Street Capitalist: Event Driven Value Investments

Lately I’ve been seeing a real uptick in the articles on gold. Even a few enterprising reporters at NPR have invested in it. I don’t own any gold and I don’t have any exposure to it via miners or other companies. But I often think about the metal and how investors are increasingly fixated on it.

(Flickr:IzaD)

Recently, Ben Stein had a chance to interview Warren Buffett and got his thoughts on gold:

My first question, as I sit there on the couch in his office, is: “What about gold? Is this a classic bubble or what?”

“Look,” he says, with his usual confident laugh. “You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

Okay, so gold is not a screaming buy to Buffett. What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?

“Equities,” Buffett answers without a moment’s hesitation.

Warren Buffett: Forget gold, buy stocks (Fortune)

My problem with gold is that I think an investment in it requires you to accurately gauge the anxieties and fears of the investors who are buying it. I don’t think I have any talent for doing that. I’ve read a bit on George Soros because his theory of reflexivity seems applicable to playing gold — and Soros has indeed said he intends to keep buying gold, but it’s not a concept I’ve mastered. Maybe mere mortals like us can’t master it. He goes into his theory of reflexivity in detail with his book The Alchemy of Finance which I’ve read. While I wouldn’t make an investment decision with his theory, I can see why it works for him.

But, I think the dollar is facing real problems. So finding investments that will protect your purchasing power makes sense.

A lot of people complain that gold is not a productive asset and that’s true. Owning gold is not like owning a business, it probably wont make you rich. I think that beyond supply and demand issues, an investment in gold is really an act of speculation. Gold investors tend to have these specific fears about the economy and see gold as this one commodity that keeps on rising. Inevitably, they must expect that when the time comes they’ll sell to another person at a higher price. That’s momentum investing and it’s a pretty tough game.

However, for some people buying might make sense. A friend, upon hearing what Buffett said that even though all the world’s gold would fill a cube 67 feet in each direction, with its high density it can easily be formed in coins. Plus, with its high value-to-weight ratio, gold can be easily moved. Now contrast that with owning an oil company. You can’t move an oil field and even if you own it, countries can come in and nationalize it or take away your permits. The same goes for farmland. I think it’s for these reasons that gold has remained a store value for so long, even if productively, it’s not very useful.

If you are ultra-wealthy and worth $100M, putting $1M-$5M in gold might make sense as some kind of disaster insurance. If things get really bad, you might be able to flee the country and use your gold holdings to start a new life. From an asset allocation stand point it might make sense. At the same time though, I wonder. If things got so bad that you needed to flee the US, maybe you would be better off investing in guns, ammo, survival training, and canned food.

So would I ever buy gold? Probably not. While I do think the US will face some difficulties such as an elevated level of inflation going forward, I have a hard time wrapping my head around the idea that we’ll be in such bad shape that fleeing the country will be the only option. I’ve seen investors such as Seth Klarman use gold as a disaster hedge without actually owning it. Instead, he used out of the money options which inexpensively gave him exposure to sharp movements in its price. I’m a fan of cheap insurance like that.

I respect the macro though and lately have devoted most of my time recently to finding special situations and event driven value investments. These tend to be more market neutral and have defined catalysts in place, making them easy to test. Right now, to me, that’s a much more appealing strategy than simply buying and holding.

If you looked back at the S&L crisis, sharp investors like Gerald Ford managed to make huge returns by acquiring the carcasses of failed banks, infusing them with capital, and picking off credits from weaker banks in their geography. Ford himself made over $1B personally with his Golden State bank deal.

Now, it appears as if other investors (including J.C. Flowers, Paulson & Co, MSD Capital, and Soros) are seeing the attractiveness in acquiring failed banks:

Of the 140 banks closed by the government this year, private investors have acquired only two outright—IndyMac and Florida’s BankUnited. Private equity investors argue that they should play a bigger role, as their funds’ billions in unspent capital could bolster the banking system.

Part of the test will be how well OneWest works with financially troubled homeowners, especially under the Obama administration’s loan-modification programs.

OneWest is already generating hefty profits. For the six months ended Sept. 30th, it posted net operating income of about $700 million, according to filings with the FDIC. In 2007 IndyMac, saddled by troubled mortgages, posted a $614 million loss.

During the FDIC’s roughly eight-month control of IndyMac before selling it, the agency cleansed the bank of some of its bad loans through asset sales and write-downs, shrinking it by about 27%, according to filings. It also reduced the bank’s headcount by about 45%.

The FDIC also agreed to share in losses with the ownership group in both the IndyMac and First Federal deals.

OneWest’s improved performance allowed it to bid aggressively for First Federal. The owners didn’t invest additional money to acquire the bank’s assets; rather, the money came from cash on OneWest’s balance sheet.

OneWest paid $401 million, or a 6.6% premium, for First Federal’s assets, according to FDIC documents. That makes it among the first FDIC-arranged deals in which a premium was paid for a failed bank’s assets—many are sold at a discount to their assets.

Investors Reshape IndyMac (WSJ)

It is difficult to throw a dart at the board and scoop up good banks, especially smaller, more regional banks. Many of these banks have not properly written down the value of CRE loans on their books. Still, some banks are poised to do well. The ones that are now overcapitalized and acquiring the assets of failed banks should offer opportunity for investors. A lot of this depends on good stock picking, you need to look at the quality of their loans, what they are acquiring (and the deal terms), and also the quality of their management teams. You need to seek out bankers who are disciplined but enterprising enough to enter the fray and take market share. This requires more effort than simply picking up an ETF, but it should be rewarding.

George Soros makes the argument for greater CDS regulation, I agree:

Up until the crash of 2008, the prevailing view — called the efficient market hypothesis — was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don’t deal with the current reality, but with the future — a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. (I call this feedback mechanism “reflexivity.”)

With the help of this new paradigm, the poisonous nature of CDS can be demonstrated in a three-step argument. The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one’s risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.

The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.

AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.

The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.

Taking these three considerations together, it’s clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination. And AIG failed to understand this.

Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. Under this rule — which would require international agreement and federal legislation — the buying pressure on CDS would greatly diminish, and all outstanding CDS would drop in price. As a collateral benefit, the U.S. Treasury would save a great deal of money on its exposure to AIG.

One Way to Stop Bear Raids (WSJ)

I posted this morning about the fact that commodities have risen quickly in just a few years, but that there seemed to be an indication that they would continue their appreciation due to actual demand reasons, rather than pure speculation. I feel like George Soros touches on this below:

Billionaire George Soros said the boom in commodities is still in a “growth phase” after prices for oil, wheat and gold rose to records.“You have a generalized commodity bubble due to commodities having become an asset class that institutions use to an increasing extent,” Soros said today at an event sponsored by the Centre for European Policy Studies in Brussels. “On top of that you have specific factors that create the relative shortage of oil and, now, also food.”

Soros Says Commodity `Bubble’ Still in `Growth Phase’ (Bloomberg)As someone who is primarily focused on finding undervalued companies, it can be a little tough to invest in the kinds of areas that seem overvalued but appear to have room for growth, such as agricultural commodities and fertilizer companies. The way I’m going about this is looking for some hidden or indirect plays at the trend, some of these are pretty illiquid and trade on the Pink Sheets/OTC so I can’t exactly name names until I’m finished doing my buying.

George Soros has a new book:

http://www.georgesoros.com/creditcrisis08

The cause of the current troubles dates back to 1980, when U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher came to power, Soros said. It was during this time that borrowing ballooned and regulation of banks and financial markets became less stringent. These leaders, Soros said, believed that markets are self-correcting, meaning that if prices get out of whack, they will eventually revert to historical norms. Instead, this laissez-faire attitude created the current housing bubble, which in turn led to the seizing up of credit markets and the demise of Bear Stearns, Soros said.To avoid a super-bubble in the future, Soros said banks must control their own borrowing. They must also curtail lending to clients such as hedge funds by demanding greater collateral and margin requirements on loans. 

via Bloomberg