Street Capitalist: Event Driven Value Investments

This week’s New Yorker has a great article (New Yorker digital subscribers click here) by Malcolm Gladwell on entrepreneurship. Gladwell finds that entrepreneurs are actually not the high octane risk-takers that they are made out to be. Instead, successful entrepreneurs are highly rational actors, akin to predators who follow systemized patterns and go after safe prey. The article prominently features John Paulson’s CDS trade but also refers to a number of other fascinated entrepreneurs like Sam Walton and Ted Turner. While the article wont be available online for a while, I thought I’d quote some excerpts that I feel are worthy of discussion.

At 24 years old, Ted Turner became the CEO of his family’s outdoor advertising business after his father committed suicide. The business was actually quite good and threw off a lot of cash while requiring little by way of capital expenditures.

Turner sought to expand his empire and went after WJRJ, a UHF TV station that was down on its luck:

It was housed in a run-down cinderblock building near a funeral home, leading to the joke that it was at death’s door. The equipment was falling apart. The staff was incompetent. It had no decent programming to speak of, and it was losing more than half a million dollars a year. Turner’s lawyer, Tench Coxe, and his accountant, Irwin Mazo, were firmly opposed to the idea… The purchase price of WJRJ was 2.5 million. Similar properties in that era went for many times that, and Turner paid with a stock swap engineered in such a way that he didn’t have to put a penny down.

Most successful dealmakers that have built real empires all have the ability to find deals with great tax treatments. The Pritzkers of Chicago, John Malone of Liberty Media, and Sam Zell have all sought out these types of deals. Turner also recognized these benefits:

WJRJ’s losses could be used to offset the taxes on the profits of Turner’s billboard business. The television station, furthermore, fit very nicely into his existing business. Turner was very experienced at ad-selling. WJRJ may have been a virtual unknown in the Atlanta market, but Turner had billboards all over the city that were blank about fifteen per cent of the time. He could advertise his new station for free.

Most of these entrepreneurs use these deals to pick up NOLs at low prices which drastically reduce the taxes paid by the businesses they run. These boost profitability and gives them an advantage over competitors. Gladwell also seeks out academic research on entrepreneurship, in order to find patterns that are displayed my large groups of successful businessmen.

First, he cites the work of Michel Villette and Catherine Vuillermot (From Predators to Icons). One of the things that Villette and Vuillermot find is that most successful entrepreneurs are not one-hit wonders. Instead, they find some kind of inefficiency in the business landscape and actively exploit it:

There is almost always, they conclude, a moment of great capital accumulation — a particular transaction that catapults him into prominence. The entrepreneur has access to that deal by virtue of occupying a “structural hole,” a niche that gives him a unique perspective on a particular market.

Villette and Vuillermot go on, “The businessman looks for partners to a transaction who do not have the same definition as he of the value of the goods exchanged, that is, who undervalue what they buy from him in comparison to his own evaluation.” He moves decisively. He repeats the good deal over and over again, until the opportunity closes, and — most crucially — his focus throughout that sequence is on hedging his bets and minimizing his chances of failure. The truly successful businessman, is anything but a risk-taker. He is a predator, and predators seek to incur the least risk possible while hunting.

If you take a moment to think about businessmen and investors who have had extraordinary success, they all seem to exhibit this trait. Most great businesses occupy a space in their industry where they are protected by the wide moat of their competitive advantages. Usually, it is a result of growing and growing until you almost monopolize your sector.

John D. Rockefeller saw an inefficiency in the oil refinery market and quickly moved. He realized that by securing rates with the railroad companies, he could at least gain a cost advantage over competitors. He also realized the economies of scale that could be had by acquiring competitors. At the time, running an oil refinery was a terrible business, many became bankrupt. But Rockfeller was able to build Standard Oil with acquisition after acquisition and emerge with a monopoly.

Sam Walton saw that rural communities were not being served by large discount retailers such as Kmart. He didn’t just open one Walmart, he opened many, using airplane flyovers to find untapped markets that would also connect advantageously with Walmart’s supply-chain system. Walmart grew so large that competitors from urban areas were unable to penetrate his geographic foothold. Walmart was then able to enter urban markets with ease and topple competitors to become America’s most successful retailer.

Ray Kroc saw a market for America’s first nationwide fast-food chain as he sold milkshake machines around the country. What he found were great hamburger restaurants run by people with no entrepreneurial drive behind them to actually franchise them. After encountering McDonald’s in 1954, Ray Kroc sealed a deal to become the company’s sole franchisee and grew the hamburger chain outside of Arizona and California. Today, McDonald’s is the world’s biggest hamburger chain.

While Gladwell refers to John Paulson as an investor who has exhibited these traits recently, Sardar Biglari may be a better example. Biglari started his hedge fund using money from a tech company that he started and sold while in college. He then went on to one by one, target fast-food companies that had high concentrations of company-owned restaurants on their balance sheets. Many of these chains were quite old so it was likely that the real estate, recorded at a cost on the balance sheet, was dramatically undervalued relative to their current market values. All together, Biglari targeted five restaurant chains: Western Sizzlin, Friendly’s, Applebee’s, the Steak ‘N Shake Company, and Jack in the Box. Biglari was able to get on the boards and take control of both Western Sizzlin and Steak ‘N Shake, eventually merging the two. Applebee’s and Friendly’s were both bought out by other companies. Biglari’s least successful attempt was with Jack in the Box, but since he only agreed to exchange shares of Western Sizzlin for Jack in the Box, the cost was virtually nothing.

The other thing Gladwell finds is that most entrepreneurs are able to find inventive ways of financing their business ventures:

Giovanni Agnelli, the founder of Fiat, financed his young company with the money of investors — who were “subsequently excluded from the company by a maneuver by Agnelli,” the authors point out. Bernard Arnault took over the Bousac group at a personal cost of forty million francs, which was a “fraction of the immediate resale value of the assets.” The French industrialist Vincent Bollore “took charge of the failing family company for almost nothing with other people’s money.” George Estman, the founder of Kodak, shifted the financial risk of his new enterprise to his family and to his wealthy friend Henry Strong.

For the entrepreneur, cheap and secure financing can drastically improve the chances of an enterprise’s survival. By investing little of his own money, the entrepreneur can amplify returns on his own invested capital while keeping dry powder in reserve for new opportunities. Most successful real estate developers exhibit the same trait as do private equity firms, little equity is actually invested in the properties acquired in favor of debt. This often leaves the newly privatized properties in danger of default in the case of a sudden economic downturn, while keeping the fortunes of the owners largely in tact.

Gladwell emphasizes the fact that Ted Turner was also averse to using cash in his acquisitions. He explains by using Turner’s purchase of the Atlanta Braves as a case:

The team was losing a million dollars a year, and the owners wanted ten million dollars to sell…

He talked the Braves into taking a million down, and then the rest over eight or so years. Second, he didn’t end up paying the million down. Somewhat mysteriously, Turner reports that he found a million dollars on the team’s books — money the previous owners somehow didn’t realize they had… He now owed nine million dollars. But Turner had already been paying the Braves six hundred thousand dollars a year for the rights to broadcast sixty of the team’s games. What the deal consisted of, then, was his paying an additional six hundred thousand dollars or so a year, for eight years: in return, he would get the rights to all a hundred and sixty-two of the team’s games, plus the team himself…

Turner is a cold-blooded bargainer who could find a million dollars in someone’s back pocket that the person didn’t know he had.

Many successful businessmen and investors seek out hidden assets when doing acquisitions. Often, the value of assets are sometimes obscured by accounting or the market climate. One of Warren Buffett’s most famous investments was in the Sanborn Map company. In 1961 the stock made up 35% of his partnership’s assets and gave him a spot on the company’s board. Astonishingly, while Sanborn sold for $45 per share on the market, the company had an investment portfolio of more than $65 per share. At the time, a buyer of Sanborn stock received an undervalued investment portfolio and a map business thrown in for free.

Using research from economist Scott Shane, Gladwell delves into the notion that the entrepreneur is a risk taker and gives reasons for why entrepreneurs fail:

…many entrepreneurs take plenty of risks — but those are generally the failed entrepreneurs, not the success stories. The failures violate all kinds of established principles of new-business formation. New-business success is clearly correlated with the size of initial capitalization. But failed entrepreneurs tend to be wildly undercapitalized. The data show that organizing as a corporation is best. But failed entrepreneurs tend to organize as sole proprietorships. Writing a business plan is a must; failed entrepreneurs rarely take that step. Taking over an existing business is always the best bet; failed entrepreneurs prefer to start from scratch. Ninety per cent of the fastest-growing companies in the country sell to other businesses; failed entrepreneurs try selling to consumers, and, rather than serving customers that other businesses have missed, they chase the same people as their competitors do. The list goes on: they undermine marketing; they don’t understand the importance of financial controls; they try to compete on price. Shane concedes that some of these risks are unavoidable: would-be entrepreneurs take them because they have no choice. But a good many of these risks reflect a lack of preparation or foresight.

Some of the reasons for failure may seem counterintuitive to a person who is seeking to start their own business. Many may balk at the prospect of taking over an existing business, but if it is a forced sale due to owner’s health or a decision to retire, a budding entrepreneur may have the opportunity to acquire a good business at a low price. This kind of thinking requires the entrepreneur to employ the kind of rational judgment that is totally counter to the cowboy image the media perpetuates.

Another of these traits is not caring what other people think. Gladwell notes that many successful entrepreneurs are willing to risk their personal reputation for their business. He contrasts the behavior of banking CEOs who kept piling up bad investments because they feared standing out from the crowd with Sam Walton’s decision to seek financing from his in-laws a second time after failing at his first venture:

Villette and Vuillermot point out that the predator is often quite happy to put his reputation on the line in pursuit of the sure thing…

If an awkward family reunion was the price Walton had to pay for a guaranteed line of credit, then so be it. He went out of his way to take a personal risk in order to avoid a professional risk. Reputation, after all, is a commodity that trades in the marketplace at a significant and often excessive premium. The predator shorts the dancers, and goes long on the wallflowers.

If there is one thing that is really representative of the entrepreneurial stereotype, it is the unflinching persistence that seems to be exhibited by all the examples used in the article. Gladwell ends with a story about the lengths Turner went to, to take back his family’s outdoor advertising business:

He hired away the General Outdoor leasing department. He began “jumping” the company’s leases– that is, persuading the people who owned the real estate on which the General Outdoor billboards sat to cancel the leases and sign up with Turner Advertising. Then he flew to Palm Springs and strong-armed Naegele into giving back the business…

Naegele, by the way, asked for two hundred thousand dollars, which Turner didn’t have. But Turner realized that for some o ne in Naegele’s tax bracket a flat payment like that made no sense. He countered with two hundred thousand dollars in Turner’s Advertising stock…

“I had kept the company out of Naegele’s hands and it didn’t cost me a single dollar of cash.” Of course it didn’t. He’s a predator. Why on earth would he take a risk like that?

Here, Turner really serves as an example for all entrepreneurs. His father had sold General Outdoor and committed suicide shortly afterwards. Such an event must have been emotionally jarring for someone like Turner, but he managed not to be constrained by grief and moved into action. All of his decisions, from poaching personnel to exploiting his adversary’s tax status exemplified the kind of clear-sightedness that is necessary for long-term entrepreneurial success. For the entrepreneur and investor, being able to keep calm emotionally is an absolute need when faced with the daily competitive pressures and changing landscape of the market.

The entire article is worth the read, I would suggest seeking out a copy from your news stand or purchasing a digital subscription, these excerpts are just a small part of it. This is especially true if you are interested in John Paulson. Gladwell dedicates a large part of the article to discussing how and why Paulson managed to earn billions of dollars by purchasing credit default swaps.

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.

The folks over at Dealbook have Paulson’s 3Q investor letter up. The letter is peppered with his insights from stocks to defaulted bonds.

What I wanted to do though, was highlight a few parts of the letter where I thought we could take a look at his methodology for looking at stocks. The idea here isn’t to find potential buys, but to see how he looks at companies.

Bank of America (NYSE:BAC)

-Paulson believes that by 2011, banks will have passed the write down cycle and return to growth in 2012.
-They are using a 10x normalized earnings multiple for large banks and the team estimates BAC to be worth $29.81 per share in 2011. Current shares trade at $16.35, so you are looked at almost 40% annualized.
-They expect provision for credit losses to come down quite a bit from 2008 levels, to 1.75%. That figure, $16,357 is about 61% of 2008′s numbers.

Then, there is Paulson’s gold position. If you looked at the latest 13F-HR filings, there are a lot of ways that investors have been playing gold. Some are going after miners, others are gaining exposure via ETFs, and then there are some that are trying to get their hands on the physical asset.

Paulson mentions two gold miners in his portfolio. This is how he looks at them:

-Five gold mining stocks comprise 14% of their portfolio.
-All five stocks would have upside in a flat environment, but an even higher upside in a rising price environment.
-AngloGold Ashanti (NYSE:AU) is the third largest gold producer in the world but trades at a lower Price/NAV than peers. So this is a value play based on comps.
-The company has a number of figures, which could contribute to its peer undervaluation:
1. Exposure to South Africa
2. Declining production profile
3. Large hedge book
4. Poor safety record.
-Paulson & Co. believe that the new CEO, Mark Cutifani would be a catalyst for change in the company and indeed: the company diversified out of South Africa, reduced their hedge book, increased their production profile, and improved their safety record.

So what we can take away here is that Paulson and his team were looking for a gold miner undervalued, relative to peers and viewed Cutifani, a great mining operator, as a catalyst.

Then, there is Gabriel Resources (TSE:GBU)

-Gabriel is another miner with an event catalyst
-The company is the largest potential goldmine in Europe and Paulson & Co. own 19.9% of it.
-NGOs have stymied the process for the mine to get their permit due to environmental concerns
-Newmont Mining and Electrum Strategic are other large owners of the company with 16% and 19% stakes
-Though the company trades at only $2 per share, the upside can go to $6-8 and $8-12 if they receive their permit and start production.

Gabriel appears to be a low risk high uncertainty situation with a binary outcome. Without their permit, the company is likely to trade flat while having a number of potential catalysts in place to unlock value.

Be sure to read the rest of the letter at the NYTimes Dealbook.