Street Capitalist: Event Driven Value Investments

Sorry for the thin posting recently, I’ve been going through final exams. This morning I had a chance to watch Charlie Rose’s interview with Nassim Taleb. Like always with Charlie Rose, the interview was top notch:

One of the things that struck me as interesting in the interview was the fact that the prospect of deflation. Nassim Taleb seems to think that that’s where our economy is heading:

CHARLIE ROSE: But let me go — you mentioned Nouriel Roubini, who has been here and who has become well-known as someone who has predicted this and saw it coming, and scares the hell out of people when he comes and sits where you do, because he sees it as getting worse, and even suggests sometimes it may mark the decline of America. How bad do you think…

NASSIM NICHOLAS TALEB: I think it is worse than Roubini thinks.

No, I — I had the same story, haven’t changed my story since — and what convinced me of this is that we switched from an environment of inflation, hyperinflation, where people are afraid of commodity prices rising, to a total deflation in no time. Look at inflation bonds…

… I know that we are going have massive deflation. The overhang of debt, massive deflation. Debt needs to be reduced. And I think Paulson seems to be doing a good job, particularly that they were part of the cause of what happened, you know, it is quite commendable.

That got me wondering - what is the best way to invest when you think that deflation is coming? When we, as value investors, invest we look for margins of safety. But if asset prices are falling, the margin of safety quickly contracts. So what are we to do?

Seth Klarman of the Baupost Group touches of this in his book, Margin of Safety. We’re lucky because the book was written only a few years after the junk bond craze, these kinds of topics were on the mind of investors. Here is what Klarman had to say on deflation:

In a deflationary environment assets tend to decline in value. Buying a dollar at 50 cents may not be a bargain if the asset value is dropping. Historically, investors have found attractive opportunities in companies with substantial “hidden assets,” such as an overfunded pension, real estate carried on the balance sheet below market value, or a profitable finance subsidiary that could be sold at a significant gain. Amidst a broad-based decline in business and asset values, however, some hidden assets become less value and in case may become hidden liabilities. A decline in the stock market will reduce the value of pension fund assets; previously overfunded plans may become underfunded. Real estate, carried on companies’ balance sheets at a historical cost, may no longer be undervalued. Overlooked subsidiaries that were once hidden jewels may lose their luster…

The possibility of sustained decreases in business value is a dagger in the heart of value investing (and is not a barrel of laughs for the other investment approaches either).

Which is really the heart of the problem with deflation, especially for value investors. We have to be cautious and not forget the fact that underlying values can indeed decline. This may have been one of the mistakes that some fund managers made when investing in banks while using book value to approximate business value. Book value was simply written down each quarter, ruining whatever margin of safety existed.

Klarman gives us three ways to invest if we think that business value may decline:

First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.

Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or hold current positions. This means that normally selected investors would probably let even more pitches than usual go by.

Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or not you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause to diminish become moot.

These rules are telling us that we need to be even more conservative if we wish to protect against deflation. That means increasing our margin of safety to compensate, and sticking with areas we’re more certain about. Sometimes value investors like to relax their standards so that they can join in the action of the market. They end up buying dollars for 70 or 80 cents and dip their toes in industries outside of their circle of competence. Maybe they’ll invest an an industry where the asset values are much harder to determine, they may make the error of overestimating and skewing their valuations as a whole. So we must become more conservative as the market becomes more turbulent.

With respect to the third factor, I really see this from a special situations perspective. Workouts like risk arbitrage, odd-lot tenders, and so on may be helpful because the price changes should be independent of the market’s precise movements and determined more by the transaction itself usually with a fixed time interval. This gives you the luxury of figuring out when the transaction will be completed so that you can compare it against what the market is doing.

Maybe you’re thinking about investing in an arbitrage situation but you think that asset values will decline over the course of the year. This could affect debt covenants or trigger a material adverse clause and kill the transaction. So you have to keep time in mind. The longer a transaction is supposed to take, the more you risk your capital, especially if you think the value of businesses will be declining.

Investing with macro issues in mind is always a tough thing, especially because its practically impossible to predict exactly what the economy will do. I don’t think that we need to study or spend too much time focusing on the economy though. We simply need to stick close to our principles and maybe exercise more caution that usual. If we do this, our returns should reward us well.

Click the image to see full-size:

I just added text to the graphic already provided by the awesome people at ProPublica. It’s really quite amazing to see not only the size of how these have grown from the past almost-40 years but also the recency of most of these bailouts.

source: ProPublica

Now, it appears as if even the great universal bank Citigroup (NYSE:C) has become yet another casualty of our financial crisis:

The federal government agreed Sunday to take unprecedented steps to stabilize Citigroup Inc. by moving to guarantee close to $300 billion in troubled assets weighing on the bank’s books, according to people familiar with details of the plan.

Treasury has agreed to inject an additional $20 billion in capital into Citigroup under terms of the deal hashed out between the bank, the Treasury Department, the Federal Reserve, and the Federal Deposit Insurance Corp. Treasury officials will charge a higher interest rate for the capital injection — 8% for the first few years — than it has charged to dozens of other banks now borrowing money under the government’s the $700 billion rescue package approved by Congress last month.

In addition to the capital, Citigroup will have an extremely unusual arrangement in which the government agrees to backstop a roughly $300 billion pool of its assets, containing mortgage-backed securities among other things. Citigroup must absorb the first $37 billion to $40 billion in losses from these assets. If losses extend beyond that level, Treasury will absorb the next $5 billion in losses, followed by the FDIC taking on the next $10 billion in losses. Any losses on these assets beyond that level would be taken by the Fed.

Citigroup would also agree to work to modify — if possible — troubled mortgages held in the $300 billion pool, using standards created by the FDIC after the collapse of IndyMac Bank.

U.S. Agrees to Citigroup Bailout (WSJ)

With the bank trading at a market cap of $20 billion a capital injection of an additional $20 billion would cut the current stock price in half, if I’m reading the terms correctly. The story seems to still be developing, I’ll post more as more details emerge. On the contrary, today’s trading shows us that the $300 billion guarantee is yielding a surge in confidence for Citi, sending their stock price up 56%.

Today’s New York Times features an awesome article: “Challenging the Crowd in Whispers, Not Shouts” by Robert J. Shiller.

Shiller discusses why the housing bubble was ignored by colleagues. At heart here is the issue of when to be a contrarian. This is a subject I’ve posted about a lot since the start of the blog. As value investors we almost always have to act as contrarians by nature.

The thing I liked about the article is that it discusses a reason for not being a contrarian that I hadn’t have thought of:

The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group…

In addition, it seems that concerns about professional stature may blind us to the possibility that we are witnessing a market bubble. We all want to associate ourselves with dignified people and dignified ideas. Speculative bubbles, and those who study them, have been deemed undignified.

I’ve never thought of contrarianism in these terms — where being a contrarian can affect how your colleagues perceive you and whether or not your professional opportunities are limited by bucking the trend.

When I think of contrarianism, it’s really from a more individualistic perspective. Many investment fund managers are able to achieve a good sense of individuality, managers in the value sector are actually afforded the luxury of being contrarian - it’s part of the job. In other professions, that isn’t the case.

Shiller describes economists working for the federal reserve, but I can think of other places affected by the same problem. A number of people working in the mortgage industry raised questions about the sub-prime loans being made, but were basically told to get back in line. Similarly, recent testimony from the ratings agencies revealed documents detailing questions that were raised regarding certain CDOs.

With economic research councils, like Shiller cites - perhaps something can be done to promote more diverse areas and contrary opinions. I know that some organizations utilize a technique where when someone proposes a plan another employee is given the task of playing devil’s advocate and arguing why the plan should be rejected.

In the other examples, the mortgage lending industry and ratings agencies the problem was a bit different. It was an agency issue. These folks were generally paid based on quantity of work, not quality. That kind of thinking creates a culture of greed and we know how that ends. Tackling that problem is more difficult. You need to adjust the psychological mindset of the people working there. The easiest way would be to alter how compensation works at those firms - so that they have an economic interest in their work, rather than being able to pass the risk off to the next person down the line.

How do you fix something like this, or prevent this kind of thinking?

You need a diverse group of mental models.

Why do professional economists always seem to find that concerns with bubbles are overblown or unsubstantiated? I have wondered about this for years, and still do not quite have an answer. It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing.

Shiller highlights one of the greatest issues with economics, the lack of interdisciplinary thinking. He’s not the first person to bring this up. Warren Buffett’s famous business partner, Charlie Munger has been a huge proponent of interdisciplinary thinking .

From his speech - Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs (PDF)

I think there’s a modern name for this approach that Whitehead didn’t like, and that name is bonkers. This is a perfectly crazy way to behave. Yet economics, like much else in academia, is too insular. The nature of this failure is that it creates what I always call, “man with a hammer syndrome.” And that’s taken from the folk saying: To the man with only a hammer, every problem looks pretty much like a nail. And that works marvelously to gum up all professions, and all departments of academia, and indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man with a hammer syndrome is to have a full kit of tools. You don’t have just a hammer. You’ve got all the tools. And you’ve got to have one more trick. You’ve got to use those tools checklist-style, because you’ll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. But if you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of answers that you won’t
find any other way.

Maybe Shiller will find Munger’s speech. I think he’s enjoy it.

Having these mental models can improve your judgment by getting you to look at problems from non-traditional perspectives. It will get you to question the crowd and might give you the oomph you need to yell instead of whisper amongst your colleagues.

For years Berkshire Hathaway (NYSE:BRK.A) has held two core positions in financial firms: Wells Fargo (NYSE:WFC) and American Express (NYSE:AXP). One of the things I did when the financial crisis began is put these two companies on my watch list. I thought that if they were good enough for Warren Buffett, maybe they could be good enough for me, especially if they experienced any sudden drops in their stock prices.

For much of the crisis, Buffett remained close lipped about his investments in either of these two companies. In the last 13F-HR filing, there appeared to be no addition to either of them. But today, on CNBC, Buffett announced a couple of things that I would take as positives for Wells Fargo:

[Buffett] told Becky that the Wachovia deal was indirectly spurred by a recent change in the tax laws. Buffett also praised Wells and its CEO, Bob Steel, saying no bank has done a better job for shareholders and depositors during the financial crisis.

He noted that he owns only two domestic stocks personally, Berkshire and Wells, and revealed that Berkshire has been adding to its Wells Fargo holdings over the year.

Warren Buffett to CNBC: Rescue Bill Not “Panacea” for Economy (CNBC)

So we now know that he’s been adding to the position and it’s actually the only domestic stock besides Berkshire that he’s holding personally. This is a pretty strong vote of confidence for the company, who is currently trying to acquire Wachovia (NYSE:WB). For much of the crisis, Wells Fargo has stayed out of the limelight of the big acquisitions we’ve seen. John Stumpf of Wells Fargo is a pretty sharp guy who is managed to create a great culture that has been conservative when compared to the rest of the excesses that have sickened the banking industry.

To get an idea for how he thinks, look at this article from the Financial Times:

In an interview with the Financial Times, Mr Stumpf quashed repeated speculation that Wells, the fifth-largest US bank, would take advantage of the collapse in the shares of many rivals to clinch a big deal.

“A large transformational [deal] is highly unlikely. Not impossible, but highly unlikely,” he said.

“We don’t need to do a deal. Organic growth is the core growth engine in this company.”

…

“We come from a culture where bigger is not better. You get bigger by being better, you don’t get better by being bigger,” he said, adding that Wells was also unlikely to stray from its western focus by buying on the East Coast.

Wells Fargo rejects speculation over deal for a struggling rival (FT)

Here’s more about Stumpf and the Wells Fargo culture from another FT article:

When, in the heady markets of 2005 and 2006, Mr Stumpf was staring down a different kind of barrel, he chose a similarly prudent route for the fifth largest bank in the US.

Faced with deciding whether to follow Wells’ rivals in selling lucrative securitised debt and subprime loans with few strings attached, Mr Stumpf and Dick Kovacevich, his long-time mentor who hand-picked him as successor in June last year, concluded the high risks did not justify the potentially high rewards…

“You can imagine the pressure on us. We were the number one mortgage originator and we had to give up market share and earnings,” Mr Stumpf says. “[But] it is more difficult to attend a party and leave before the trouble starts than not to attend the party at all. Part of my job here is to make sure we don’t attend parties that make no sense.”

With his laid-back delivery and penchant for catchy metaphors – traits he shares with Warren Buffett, his occasional bridge opponent and Wells’ largest shareholder – the 54-year-old Mr Stumpf makes Wells’ escape from the crisis sound easy. The reality is that the lender’s bold counter-cyclical call saved the company from the worst US housing bust since the Great Depression…

Asked to identify the biggest change he has introduced since taking over the CEO job from Mr Kovacevich, who is staying on as chairman until December, his brisk response is “None”. Noting that he has been with the company for more than 20 years, he adds: “There is no sea-change. I am fully invested in the culture, and one of my roles here is as the keeper of the culture…I don’t have any passion or ego to put my mark on the company. This is about sticking to our knitting”…

A strong balance sheet, an enviable competitive position and a satisfied workforce: Wells is such an outlier in the ravaged US financial sector that rivals have begun to wonder if it has a secret formula.

Mr Stumpf shakes his grey-haired head: “It’s about culture. I could leave our strategy on an aeroplane seat and have a competitor read it and it would not make any difference”.

Wells Fargo cracks the whip (FT)

I can’t say if the deal with Wachovia is a good deal for Wells Fargo (the pains of integration post-merger) or will even go through. As you know, Citigroup tried to buy the company with assistance of the US Government at a substantially lower price. If I had to bet though, I would say that the Wells Fargo deal has a greater likelihood of passing, simply because it doesn’t rely on assistance from the government. If Citigroup revises their bid to include that, there could be a good bidding war for Wachovia and its $448 billion in deposits.