Street Capitalist: Event Driven Value Investments

My friend Miguel Barbosa has an excellent interview with James Montier (of GMO and author of: Value Investing: Tools and Techniques for Intelligent Investment). I thought I would give you a couple of excerpts, I believe the whole interview is worth reading and suggest you do so. Miguel tells me that he should have his second part up soon.

A few days ago, when discussing value investing, a friend asked me why value investing does not stop working. Value investing thrives because of certain inefficiencies in the market and it has been written about for more than 70 years now. So why doesn’t the market catch on? Montier provides us with an answer:

Miguel: Tell us about the price = quality heuristic? Why do investors overpay for beauty and underpay for toads…after all they are one step away from becoming princes are they not? This heuristic complements the Anginer et all study where ugly defendants are more likely to be found guilty and receive longer sentences than attractive defendants.

James Montier: We humans have a bizarre bias against a bargain. For instance, my friend Dan Ariely has done some great experiments in this field showing some pretty odd findings. Imagine you taste two glasses of wine one you are told comes from a $10 bottle, the other comes from a $90 bottle. You will almost certainly say that the $90 wine tastes much better. The only snag is that the two wines are exactly the same. So never come to dinner at my house, because I’ll give $10 wine, and tell you it costs $90!

The same thing happens with pain killers. It is why branded pain killers exist alongside generic equivalents. They both have exactly the same active ingredient, but people report the branded version works better.

I suspect that something similar happens with stocks. Stocks are the one thing we don’t like to see on sale. So a ‘cheap’ stock must have something wrong with it, and an ‘expensive’ stock must be a sign of quality – at least that’s the way we tend to view things.

The Anginer et al study shows some similar findings in the legal context. Ugly defendants get far worse sentences, than attractive defendants. We have a hard time believing that attractive people could have been bad – a kind of halo effect, if you will.

If you haven’t already, I really suggest you read Dan Ariely’s book Predictably Irrational, it is one of my favorites. Montier gets at why I think markets wont figure out value investing — the participants are too irrational. Usually, what you will see are investors who claim to practice value investing, only to abandon it when things get tough. It is a style of investing that requires levelheadedness, courage, and patience, which many investors lack.

One of the topics Montier touches on is short selling, which I thought was pretty interesting. Most value investors don’t short, so it is always nice to take a look at the ones who do:

Miguel: Tell us about the folly of using price to sales as a proxy for value.

James Montier: Price to sales is fine if you are looking for short candidates, but as a long side value criteria it makes no sense to be at all. After all as long as you promise to value me on price to sales, I’ll set up a business selling $20 bills for $19…I’ll never make a profit, but if you are looking at price to sales you won’t care.

Price to sales is typical of the drift up the income statement when the bottom line gets too demanding. If your PE starts to look expensive, get everyone to look at a less demanding metric, enter stage left price to sales. If that starts to look tough, abandon the income statement and look at the value based on eyeballs and clicks!

Miguel: What I enjoy about your writing is that you aren’t afraid to talk about “controversial topics” – yes I’m talking about your work on short selling. Can you quickly tell us what you have learned about short sellers (their characteristics, screens, etc).

James Montier: Short sellers are everyone’s favorite scapegoats. They make money when things go ‘wrong’. Of course, what the authorities forget is that simply because a short seller sells a stock, doesn’t mean it goes down – if only it were that easy we’d all be short sellers. As David Einhorn observed, I’m not critical because I’m short, I’m short because I‘m critical.

In my experience, short sellers are amongst the most fundamental investors you’ll come across. They understand the ins and outs of a business better than just about everyone else. They are highly skilled at figuring out poor economics when they see if. They act as acting police, helping to uncover fraud – something that the regulators used to do (a very long time ago).

My own work on short selling has focused on a number of areas. In general, shorts tend to come into a couple of categories: bad businesses (i.e. poor economics), bad accounting (obvious), bad management (the guys at the top haven’t got a clue). In addition I often look for several traits, such as expensive, unrealistic growth expectations, too much debt, and poor capital discipline (i.e. needless and tangential M&A).

I also created a measure called the C-score (C is for cheating or cooking the books). It aims to look for the quantitative red flags which often accompany bad accounting.

Excerpt: Details of the C score Page 263 of Value Investing Tools & Techniques for Intelligent Investment

1. A growing difference between net income and cash flow from operations.
2. Day sales outstanding is increasing.
3. Growing days sales of inventory
4. Increasing other current assets to revenues.
5. Declines in depreciation relative to gross property plant and equipment.
6. High total asset growth.

Miguel Barbosa interviews James Montier (Simoleon Sense)

Those are just two questions that Montier answered. There are many more over at Simoleon Sense and I highly recommend the interview.

David Einhorn is a value investor who I’ve followed for a few years now. His call on Lehman Brothers was quite prescient and he’s someone I always take time to listen to:

George Soros makes the argument for greater CDS regulation, I agree:

Up until the crash of 2008, the prevailing view — called the efficient market hypothesis — was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don’t deal with the current reality, but with the future — a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. (I call this feedback mechanism “reflexivity.”)

With the help of this new paradigm, the poisonous nature of CDS can be demonstrated in a three-step argument. The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one’s risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.

The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.

AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.

The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.

Taking these three considerations together, it’s clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination. And AIG failed to understand this.

Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. Under this rule — which would require international agreement and federal legislation — the buying pressure on CDS would greatly diminish, and all outstanding CDS would drop in price. As a collateral benefit, the U.S. Treasury would save a great deal of money on its exposure to AIG.

One Way to Stop Bear Raids (WSJ)