquidation value :<= 1.0;
P/E: <= 5.0;
Dividends: no dividend requirements.
Return (After tax/comm): +20.1%

Portfolio 4
Price/liquidation value: <= 0.85
P/E: <= 5.0;
Dividends: no dividend requirements.
Return (After tax/comm): +29.2%

Note the differences in performance that come with the adjustments in the portfolio’s screen factors. The best performing portfolio is #4, which contained not only a requirement that the securities be below liquidation value but also that they trade at a low price to earnings level. This resulted in a wide margin of outperformance for portfolio 4 compared to the others. This helps us see that not all net-nets are alike, and that employing the usual methods of sound stock investing in the net-net area will enhance results. Usually, the universe of net-nets is pretty limited, which I believe helps in making it possibly for investors to deeply examine. Plus, since many of these companies are tiny, the small investor may have more luck getting in contact with management than they would with large companies such as GE.

Over the same period, the Value Line index had a return of -0.3% and the OTC index had a +1.3% return. The liquidation value portfolios had huge levels of outperformance versus the respective indexes. G&P give a few reasons for why this might be: 1. large institutional investors can usually only invest in the top 1000 to 1500 high-capitalization stocks. 2. There are less research dollars in the area of such small stocks, resulting in a second tier of stocks that are unrecognized and thus may be inefficiently valued by the market.

G&P end with a comment on the future:

Unless the structure and focus of the securities industry changes dramatically towards more coverage of secondary issues,a route made unlikely by basic economic realities, the individual may not have to worry about the prospect of a completely efficient second tier. On the other hand, in the more computerized future, it is likely that “bargain” stocks will become harder to find and will provide lower excess returns than the “bargain” stocks currently available. Even under these circumstances, the small investor should retain a significant advantage over the large institutional equity funds.

As Ben Graham noted in his classic, The Intelligent Investor, “It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone — after deducted all prior claims, and counting as zero the fixed and other assets — the results should be quite satisfactory.” Apparently, in today’s world of efficient markets, investors can still profit from Ben Graham’s advice.

What’s really quite interesting is that much of this remains relevant today. The economics of the business right now prohibit many funds from stalking net-nets. Even though now it’s easier to find net-nets on screens, the universe is sufficiently large enough to satisfy the appetites of smaller investors and continue to provide opportunities that most larger players are unable to touch. In Greenblatt’s other book, he provides examples like spinoffs and other special situations which are not securities selling below liquidation but are undervalued and untouched by other market players because of institutional constraints. This is what I believe he is getting at when he says that a small investor should retain a significant advantage over the large institutional equity funds.

Some readers may be skeptical of this 30 year old advice. But remember that Graham was able to thrive with net nets 50 years before that. More recently, James Montier the strategist at Societe Generale penned a piece in September that said if an investor invested in a basket of net-nets over a 20 year period, their average annual return would be around 35%. My guess is that net-nets will always remain an area for small investors to profit from, as long as we actually start looking there and embrace the advantages that come with being a small investor.