Street Capitalist: Event Driven Value Investments

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.

So the Treasury unrolled their plan earlier this morning. The gist:

First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

Statement by Secretary Henry M. Paulson, Jr. on Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers (US Treasury)

So far, Paulson has stated that he doesn’t know what the Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) bailout will cost US taxpayers. Part of that has to do with the fact that it’s almost wholly dependent upon the how long it takes for the housing market to stabilize. Keeping in mind this:

The GSE’s common stock and existing preferred shareholders will bear any losses ahead of the government. In exchange for entering into these agreements with the GSEs, Treasury will immediately receive the following compensation:

** $1 billion of senior preferred stock in each GSE

** Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price

It’s pretty safe to say holders of the common are in a terrible position right now. So what went wrong? Roger Lowenstein penned a really great essay this weekend about the connection between Long Term Capital Management and what’s been happening as a result of the credit crunch. He says:

More recently, housing lenders — and the rating agencies who put triple-A seals on mortgage securities — similarly misjudged the correlations. The housing market of California was said to be distinct from Florida’s; Arizona’s was not like Michigan’s. And though one subprime holder might default, the odds that three or six would default were exponentially less. Randomness ensured (or so it was believed) a diverse performance; diversity guaranteed safety…

If 100-year floods visit markets every decade or so, it is because our knowledge of the cards in history’s deck keeps expanding. When perceptions change, liquidity evaporates quickly. Indeed, the belief that one can safely get out of a “liquid” market is one of the great fallacies of investing.
This lesson went unlearned. Banks like Citigroup and Merrill Lynch felt comfortable owning mortgage securities not because they knew anything about the underlying properties, but because the market for mortgages was supposedly “liquid.” Each firm would write down the value of its mortgage investments by more than $40 billion.

Long-Term Capital: It’s a Short-Term Memory (NYTimes)

The article is a great read. At the end, Lowenstein says that “Investors, meanwhile, could help themselves by preparing for the next 100-year flood.” This made me think of Warren Buffett’s requirements when looking for a new CIO:

Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

The last line is quite prophetic. How do you avoid risks that have never been encountered? I found some good guidelines in Guy Spier of Aquamarine Capital Management’s 10 investing principles. Principle #10 is called “Prepare for Black Swans”. He states:

My goal is to invest in such a way as to minimize the impact of negative black swans, or highly unpredictable events, and to maximize the exposure to positive black swans. If black swans are, by definition impossible to forsee or predict, how is it possible in practice to guard against the bad ones and simultaneously increase the likelihood of benefiting from the good ones?

Spier breaks this down into 6 factors:

In my case, avoiding negative black swans comes down to investing in businesses that are likely to survive any social, economic, political, or natural disaster. That means investing in companies that:

1. Are run by honest management
2. Have a strong balance sheet and/or significant financial flexibility
3. Enjoy enduring assets that are exceptionally hard to impair and nearly impossible to replicate
4. Are geographically diverse
5. Have a moat that is growing wider over time
6. Make a positive contribution to our civilization

I wrote previously about using a checklist when determining what to invest in and Spier outlines a great checklist. He explains later that he specifically looks for companies that are cash-generating machines because it enables them to weather economic storms and poor market cycles. Screening for factors like high amounts of free cash flow and low debt would be a good place for investors to start.

Going through Spier’s checklist, you’ll see that most of the firms that have blown up recently fail to meet criteria #2. Investors should scrutinize this area heavily, they not only need to look at the amount of assets, but the type of assets. Part of the problem here is that the values assigned to some of these assets widely diverged from their true value. Sticking to your circles of competence is essential, so that you don’t decide to blindly throw your faith behind assets that you really don’t understand.

Right now is the time for investors to exercise patience when searching and studying potential companies. Many have been caught up in the action of it all and chose to quickly buy stakes in companies that fell substantially in a short time span. This may have forced them to relax some of their analytical standards and miss critical details. Take your time and remember this quote from the master himself:

I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.
- Warren Buffett

Guy Spier of Aquamarine Capital Management is someone I’ve been wanting to read more about and learn from. He doesn’t appear in the news as much as other value investors, so I was really surprised to see an article written by him in Time magazine today:

Buffett has always made a point of doing business with integrity — and of working only with people who share his values. As we learned at lunch, he credits his father with teaching him early on to rely on his own sense of what’s right, rather than looking for affirmation from others. “It’s very important to live your life by an internal yardstick,” he told us, noting that one way to gauge whether or not you do so is to ask the following question: “Would you rather be considered the best lover in the world and know privately that you’re the worst — or would you prefer to know privately that you’re the best lover in the world, but be considered the worst?”
When it comes to investing, nothing is more important than the ability to think clear-headedly for oneself — and Buffett is unsurpassed on this front. In the late-90s, he was widely criticized for his refusal to invest in booming tech and Internet stocks, a decision that was richly vindicated when the bubble burst. Buffett has made a fine art of keeping this kind of distracting noise at bay: for example, he said he even limits his contact with the managers of businesses in which he invests, preferring to assess them by studying their companies’ financial records —a more neutral source of information.

My $650,100 Lunch with Warren Buffett (Time)

The whole article is worth reading and I think it shows us one of the reasons Buffett is such an interesting character to study and learn from. The fact that he takes such a hands off approach to is businesses is pretty remarkable. He really has an uncanny ability for picking CEOs to operate businesses who are truly passionate about their work which is a quality that you can’t pluck out of an MBA.

To contrast this, look at Edward Lampert of Sears. He gets a lot of comparisons to Buffett, but when it comes to attracting talent they’re worlds apart. Lampert has been unable to find the right managers to run the businesses and brands within Sears and I think it’s one of the key factors that is holding down the company’s turn around. Maybe in that situation the “people” input is simply not being given the weight it deserves.

Guy Spier’s account seems to show us that the real wisdom that can be gleaned by Warren Buffett is how to measure and judge character and people, something that is a product of decades worth of relationships and experiences. That seems to make a $650,100 lunch or even $2.11 million lunch worth the expense if you get just some of the insights of a lifetime in just a lunch at Smith and Wollensky’s!