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.

I mentioned Seth Klarman and inflation hedging previously in my post about his talk at the CIMA conference. Here is another quote, this time from a recent article on MarketWatch:

Seth Klarman, a top-performing value investor and head of The Baupost Group LLC, told clients in an Oct. 10 letter that the economic downturn could be “vicious and protracted.”
“The financial market collapse and bailout makes us sick,” he wrote. “There is likely more carnage to come.”

The U.S. dollar will likely weaken and its reign as the world’s reserve currency could end, Klarman predicted. Longer-term, U.S. interest rates may rise as foreigners have to be enticed more to invest in dollar-denominated assets, he added.

The recent Treasury Department bailout has yet to be paid for and should add to inflationary pressures over time, especially when the economy begins to recover, he said.

I still haven’t figured out what his inflation hedge might be, but it’s something worth thinking about. Here’s a line from his book Margin of Safety, which hints a bit at inflation hedges:

…value investing can work very well in an inflationary environment. If for fifty cents you buy a dollar of value in the form of an asset, such as natural resource properties or real estate, which increases in value with inflation, a fifty-cent investment today can result in the realization of value appreciably greater than one dollar.

What might he be looking at? Timberland? Oil and gas properties? Or maybe land itself, domestically or abroad.

Note: these notes come from BenGrahamMan at the Motley Fool Boards, the original thread is here.

Seth Klarman runs the Baupost Group, a prominent value investing fund that has had stellar performance since inception. What’s really amazing about Klarman is how risk averse he is, I’ve heard that sometimes he will convert nearly 50% of his portfolio into cash while still still posting strong returns. In my previous post, I mentioned the Buffett quote where he says that they look for people with risk aversion programmed into their DNA, I think Klarman fits the bill.

He’s the author of Margin of Safety, the expensive and out of print value investing book, and has recently contributed an entry to the new edition of Security Analysis.

1. The biggest fear was buying too soon and on way down, from up in over-valued levels. We knew market collapse was possible and sometimes imagined I was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.

2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can’t be predicted, and would be equally wrong.

3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.

4. In a market like we have been experiencing. Most investors lose their rudders. They become unwilling to part with cash. They start working on macro economic level. Investors look to pull out of market and wait for a clear signal of change. Value investors should be able to keep their focus and remember Graham and Dodd of 1934.

5. If you can maintain your focus, resist business pressures and have a multifaceted tool kit, you can expect to prosper, even in difficult times.

A. Always recall road map of Graham and Dodd. Revisit this road map when times get difficult. Maintain discipline and value with a margin of safety. This doesn’t mean you won’t lose money. It means if there are drops in price, you have even more of a bargain.

B. Avoid highly leveraged stocks, junk bonds and shaky financials.

C. Look for bargains in various industries and nations.

D. Look at value, not great companies and great management.

E. Listen to Warren Buffett when he states you should buy a stock as if the market would close for a long period of time after you bought the stock.

6. Remain focused on the long run. Graham and Dodd motivate our diligence. They are like silent sentinels. Navigate the best you can and Graham and Dodd are the North Star for value investors.

7. Stand against the prevailing winds, selectively and resolutely. Yet for a while a value investor will under-perform. Interim price declines allow you to average down. Do not suffer the interim losses, relish and appreciate them.

8. Value investing at its core is the marriage between a contrarian streak and a calculator. Buying what is in favor is ensuring long-term under-performance.

9. It is critical to remind your clients, investment team and as often as necessary yourself, that you can only control your process and approach. Understand that you cannot control or forecast the vagaries of the market. Then you should invest in what you believe and what your research dictates. Be indifferent if you lose your short-term oriented clients, remembering that they are their own worst enemies.

10. Controlling your process is essential.

A. Be focused on process, not outcome.

B. Do not judge a decision based on its outcome.

C. During periods of under-performance it is easy to change your process.

D. When a firm is worried about tempers, second-guessing and fear, the process will fail. Look for long-term results; anything else will corrupt the process.

11. Value investing is an art and not a precise science. It is dealing with the fact that we do not work with perfect information.

12. Mechanical rules are dangerous. Graham and Dodd principles should serve as a screen.

Q&A

1. How do you see current investment climate?

A. James Grant - Look at some MBS and beaten down bonds. Some are priced to yield teens. They are priced for a further 25% decline. Also unsecured debentures of nations top retailers. These are priced at 5% to 7%. Hence, short the retailers at 6% and go long the beaten down mortgages.

B. Seth Klarman - Unusual amount of forced sellers, via margin calls. This could breed opportunity. We see a lot of money managers staying on the sideline. We finds this to be an opportunity to buy. Buy when others react to news or false news. Our experience is when people give away stocks out of need, due to fear or margin calls, that sounds like a great buying opportunity. In this environment you are playing against very smart people.

C. Bruce Greenwald - Take a deep breath. All the doomsday talking is not being reflected in stock prices. Stocks are basically down 25%, but unemployment is not great like early 1940’s. You need to put this into perspective like 1991 or 1982.

2. Klarman discussed buying one security at a time. Not everything is a bargain out there. Be selective. Many of us have seen opportunities now, and history says to buy them. We bought knowing that banks are going to fail, that real estate would drop, but that certain mortgage backed securities were under-valued. Never leverage, where you can have an opportunity to buy and not be able to take advantage of it because of leverage.

3. James Grant - Treasuries are yielding less than expected future CPI. Treasuries are now being priced as a macro-economic play. Treasuries are not intrinsically safe. They are not safe based on valuation.

4. What factors do you look at in sizing a position?

Seth Klarman - We think this has been missed over the last 15 years. Most of the diversified risk is done via 20 to 25th position. We have had a 10% or so concentrated position about a dozen times over the last 20 years. Most of the time we have 3,5 and 6% position. We will take it higher if we see a catalyst for increased value. We would not own 10% position in a common stock, only because it seemed under-valued. We would have a greater than 10% position if there was a margin of safety. I see managers make mistakes with concentrated positions in similar industries. Small positions of say 1% are nonsensical. We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don’t own gold as a commodity. We won’t disclose our inflation hedge, yet with enough work, you can find true inflation hedges.

I have to wonder what Klarman’s inflation hedge is. I know that Warren Buffett believes that one of the better ways to navigate through inflationary times is to own companies that can increase prices (think See’s Candies) with little worry for losing market share. On the other hand, some investors choose to look towards commodities. David Swensen of Yale’s Endowment fund is pretty famous for investing in timber and Prem Watsa of Fairfax Financial (NYSE:FFH) made a recent investment in that area as well. Anyone out there have an idea?