Street Capitalist: Event Driven Value Investments

For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:FRFHF/ TSE:FFH) was my largest holding. It was in September and I was nervous about the potential for the sub-prime issue to spread to the rest of the economy. Fairfax represented a really unique opportunity because I purchased shares not only at 1/2 book value but also received the benefits of their credit default swap portfolio which was positioned against major Wall Street financial institutions. In a way, I had an undervalued company which also gave me the ability to hedge against the worst financial crisis in recent history.

Today, Gregory Zuckerman has a wonderful article on Fairfax Financial in the Wall Street Journal:

As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.

Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.

The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.

The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.

Firm Makes Bold Bet on Falling Prices (WSJ)

With The Greatest Trade Ever and The Big Short, investors went looking for cheap insurance against seemingly improbable events. Today though, that insurance isn’t so cheap. The massive waves of CDOs that were originated in the lead up to the financial crisis helped make a market filled with inexpensive CDSs. That isn’t true for today. To me, insurance is worthless if it is overpriced. Fairfax on the other hand is once again demonstrating their shrewdness. Spending only $174M to protect a $22B portfolio sounds like a good bet:

The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.

In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.

The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.

Right now there is a debate about whether we will experience deflation or inflation. It is my thinking that we will follow deflation briefly before inflating our way out of it — moving us into a period of inflation. That seems contrary to Watsa’s bet. But the thing to keep in mind is that Prem Watsa, Fairfax’s CEO, needs to protect his investment portfolio.

Most people don’t realize this, but investment income is what keeps most P&C insurance companies afloat. From 1975 to 2009 there have only been 5 years where the P&C insurance industry generated positive underwriting income. Over the same period insurers had an underwriting deficit of $445B. To make matters worse, we’re in a period of abnormally low interest rates. Most insurers have the bulk of their investment portfolios in fixed income securities. That income is likely to face some downward pressure given today’s yield curve. Some insurers try to chase better yields by going into munis, but I’d be cautious. Some municipalities have rather high budget deficits making the chance of default not entirely unlikely. One might find good short candidates by going through the investment portfolios of different insurers and finding the ones with the worst positioned investment portfolios that are coupled with bad underwriting.

So when I see Prem betting $174M to protect a $22B portfolio against deflation, I don’t necessarily take that as Prem betting the house. $174 million is only about 0.8% of the portfolio. I see this as a way to make sure Fairfax’s investment portfolio, which is crucial to the company’s survival, is protected. As long as their counter parties in the trade (Citibank Canada and Deutsche Bank) survive. It’s entirely possible that the team at Hamblin-Watsa will seek out other derivatives to help them hedge against other adverse macro-economic scenarios. I think that as long as the trades are cheap and offer asymmetric returns, Fairfax will probably consider them.

What does this mean for individual investors like you and me? I think that if right now, you see Fairfax as being undervalued without the derivative trade working out – you might want to consider it for your portfolio. Worst case: you have a cheap insurance company run by one of the best capital allocators in the insurance business. Best case: you have a cheap insurance company that should help hedge your portfolio against deflation. Most individual investors are unable to purchase the kinds of hedges that Fairfax employs, so this is one way to work around that. I would not buy solely on the derivatives trade because we don’t know how long it will take for Fairfax to actually realize their gains (if they realize any at all).

This weekend had two articles on deflation put out by the WSJ and NYTimes. It’s interesting to see the increasing frequency of deflation mentioned in the news. I think that it creates interesting problems for an investor because you never really hear about how to invest in a deflationary environment. Warren Buffett has written extensively on inflation but I cannot recall any letters that go into detail on deflation. That’s probably because deflationary environments are so rare. Both articles provide us with some perspective though.

First up is Paul J. Lim’s Afraid of Deflation? Try Some Medicine (NYTimes):

Late last month, Jeremy Grantham, the chief investment strategist at GMO, an investment firm based in Boston, issued a warning about deflation after worrying for months that inflationary pressures were brewing. Mr. Grantham told GMO clients recently that as the recovery has slowed, “downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor.”

In doing so, he joined a growing list of prominent analysts — including William H. Gross, the co-chief investment officer of Pimco — who’ve raised concerns that consumption may be postponed and growth thwarted if price declines occur throughout the economy.

Long periods of deflation are quite rare. In fact, before Japan’s on-again, off-again experience with deflation starting in the 1990s, you have to go all the way back to the Great Depression to find another sustained bout of this trend in the developed world.

One of the issues with deflation is it’s difficult to pick the right historical frame of reference. Japan is brought up the most and I think Richard Koo’s book Lessons From Japan’s Great Recession is regarded as one of the best books on the subject. But some investors don’t even think that Japan will be the right playbook:

Strategists who’ve expressed concerns about deflation aren’t necessarily predicting a return to protracted, Depression-era downward price spirals. “We’re certainly not positioning for a Japan-like scenario,” said Ben Inker, a colleague of Mr. Grantham’s who is GMO’s head of asset allocation.

Robert D. Arnott, chairman of the asset management firm Research Affiliates in Newport Beach, Calif., said that while a brief bout of modest deflation was a threat in the short run, inflation — or rising prices that eat away at consumers’ purchasing power — remained the bigger long-term menace.

He said that growing fears over deflation made it more likely that policy makers would overreact in their attempts to stimulate growth in the economy. And that, in turn, means that “inflation is still what you have to worry about down the road,” he said.

The investors profiled offer a variety of ways to protect your portfolio against deflation. These include long-term government bonds, TIPS, cash, high quality dividend paying stocks, and fixed income securities from companies without highly leveraged balance sheets. I really like the idea of increasing your cash allocation when you start to get worried. That dry powder can be immensely useful when it comes to investing in companies at deep discounts. Whenever the market has a major downturn, its the investors that have a lot of cash who can profit. Moreover, I think that being willing to increase your cash allocation helps you think about the overall valuation of the market. Sometimes, people get so fixated on staying fully invested that they will relax their standards and buy stocks that aren’t really cheap. This behavior leaves you without any real margin of safety in case you’ve missed something in your analysis or if some kind of externality shocks the market.

Then there is Jane J. Kim and Eleanor Laise’s article How to Beat Deflation (WSJ):

Deflation is generally bad news for stocks, since a period of falling prices and weak demand tends to weigh down corporate earnings and, therefore, share prices.

But that doesn’t mean investors concerned about deflation should avoid stocks entirely. Companies with plenty of cash, low debt, steady dividends and products that people will buy even in tough economic times should fare relatively well, analysts say.

And if inflation does come roaring back in the longer term, these companies might still do well because they tend to have significant pricing power. That means they can raise prices to compensate for their own rising costs.

The authors caution that investors should steer clear of financials in a deflationary environment because of the potential for higher defaults and weakened loan demand. The warning on banks is especially important when you think about the commercial real estate market. But what about hard assets?

Gold, which many investors consider an inflation hedge, also can be a useful deflation-fighting tool, analysts say. The government tends to respond to deflationary concerns by printing money, which in turn can spark fears of inflation and drive up the price of the metal. Gold is a hedge against financial stress, and “the source of stress doesn’t matter, whether deflationary or inflationary,” says Joe Foster, manager of the Van Eck International Investors Gold Fund.

In a deflationary period, investors should be especially wary of commercial and residential real estate and the real estate investment trusts that invest in such properties, analysts say. Much of the value of real estate is predicated on an ability to raise rents, says Morningstar’s Mr. Peters. A lack of inflation, little rent-raising power and low occupancy rates, he says, “could come back to hammer this group a second time.”

Gold is not really an investment for me, but I could see its usefulness especially if you think we are going to try to inflate our way out of deflation. It seems as if banks with high CRE exposure might be some of the worst stocks to invest in if you are particularly fearful of a deflation. My thinking is that a higher cash allocation and investments in high quality dividend paying stocks, at perhaps a greater discount than normal might work for smaller investors. I’ve only excerpted certain portions of the articles above, so remember to go back and read the rest.

Last week, Fairfax Financial had their latest quarterly conference call. Fairfax is a holding company of different insurance operations helmed by Prem Watsa, a value investor who is sometimes called the Warren Buffett of the north. I first discovered Fairfax about 3 years ago. I learned of the company’s investing talents and saw that they looked undervalued while trading at a heavy discount to book value. Fairfax also held a portfolio of credit default swaps against major financial institutions which acted as a great hedge against the financial crisis.

Since then, I always look to their commentary to see how they think about today’s markets and their perspectives about risk in the future. Here’s what Watsa said about their hedge ratio:

Prem Watsa

Yes, I’m sorry. So, in response to the in equity markets in 2009, and early 2010, the economic uncertainty in the U.S. our equity hedge ratio to approximately 93% of our equity exposure. The effect of this increase by entering into Russell 2000 and total return swap contracts, average index level of 646.5. This was in addition to the S&P 500. Russell’s total return swap contracts we had done in September 2009 at an S&P 500. Now, I’ll give you some information on the line financials, Thank you.

Fairfax Financial Holdings Ltd. Q2 2010

By hedging 93% of their equity exposure, the folks at Fairfax must really be concerned about the possibility of another downturn. In a recent interview with Value Investor Insight, Watsa outlined some of his worries:

What environment are you positioned for today?

Prem Watsa: The two historical periods we believe are relevant are the U.S. in the Great Depression and the Japanese experience over the last twenty years. In Japan, nominal GDP remained flat for 20 years even though total debt as a percentage of GDP went from 50% to 200%. People will say it’s different this time and that that can’t happen in the U.S. Maybe, but I remember being in Tokyo in 1989 and people were saying the same thing. It won’t be that bad because we have high savings rates, or because the Keiretsu cross-shareholdings provide stability. Look how that turned out.

The economic story was similar in the U.S. in the Depression. After falling dramatically, nominal GNP came back up at the end of the 1930s to where it was in 1929, so there was no growth for the entire period. If not for the war, that would have lasted for a longer time.

So we don’t believe the financial crisis is over. After 20 years in which most developed countries saw leverage going to record levels, we think there are many, many years of deleveraging to go. Governments have tried to step in to mitigate the pain of that process, but as you see already in Europe, attention is turning to cutting spending and raising taxes. We expect after the mid-term elections to see much the same thing in the U.S. With a $1.5 trillion deficit and near-0% interest rates, there aren’t many bullets left.

Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession.

Are you at all concerned about inflation and rising interest rates?

Prem Watsa: Right now we’re more concerned about deflation, which would reduce Treasury rates even further. If we have a repeat of the U.S. in the 1930s or Japan over the past 20 years, long Treasuries could keep going down – or at least stay very low – for some time.

If we look at Fairfax’s equity portfolio, we can see that it is heavily weighted towards large cap high quality companies like Johnson and Johnson, Kraft, and Walmart. A number of investors have come out saying that large caps present a good value proposition right now – you can find some companies with a steady history of dividend increases and buybacks trading at historically high yields. If you’re worried about inflation, these companies are likely to provide better value than most fixed income investments.

Still, Fairfax has a substantial hedge on their equity portfolio. We know that Seth Klarman of the Baupost Group has also expressed concerns about how fast the market recovered after the crisis. So maybe there is a need to hedge portfolios. Now, smaller investors are precluded from buying the derivatives that Fairfax is using. The simplest choice would be to increase your cash allocation. Klarman has sometimes gone as high as 50% cash in recent year. If you want to get more complicated, you can use cheap insurance by way of out of the money options. With those you can profit immensely if the market declines far more than people expect, you are betting on an improbable event. These options are inexpensive because the event is so improbable to most. The flip side is that you need to continuously rollover that protection because options are targeted to a specific point in time. And it’s a negative carry trade, meaning that each time you are wrong and have to rollover, you lose a little money. The method you choose should fit your investing style. The options approach is definitely going to require more time and a means of offsetting the negative carry (or a willingness to accept it).

I had a chance to interview Zeke Ashton of Centaur Capital and manager of the Tilson Dividend Fund. I think you’ll enjoy the interview. Ashton is a generalist, he is willing to short stocks, and looks across all types of companies — from microcaps to large caps. Plus, he’s based out of Texas. I’ve been hoping to showcase more Texas-based fund managers to prove that we’re not all energy traders down here.

Please give me your thoughts on the interview in the comments section or feel free to e-mail me. I’m always looking for new investors to interview.

You can find more about the Tilson Dividend Fund here or learn more about the fund’s performance via Morningstar.

My questions are in bold.

Can you give us a brief bio of yourself and how you came to run Centaur Capital?

I started my career in the financial software business as a consultant deploying complex treasury and risk management systems for large banks and conglomerates, mostly in Europe. At the time, I thought that my natural career progression might be to become a risk manager for a large bank or insurance company.

Somewhere along the way I developed an interest in the stock market and discovered Warren Buffett’s Berkshire Hathaway letters and was immediately hooked. I also was a big fan of the Motley Fool website, and when I decided that I wanted to change careers to investing, I was fortunate enough to land a job there. I moved back to the States and started working for TMF as an investment writer in early 2000 – just in time for the bear market. I spent two years writing articles and research on investing for TMF, which enabled me to learn and refine my own investing approach.

In 2002, I decided that I was ready to start investing professionally, and moved to the Dallas area and started Centaur Capital Partners. I set up a private limited partnership and opened for business with less than $1 million under management, and it took several years to get to the point where Centaur Capital was a viable business. In 2005, we launched a mutual fund called the Tilson Dividend Fund (TILDX) in partnership with our good friends Whitney Tilson and Glenn Tongue at T2 Partners, and that has done well. We’ve now been in business for eight years, and while it’s not been without its challenges, overall I feel very fortunate to be where I am today.

A while back in 2007 at the Value Investors Congress, you gave a presentation (PDF) about how you think about asset allocation at Centaur. Is it largely the same today? Or has the financial crisis influenced your take on capital allocation?

That VIC presentation was primarily a discussion about portfolio construction, and it was really in reaction to what I thought was a growing pressure amongst value investors to run excessively concentrated portfolios. Keep in mind that this was 2007, and the market had produced a long stretch of good returns from 2003 to early 2007. The book “Fortune’s Formula” had become quite popular, and there were many discussions amongst investors about the potential for employing the Kelly Formula as some sort of secret sauce that would allow investors to increase returns by increasing concentration.

My own view is that most investors are better off running portfolios of 15-25 stocks because such a portfolio would ultimately be a truer reflection over time of an investor’s skill. In other words, a 15-25 stock portfolio has enough concentration to allow a skilled investor to really stand apart from the market, but is not so concentrated that bad luck, bad timing, or one or two mistakes can sink an otherwise competent investor. One of the points of emphasis in that presentation was that concentration shouldn’t be a constant, but rather should be idea and environment dependent. It has always seemed to me that each idea in the portfolio should be sized based on a careful assessment of the body of evidence available for that idea, with particular emphasis on risk factors. This would include factors such as how deeply the security appears to be under-valued, how predictable and reliable the business is, how it is capitalized, the quality and track record of the management team, and even how familiar the investor is with the idea. Also, it should be influenced by the presence of clearly correlated ideas in the portfolio.

I believed then and I believe now that using the flexible 20-stock model portfolio position sizing exercise that I described in the presentation is a very solid framework to start with. In looking back over that presentation today, I wouldn’t change a thing regarding the content of that discussion. But I’d sure like to have the stock picks back – I presented four ideas at that conference and three of the four performed very poorly in the bear market that followed.

How long do you study a potential investment before you decide to buy? After initiating the position, do you continue your research process on the name?

We generally produce a research document that covers all the important components of the investment, both qualitatively and quantitatively, prior to investing. For a simple idea, the document may well be five pages long. For a very complex idea, the report will be longer. But regardless of the complexity of the idea, writing a research document using a fairly standard template serves as both a form of checklist for us and ensures that we both understand the idea and can articulate why the idea meets our criteria for both value and safety. It also allows for a “quality check” in that it can be reviewed by a second analyst internally and even potentially by contacts outside of our shop that may be able to review our work and provide some insight back to us.

You have mentioned in the past that you are increasingly looking at macro data when making an investment. What kinds of macro indicators do you look at? Has there ever been a situation where a stock looked cheap but you did not invest because of the macro?

I wouldn’t say necessarily that we look at macro “data” when making an investment. It is more the recognition that an otherwise compelling idea can get overwhelmed if the larger forces surrounding that idea are negative enough. Going forward, we will probably be a little more cognizant of looking for the larger risks that could really hurt us as investors. As for an example, we basically decided in mid-2008 that we weren’t going to invest in any bank or other leveraged financial business given our concerns about the credit environment, and we sold the one stock he held at that time that qualified, which was American Express (NYSE:AXP). Granted, this was an extreme case, but it did help protect us from the worst of the permanent capital losses that many of our value investing peers suffered in banks and other leveraged financial stocks.

I suspect that our approach going forward when assessing ideas where we have identified a major industry or macro risk would be to use smaller position sizes, demand more compelling prices, or actively look for a way to hedge out any obvious macro risk that we identify if it can be done in a cost-effective way.

When you use valuation methods like DCFs, what kinds of factors do you look at when forecasting? Is it mostly things in the current-year, the past, or your own predictions? How far out do you model?

We use DCFs more as a sanity-check and to reverse engineer current market expectations than to try to produce any kind of precise valuation. When basing our views as far as what the future might look like, we try to look at a longer view of the company’s operating history (normally five to ten years) to see how the business has done over time. As an example, one of our larger current positions is Lab Corporation of America (NYSE:LH). Qualitatively, this is an outstanding business with tremendous barriers to entry. There is something of a Coke / Pepsi dynamic in the laboratory services industry, with competitor Quest Diagnostics (NYSE:DGX) the slightly larger company in the industry and LH being a strong number two in terms of revenues. LH has been a consistent but moderate grower over many years, with revenue growth in the high single digits and free cash flow growth at around 10% for the last five years. In looking at the recent stock price of around $72, when we plug the numbers into a DCF spreadsheet, we find that the market basically assumes that LH will never be able to grow its free cash flow at more than 2% annually going forward forever. Our view of the company’s growth prospects is significantly more optimistic than that.

So that’s our first sign that LH is a potential opportunity for us.

If I drop in even 5% average FCF growth for LH going out for ten years before dropping down to a terminal growth rate of 2% after that, my spreadsheet tells me the stock is worth $96. Because I’ve owned LH in the past and am extremely familiar with the business, I am very comfortable taking the view that the company will be able to grow its FCF much faster than the current market price is discounting. I don’t have to be super precise. When the stock gets to $85-90, it will be a closer call and I will probably respond by reducing our position size somewhat. So we try to use the full body of evidence we have available about a company, but in general we just don’t buy stocks that require heroic growth assumptions to justify the current price.

You operate largely as a generalist. Sometimes that entails investing in unfamiliar industries. Can you give an example of a case where this happened? What were some of the things you specifically did to learn the ins and outs of the business?

Yes, being a generalist means that one needs to have a framework for getting up to speed quickly when looking at a company or industry that is new for us. So we have learned to quickly identify the business model, which gives us a huge head start in terms of how to approach the research. There really probably aren’t more than a dozen or so basic business models in existence and most companies employ a variation of one of them. Then we start our study of the targeted business and some competitors, and we start reading annual reports, industry publications, and whatever we think we need until we feel we have a good handle on the business. One of the good things about this business is that knowledge is cumulative and the longer I’ve been investing, the more businesses and industries I’ve become familiar with and the faster I am able to get up to speed.

What is one company that you think you would be comfortable with buying and holding for 15 years? Why?

That’s an interesting question, and I’m going to have to answer it by changing your question a bit. We’ve come to believe that if your goal as an investor is to compound at high rates (our goal is 15-20%), that a “buy and hold” philosophy for 15 years simply isn’t likely to work except perhaps in very rare cases. To get that kind of return, you have to buy stocks when they are undervalued and sell them when they are fully valued. Therefore, to give you a stock that I’d be comfortable buying and holding for 15 years simply doesn’t reflect our philosophy, since over a 15-year period we’d expect to have the opportunity to buy a stock at discounted prices and sell it back at full prices multiple times. Of course we are prepared to wait a long time if necessary to get fair value for our holdings, and there are other cases where the performance of the company results in ever-increasing estimates of fair value such that we can hold on to the position for a long time. But we are usually hoping that we will be able to get full value for our stocks within 2-3 years of purchasing them.

So let me give you a list of companies that we admire and that we very much like to own when the stocks are cheap: Fairfax Financial (TSE:FFH), because we admire Prem Watsa. Berkshire Hathaway (NYSE:BRK.A / BRK.B) of course. In our current portfolio, I like Lab Corp (NYSE:LH), Dreamworks (NASDAQ:DWA), and a small Canadian company called Ag Growth International (TSE:AFN). In all of these, I either have a great deal of comfort and admiration for the management team, or else the business is extremely unique and enjoys a strong competitive advantage.

One of the things that value investors often talk about with shorting is how it gives you potentially unlimited losses. How do you manage risk with shorts?

Shorting is a very tough business, and we continue to learn new lessons every year. I have come to the belief from talking to several guys who are more experienced than myself on the short side that the best way to manage risk is to keep position sizes small and have a slightly more diversified short book. We also limit the size of our overall short exposure. Unlike the long side, where we have no individual position loss limits, we have historically used a position loss limit on short positions, though over time it has probably hurt us as much as it has helped us.

Can you give an example of a past investment mistake? What do you think happened? What did you learn?

Sure. Rather than give you a specific mistake, I’ll give you a category mistake that we’ve made more than once and that I therefore think is one that investors are extremely vulnerable to. The mistake is one of commitment bias, where for example we will decide that a given idea is very compelling but due to its potential risk is justifiable only as a small position. For example, every once in a while we find ideas where there is a very wide range of possible outcomes, but where either the potential magnitude of the return in the good case scenario is very high or we think the probabilities are favorably skewed in our favor. On balance, we’ve done OK with this kind of idea. The problems have come when we’ve initiated the position at an appropriate position size (say, 1% of the fund, or 2% or whatever) but then the stock declines either because of some new development or for another reason. We’ve often added to the stock and built them to inappropriately large position sizes simply due to the lower price, rather than sticking to our initial game plan of limiting our bet. Because of this, we’ve occasionally made what would have been a small loser into a bigger loser.

Another and similar mistake is reacting immediately to a sharp decline in an existing holding on negative news without taking adequate time to fully review the new information to ensure that making the additional deployment is justified by the new development. We try now to be rigorous in ensuring that each incremental add to an existing position is truly justified by the existence of a widening discount to our expected range of fair value and not due to some embedded commitment to the name.

What are some of your favorite books? Investing or non-investing related.

I kind of like to follow good writers around. For financial-related books, I always like to read anything by Roger Lowenstein, with particular nods to his biography of Warren Buffett as well as his book Origins of the Crash that described the causes of the tech and large cap bull market of the late 1990’s. I think Michael Lewis does fantastic work – his latest of course is The Big Short, but I also loved Liar’s Poker as well as his non-financial books The Blind Side and Moneyball.

How do you look at the market cap of a company? Are you less willing to invest in large caps? Do you see more opportunities in one than the other?

No, we don’t care what the market cap is. We are looking to get the best combination of value and safety out of our investment dollars as we possibly can. I do think that large cap, high quality stocks are as cheap now relative to the rest of the market as I’ve ever seen them, and that being the case our portfolio is more heavily weighted to large company stocks than it has been for most of our history.

Can you give us a company that you think is undervalued/attractive right now? What is your thesis there?

Sure. Lab Corp is our biggest position, and I’ve already explained our thinking there. Let me give you an esoteric one. This one is a small position for us, because the stock trades on the pink sheets and isn’t very liquid. Therefore, I’m not making a recommendation, only naming a stock that I personally think is undervalued and attractive. The company is Mass Financial Corp (PINK:MFCAF), and it trades in the U.S. on the pink sheets under the ticker MFCAF. MFC is a merchant bank specializing in a combination of traditional financing services and proprietary investing, primarily involving commodities and natural resources. The business is run by Michael Smith, who is also the chairman of the company formerly known as KHD Humboldt Wedag and is now called Terra Nova Royalty Corporation (NYSE:TTT).

MFC was spun out of KHD in January 2006, and had negligible book value at the time of its spin-off. The stock trades for $9 and change, and has a market cap of approximately $200 million. In the last four years, MFC has averaged over $40 million in net income and over $50 million in free cash flow. Here’s the book value per-share at the year-end each of the last four years, starting basically from zero at January 2006 (note that the book value per share figures are adjusted for a 9% stock dividend issued in late December 2009):

December 31, 2006 $2.43
December 31, 2007 $4.39
December 31, 2008 $5.71
December 31, 2009 $9.72

Going back further, prior to folding MFC into KHD, Michael Smith ran the company (then called MFC Bancorp) from 1984 to 1995, and during that stretch he grew book value from $1.49 per share to $17.09 per share, which is a pretty impressive performance. Overall, we think that MFC is a very intriguing investment at a discount to book value given the impressive track record.

The downside to an investment in MFC is that there is never really any way to know what Michael Smith is up to. Smith’s policy is to report financial results every six months, and only issues press releases when a material development occurs. In addition, the company’s disclosures are not as highly detailed as one might like regarding its merchant banking and direct investment activities. Nevertheless, the performance of the company speaks for itself, and MFC has an extremely strong and liquid balance sheet and uses very little leverage in its activities, making the historical performance that much more impressive. A couple months ago, MFC took over a majority interest in a micro-cap Canadian listed company called Canoro Resources (CVE:CNS), which has some very interesting oil and gas assets in India. As I mentioned, MFC is a small position for us, but I like having it in the portfolio.

Zeke, thank you for taking the time to interview with Street Capitalist

A while back I mentioned that Monsanto might be a company worth looking at because of their competitive advantage in the seed business. Unfortunately, the stock has moved a lot since we first posted about it at the end of June:

Up 21% in a little less than a month! Too bad I didn’t buy it back then.

Monsanto (NYSE:MON) has been a real innovator in their field, here is how they define their business:

Monsanto Company (Monsanto) along with its subsidiaries, is a worldwide provider of agricultural products for farmers. The Company’s seeds, biotechnology trait products, and herbicides provide farmers with solutions to produce foods for consumers and feed for animals. The Company operates in two segments: Seeds and Genomics, and Agricultural Productivity.

The thesis you often hear from agriculture bulls of the company is that if the developing world truly does continue its pace of development, we’re going to need more food to nourish those people and that food is going to be grown with the help of Monsanto’s products. Then, if there is a bull market in agricultural commodities — Mosanto’s products will be needed in order to help give farmers the ability to increase their yield and sell for higher prices.

So then what has been the bear case?

We just got out of an agricultural commodity boom and one of the things Monsanto did was steadily increase pricing on their products as the prices of commodities continued to rise. This made a lot of sense when prices for commodities were high, they were able to capture the benefits from the increased yield in their crops. But Monsanto did not adjust pricing as commodities started to fall. That caused a drop in sales which led to an increase in inventories.

Now, I haven’t had a chance to do much valuation work on Monsanto. I know the company on a more qualitative basis. But, Glenn Busch from ValueInvestingCenter has taken a stab at valuing the company:

The Seed and Genomics division is by far the largest division at Monsanto CO. (MON) based on revenues; it accounts for 62% of Monsanto’s revenue. In fiscal year 2009 the Seed and Genomics division had $7.29 billion in sales. For fiscal year 2009 the Seed and Genomics division had a Gross Margin of 61% and an Operating Margin of 22%. In 2008 Seeds and Genomics had an operating margin of 18%. The increase in margins has been due to the launch of newer- higher margin products. Margins are expected to continue to increase further based on more launches of higher margin products like Genuity VT Triple Pro Corn.

For the discounted cash flow that I will run on this division I will use an operating margin of 20% even though recent margins have been higher and are expected to increase further. I will use current interest expenses and taxes but I will use normalized Statement of Cash Flows line items. For growth rates, I will use the median analyst estimate of 10% and the lowest analyst estimate of 6%. I will use 10% as the discount rate because Monsanto CO. (MON) is a large multi-national company with minimal debt and a leader in its field. Currently, Monsanto Co. (MON) has 545 million shares outstanding and to keep it simple I will not factor in any share buybacks.

Below is the range of values for the Seed and Genomics division.

6% Growth = $51.00
10% Growth = $59.00

With Monsanto Co. (MON) currently trading around $57.00 we’re pretty much getting fair value for the Seed and Genomics division and everything else free.

Valuing Monsanto Co. (MON) (Value Investing Center)

According to Busch, one of the problems was in Monsanto’s agricultural products division. Monsanto produces a herbicide called Roundup, which featured lower adoption rates due to a flood of competitors (they lost patents) and some customers over pricing. They’ve had to reduce prices to clear out excess inventory which has carried over into their margins. Here is Glenn’s take on the division:

I will value the worst case scenario like a perpetuity using a discount rate of 10%. I’ve chosen to value the worst-case scenario like a perpetuity because Roundup is still the largest selling glyphosate product on the market. Glyphosate is also the largest herbicide in use and has been this way for a long time. Monsanto lost its U.S. Patent in 2000 and still has maintained a high level of Roundup sales. I would expect Monsanto to continue to sell more Roundup than what I’m basing this valuation on.

Below is my value for the worst case scenario.

$3.90

Valuing Monsanto Co. (MON) (Value Investing Center)

So in Glenn’s low case, Monsanto is worth $54.90 all together versus a current price of $57.32. Not a bargain, but it could be if we see another AgBoom because Monsanto could simply increase the prices on their products and reap the benefit. Glenn talks about this towards the end of his write up, which you should read to get the whole picture. I’ve only excerpted part of it.

Jeremy Grantham has a great essay over at Morningstar which gives us some insights into how he is looking at investing GMO’s funds:

Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “flation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future…

At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitative considerations. They draw their strength from our regular seven-year forecast. Today this forecast (see Exhibit 1) suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus infl ation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very light on other U.S. stocks. At a time when fixed income is desperately unappealing, this, not surprisingly, results in our accounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wracking as the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a few weeks ago, but then again, prices are 13% cheaper. I regret not having seen the light a few weeks earlier. Running at the same rate of change in attitude as both the market and general opinion is both frustrating and unprofitable. But even as global equities approach reasonable prices, I would err on the side of caution on the margin.

Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is my long-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibrium return. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhaps by a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9% are a little expensive (6% or 7%) but make a respectable filler for a global equity portfolio. Forestry remains, in my opinion, a good diversifier if times turn out well, a brilliant store of value should inflation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.

Summer Essays: Finance and Portfolios (Morningstar)

I’ve posted recently that I am also seeing value in large cap stocks many of which seem to have strong exposure to emerging markets and franchises that should be able to withstand tremors in the global economy. Grantham’s point about deflation is interesting. Unlike with inflation — where certain businesses can simply raise prices, deflation creates a downward pressure that is harder to tackle. I’ve noted in the past that Seth Klarman believes in deflationary environments we should seek a wider margin of safety. So if you used to buy at 60 cents on the dollar, maybe you start buying at 40-50 cents.

Sorry about taking so long with the Red Robin post, I am still getting together the charts/models to present.

Edward Chancellor, author of Capital Account, has a wonderful article on sovereign debt defaults. Chancellor cites a lot of research from Reinhart and Rogoff’s This Time is Different, a book about financial crises:

This paper seeks to answer several questions: Why in the past have governments defaulted on their debts? When have deeply indebted countries kept faith with their creditors? Under what conditions do governments opt for inflation rather than default? And, in the light of our historical findings, is Greece really the crest of a wave of sovereign debt crises about to crash down upon the developed world?

Reflections on the Sovereign Debt Crisis (Scribd)

Here are some of the charts that I found interesting:

Chancellor ends his paper with a brief look at the Japanese savings rate, which appears to be coming down. He thinks that going forward, the past wont be indicative of Japan’s future:

The situation going forward looks rather different. As the population ages, Japan’s household savings rate is in steep decline. Pension funds have become sellers, rather than buyers, of JGBs. The capacity of both the Bank of Japan and domestic commercial banks to acquire yet more government bonds is limited. Japan’s political system has failed to address the chronic crisis in public finances. Huge deficits have become entrenched at a time when the cost of financing the national debt has consistently exceeded the country’s growth rate. In short, Japan is stuck in a debt trap.

Furthermore, Japanese debt is relatively short term. The face value of bonds that have to be rolled over this year is equivalent to nearly half of Japan’s GDP.29 Unless Japan changes direction, its public credit will come under threat.

As always, try to read the full paper. It’s pretty short at 10 pages and an excellent read.

Today, Charles Stein over at Bloomberg has an excellent article detailing what happened to Seth Klarman’s Baupost Group during the financial crisis:

Seth Klarman almost doubled his hedge fund’s assets to $22 billion in the past two years as the industry shrank by sticking with the off-the-beaten-path investments he’s pursued since starting out in 1983…

While Klarman didn’t post the gains that made Paulson famous, he was able to raise almost $4 billion in 2008 when firms including D.B. Zwirn & Co. and Peloton Partners LLP liquidated funds. Baupost was the ninth-largest hedge-fund firm as of Jan. 1, according to AR magazine, Pensions & Investments magazine and data compiled by Bloomberg. He oversees more money than better-known managers such as Ken Griffin and Steven Cohen.

Klarman Tops Griffin as Hedge-Fund Investors Hunt for `Margin of Safety’ (Bloomberg)

I really think Baupost’s performance during the financial crisis was exemplary of value investing at its best — going into the crisis, many fund managers were overly concentrated in long positions. Even the famed long/short funds, which were supposed to use shorting to hedge against market downturns were simply not short enough to make a difference.

Most long-only value funds ran into the same issue. This stems mainly from an unwillingness to take large cash positions when the market gets frothy. That kind of value investing cuts both ways, taking a few concentrated positions will usually allow you to outperform major indices, but it also means that during a downturn your portfolio may get hit with higher than average volatility. As a result, some value funds would actually underperform the S&P 500′s already dreadful performance.

Most people like to knock Baupost’s performance in the 90′s, for not outperforming the S&P but I think that misses the point. What Klarman and his team have put together at Baupost is a fund that can achieve great absolute returns. For some entrepreneurial investors seeking massive John Paulson-like returns, this might not mean much. For college endowments though, having the benefit of limited losses, or actually appreciating in a down year must be a tremendous asset and shows the kind of niche that Baupost can serve.

The other thing that stands out about Baupost is their willingness to travel across all asset classes in search of returns:

A value investor who looks for securities he considers underpriced, Klarman, 53, said he’s best at “complicated” situations where fewer investors compete for assets. Over the years, Baupost has invested in Parisian office buildings, Russian oil companies and real estate that the U.S. government disposed of following the savings and loan crisis of the early 1990s, said Thomas Russo, a partner in the Lancaster, Pennsylvania-based investment firm of Gardner Russo and Gardner…

“He specializes in illiquid, complex assets,” said Russo, who has known Klarman since 1984.

Baupost gained an average of 17 percent annually in the 10 years ended in December, a period in which the Standard & Poor’s 500 Index fell 1 percent a year. The hedge fund has returned 19 percent a year since it was started, even as it held more than 40 percent of its assets in cash at times.

More recently:

Among the money-making bonds Baupost purchased, according to an October 2008 shareholder letter, was debt issued by Washington Mutual Inc., whose bank unit failed in 2008 and was bought by New York-based JPMorgan Chase & Co. Baupost also acquired bonds of CIT Group Inc., a New York-based lender that emerged from bankruptcy in 2009. The fund was part of a group of creditors that made a $3 billion loan to CIT in July 2009.

Klarman, in a May 18 talk to financial advisers in Boston, cited another Baupost purchase during the crisis to illustrate the way he thinks about investing. In a series of “what if” exercises, the firm calculated how much bonds of Ford Motor Credit Co. would be worth under different scenarios, including an economic depression in which loan defaults rose eightfold. The conclusion: the bonds, then selling for about 40 cents on a dollar, would still be worth 60 cents.

Stein goes on to outline some of Klarman’s more macro views. His fund is bearish and worried about inflation. Baupost’s US equities weigh in at only $1.7B versus their $22B in AUM, or a about only 7.8%. In addition, like many others, Klarman is apparently a big fan of Jeremy Grantham’s research at GMO:

Klarman’s views on the U.S. stock market echo those of Jeremy Grantham, chief investment strategist at Boston-based Grantham Mayo Van Otterloo & Co., who recommended investors buy stocks in March 2009 after more than a decade of saying they were overvalued. Grantham’s latest forecast, posted on the firm’s website, predicted U.S. large cap stocks would return 0.3 percent a year, adjusted for inflation, over the next seven years.

Klarman called Grantham “a very smart person” whose forecasts he watches carefully. In an e-mail, Grantham called Klarman “just about the smartest guy around.”

How does Baupost hedge against such possible scenarios?

Klarman buys put options and credit-default swaps, which he calls “cheap insurance,” to protect Baupost against risks such as a steep fall in the stock market or a surge in inflation. He currently has a put, or an option to sell a set amount of a security by a specific date, that will pay off only if interest rates go dramatically higher, he said in his Boston speech. In an October 2008 letter to shareholders the firm said it benefited from credit-default swaps, without saying what the swaps were meant to protect against.

When Klarman can’t find investments he likes, he holds cash. “We prefer the risk of lost opportunity to that of lost capital,” he wrote in his 2004 yearend letter to shareholders. In 2007, Baupost gained more than 50 percent, even as it held more than 40 percent of its assets in cash.

Klarman Tops Griffin as Hedge-Fund Investors Hunt for `Margin of Safety’ (Bloomberg)

Using the cheap insurance strategy sounds really sensible to me. Fairfax took the same approach when they purchased credit default swaps to protect against the financial crisis and they paid off handsomely. For more ordinary investors, derivatives like CDSs are probably inaccessible.

There are still some ways of insuring against disaster. One would be using out the money puts on things like the S&P 500. This kind of approach makes it so you are betting on what are initially perceived to be improbable events. Klarman’s fund used this very approach in their early days, against frothy indices like the Nikkei. To learn more about this approach, be sure to read Michael Lewis’ awesome book The Big Short because sections dedicated to Cornwall Capital outline this style of investing.

There are downsides to this approach though. First, you will incur frictional costs whenever your hedges don’t work out. Second, they require you to identify the right kinds of things to hedge against. You end up having to pay attention to whether the market is overvalued or not. This should not be so hard if you are a disciplined investor because you’ll end up seeing your range of opportunities dry up. If you are the kind of investor that keeps making excuses to allow you to buy overvalued stocks, this strategy is not for you.

Seth Klarman and his fund continues to impress me with how they have taken Benjamin Graham’s ideals and adapted them to the modern world. It’s true, for most investors, some of his strategies are out of reach. But some of his ideals – like going to cash when things are overvalued, or taking a real bottoms up approach with your analysis and looking for catalysts in your investments are all things you can incorporate into your process right now.