Street Capitalist: Event Driven Value Investments

Jason Zweig’s latest column at the WSJ (Psyching Yourself Up to Let Losers Go ) tackles a tough issue for most investors - when to sell. Selling can be difficult for a variety of reasons, but a big factor is psychology. We don’t like to let go and give up things we’ve bought. Zweig provides us with a telling statistic:

Individual and professional investors alike struggle with selling. Berkeley finance professor Terrance Odean has found that investors are at least 50% more likely to sell their winners than their losers. Among the money managers surveyed by Cabot Research, a Boston consulting firm, fewer than 30% base their sell decisions on “extensive research.” The rest concede they basically sell by the seat of their pants.

To defend our portfolios from our emotions, Zweig offers us six techniques.

1. Use stop-loss orders

I’ve never been a fan of using a stop-loss order on a company’s stock. I know that Investors Business Daily advocates the use of selling whenever a company falls 10% and I think it’s too trivial of a rule. Zweig says that he doesn’t advocate the use of stop losses but prefers “stop look” orders:

Whenever a stock drops, say, 25% below what you paid, automatically review your original top three reasons for buying to see whether they are still valid. That will prevent you from selling without thinking first.

This is a pretty good idea. I practice the same kind of exercise myself. I don’t have any alerts set to tell me when about a drop of 25%, but I do check my company’s prices regularly. An easy way to get notified of drops in your companies can be done with Yahoo Alerts, you can get an e-mail or text message based up requirements you set (price drop/rise or percent drop/rise). Two of my holdings, Air Transport Services Group (NASDAQ: ATSG) and Steak N Shake (NYSE: SNS) have fallen a bit from my initial buying points ($1.70 and $10.00).

In each of these cases, I re-analyzed my investment thesis, to see if anything changed. With ATSG, the fall from $1.70 to below $1.00 was triggered by almost no news. DHL severing business ties with ATSG was already part of my investment idea- so I didn’t see a reason to sell. With SNS, my thesis hinged on Sardar Biglari getting onto the board and gaining control so that he could make the right decisions for the company. I decided that I would not sell till that thesis was properly tested.

2. Don’t Go Far Afield

Here, Zweig recommends buying an industry index if the company you purchased ends up having poor results. I don’t quite agree with this advice. It all seems a little bit like decisions made by an investor who doesn’t know what they’re doing who is trying to catch a trend (and may be too late).

The only time I think that this is valid is when you’re investing in an industry with good economics but where the individual players might be too hard to pick. I’m thinking of Buffett’s investments in pharma with companies like Sanofi Aventis (NYSE: SNY), GlaxoSmithKline (NYSE: GSK), and Johnson & Johnson (NYSE: JNJ). The difference with Buffett’s investments in pharmaceutical companies is that he still was not buying an ETF, he bought just a few of the players in that industry. An ETF will usually have many more holdings and carry the risk of over diversification.

3. Shop Before You Drop

Zweig’s next technique is a bit better-

Ask yourself: Which stock or fund would I most like to own? Then view your losers as a source of funding to reduce the amount of cash you would otherwise need to raise

Sometimes I think that selling losers can be good, especially if you’re purchasing a better buy. Maybe a new opportunity has presented itself with a higher return or the margin of safety in your losing investment has narrowed.

4. Re-price it.

Here, the idea is to take your original purchase price and divide it by 10 and compare that price with its current price. A simpler method might be to look at the price you’re seeing right now and compare it to your conservative estimate for the company’s margin of safety(the spread between the current price and the company’s intrinsic value you in your eyes). If you’re buying companies at what you think are 50% discounts, you’ll see a wider margin of safety. It will then be up to you to decide if anything has changed.

If the margin of safety has narrowed to a point where maybe the capital could be better used elsewhere, then you should.

5. Follow your sales.

This is some of the best advice in the column.

Using an online portfolio tracker, monitor the returns of all the stocks you sell after you sell them. Studying the aftermath of your mistakes will enable you to learn which you sold too soon and which too late. You cannot improve what you do not measure.

I try to do the same. On my Google Finance page I keep all of my stocks, even after selling them. I like to see what they’re currently doing and learn from my mistakes and the company’s mistakes. By doing this, you expand your circle of competence. It makes me think of a quote from Edward Lampert in Fortune Magazine.

[The] idea of anticipation is key to investing and to business generally. You can’t wait for an opportunity to become obvious. You have to think, “Here’s what other people and companies have done under certain circumstances. Now, under these new circumstances, how is this management likely to behave?” The plays my father designed for me helped me learn to think ahead. Lots of days I asked him, “Why can’t we just invite kids over and play a game?” In order to do something well, he explained, you have to keep practicing and preparing.

And I think that’s one of the more important concepts to keep in mind when investing. You can often draw upon past experiences when making future decisions. The situation might not be entirely the same, but it’s incredibly useful to have that kind of knowledge filed away for future reference.

It looks like one analyst seem to think so:

Analyst Steve West said in a note to investors that the company’s “long-awaited” strategic plan is due to be released in the next few months - a move that likely will improve sentiment in the stock and make for the beginnings of a turnaround.

West said he does not see traffic at the chain improving until at least 2009 “as the strategic plan will take time to implement and the consumer remains strained.”

But he said the company’s management is “taking the right steps for a fiscal year 2009 rebound.”

Although he said he does not know details of the plan, he expects it to include closing underperforming stores, cost-cutting, selling real estate, refranchising company-owned stores and repurchasing shares.

Steak n Shake shares rise on analyst report (IBJ)

I believe that one of the right steps was the sale-leaseback transaction Biglari executed recently. The move elicited a pretty negative response from some investors, but when faced with the possibility of bankruptcy since the company was/came close to violating debt covenants, it seemed like the right move.

Biglari’s withdrawal of the tax abatement plan appears to be the right move as well. Receiving that kind of support from the local government could have added to the costs of Steak N Shake (NYSE: SNS). These tax abatement plans are there typically for a business that is supporting and employing members of the community. They would discourage or possibly prohibit the closing of underperforming restaurants and firing of employees, which is just the sort of cost-cutting we might need right now.

Right now, controlling costs is at the forefront for most fast food and casual dining chains. It’s evident from the reports coming out that describe McDonald’s (NYSE:MCD) retooling of the double cheeseburger to make it less of a loss-leader and Burger King’s (NYSE:BK) hope of reducing the size of the Whopper Jr. to control costs. With most commodities going up, all of these companies are in a tough position. It’s an intensely competitive business, with your enemies usually operating next door. If you raise your prices to push your increasing costs to the consumer, you risk losing sales.

I’m still holding my shares, and believe that my previous estimate for the company’s valuation of $20 per share is still in tact, but I’m not entirely sure of how long it will take to play out. We’ve already seen the bankruptcies of Bennigans, Steak & Ale, and creditor pressure on Uno’s.

 

It’s likely that we’ll see more distress in this sector, just as some of the highly leveraged chains find themselves strangled by a perfect storm of debt, higher costs, and lower customer traffic. Shrewd capital allocation skills are going to be needed as the industry passes through this rough period, luckily our new CEO seems to have them.

In an ideal world, managers at corporations would listen to the ideas that shareholders bring to them. After all, the shareholders are the true owners of a company. Usually though, egos start to fly and things don’t work out that way. When that happens, shareholders often utilize proxy contests in order to replace members of the board of directors and make their voices heard. The problem is that these proxy fights are messy and expensive. You have to obtain extensive legal council and take on the costs of actually mounting a campaign to distribute ballots and get votes yourself. For smaller investment funds the fight just might not be worth it.

The reason I bring this up is that there seems to be a little controversy regarding Sardar Biglari’s reimbursement of $500,000 from Steak N Shake (NYSE: SNS) while also serving as CEO of Steak N Shake (and taking a salary).

In connection with his appointment as Chief Executive Officer of the Company, Mr. Biglari’s annual salary was increased to $280,000. There is no other plan, contract or arrangement to which Mr. Biglari is a party or in which he participates that was or will be entered into, or any material amendment to such a plan, contract or arrangement, in connection with Mr. Biglari’s appointment as Chief Executive Officer. Mr. Biglari does not receive board fees or any other compensation.

On August 6, 2008, the Company’s Board of Directors agreed to reimburse Western Sizzlin and the Lion Fund for expenses related to this year’s proxy contest in the amount of $500,000. Mr. Biglari serves as the Chairman and Chief Executive Officer of both Western Sizzlin and the Lion Fund. This expense reimbursement is being disclosed pursuant to Item 404(a) of Regulation S-K.

Form 8-K for STEAK & SHAKE CO (Yahoo!)

While this looks sketchy, it’s not. Back in January, Biglari publicly disclosed that he would be seeking reimbursement for expenses incurred by having to wage a proxy contest with Steak N Shake. He says here:

The expense of soliciting proxies is being shared pro rata by the Lion Fund, Western Sizzlin and Western Acquisitions based on their pro rata share of the aggregate number of Shares held by all members of the Committee. Costs of this solicitation of proxies are currently estimated to be approximately $[________]. The Committee estimates that through the date hereof, its expenses in connection with this solicitation are approximately $[________]. We intend to seek reimbursement from the Company of all expenses we incur in connection with the solicitation of proxies for the election of the Nominees to the Board at the Annual Meeting. We do not intend to submit the question of such reimbursement to a vote of security holders of the Company.

Preliminary proxy statements, contested solicitations (Steak N Shake)

Had Biglari pulled the reimbursement out of a hat, as a shareholder I’d be angered. But he didn’t. When he began his proxy contest with the company he publicly disclosed that he would seek reimbursement. If shareholders had disagreed with this, they could have voted in favor of company management.

In general, I like to see these reimbursement policies in play. They are enablers for shareholder activism which means that even in the micro-cap/small-cap area, we can see corporate management held accountable to their shareholders.

This weekend I had the privilege of reading the new Robert Cialdini book Yes!: 50 Scientifically Proven Ways to Be Persuasive. I first learned about the book from reading and watching a few talks with Charlie Munger, Warren Buffett’s right hand man. Yes! is a great book, it showed me a lot of different ways that we see psychology being used - especially when businesses are trying to sell to us.

One of the chapters which stood out to me discussed an experiment on how companies report their earnings.

Fiona Lee and colleages suggest that organizations that attribute failures to internal causes will come out ahead not only in public percetption but also in terms of profit line.

They also suggest that the public response to an organization’s internal focus to explain failures might be to assume that the organization has a plan to modiy the internal features of the organization that may led to the problems in the first place.

So what does it look like when a company does not attribute failure to an internal cause?

From the Steak N Shake (NYSE: SNS) 10-Q:

During the second fiscal quarter, same-store sales declined 6.3% primarily as a result of a decline in guest counts of 8.8%. Our same store sales and guest counts were negatively impacted by multiple factors, including further deterioration in the consumer economic environment and increased promotional activity from competitors…

Rising unemployment rates, steadily increasing gasoline prices, continuing housing related issues and declining levels of consumer confidence resulted in decreased guest traffic for us and many of our peers in the restaurant sector.

The researchers controlled variables and looked at companies which blame internal factors (strategic decisions, the release of new products) for poor earnings versus companies that blame external factors (the economy).

The results:

They discovered that when these companies explained failures in their annual reports, those that pointed to internal and controllable factors had higher stock pries one year later than those that pointed to external and uncontrollable factors.

This got me thinking to a quote I saw from Sardar Biglari at the Western Sizzlin meeting:

Steak N Shake is not declining because of the economy … almost everything that could go wrong with Steak n Shake has gone wrong.

We should be in for good things now that we have a CEO who is willing to blame our current woes on internal deficiencies, instead of writing them off as problems outside of management’s control.

Today Steak N Shake (NYSE SNS) annouced that Sardar Biglari will serve as Chief Executive Officer:

Mr. Biglari commented, “I would like to thank Wayne for his guidance over the last several months. In reviewing Steak n Shake and beginning to implement its restructuring, the Board and I concluded that to achieve the best results, we need an executive who will be focused on restaurant operations. As a consequence, we will seek a president with significant restaurant experience to concentrate on improving restaurant operations, whereas I will assume the CEO position, leading the organization principally from a strategic, financial, and governance perspective. Concurrently, we are presently undergoing a comprehensive examination of the company and are in the process of implementing a restructuring program — closing underperforming locations, reducing G&A, shortening hours of operation in many locations, and other initiatives — all on the premise that Steak n Shake will be managed based on cash flows in order to create long-term value for shareholders. Steak n Shake is an iconic brand with greatly talented people working throughout the organization. Because of all these advantages, I am confident we will regain the chain’s prior status as a great company. Details of our plan will be disclosed within the next 60 days in a shareholder letter.”

The Steak n Shake Company Announces Change in Leadership (Yahoo)

My reaction to this change is positive but mixed. Biglari became chairman with the intention of helping influence the board into finding someone to run operations for Steak N Shake (SNS). The fact that this has not happened is a little disappointing, but I know that Biglari is working 17 hour days and he has already had a positive effect at the company (steering SNS to tax savings). I’d rather that we patiently wait for the right president to be found. We’re going to need someone good in order to excel in this kind of economic climate.

One thing I’m wondering is whether we’ll see a merger between Steak N Shake (SNS) and Western Sizzlin (WEST). It would be a little similar to what Eddie Lampert did with Kmart and Sears. The same could happen with Steak N Shake with Western Sizzlin since both are in the restaurant industry, we could see some cost savings and synergies achieved by merging. Although getting the financials to work out, especially currently, would be a major stretch.