Street Capitalist: Event Driven Value Investments

This morning while reading today’s Heard on the Street column by Peter Eavis at the WSJ, I saw an interesting line:

But Mr. Buffett has expressed regret that he didn’t do certain deals differently, including an investment in Gillette in 1989.

This struck me as strange since Buffett’s investment in Gillette is generally regarded as one of his best. I never knew that he had any regrets for it. The investment was regarded as his best out of the four convertible preferreds from the late ’80s (USAir, Salomon Inc., Champion International are the others). He was able to not only keep the company defended from raiders but also make a handsome profit while owning “7% of the razor market”. Upon searching a bit, I think I found what Eavis mentioned as Buffett’s regret:

Our best holding has been Gillette, which we told you from the start was a superior business. Ironically, though, this is also the purchase in which I made my biggest mistake - of a kind, however, never recognized on financial statements.

We paid $600 million in 1989 for Gillette preferred shares that were convertible into 48 million (split-adjusted) common shares. Taking an alternative route with the $600 million, I probably could have purchased 60 million shares of common from the company. The market on the common was then about $10.50, and given that this would have been a huge private placement carrying important restrictions, I probably could have bought the stock at a discount of at least 5%. I can’t be sure about this, but it’s likely that Gillette’s management would have been just as happy to have Berkshire opt for common.

But I was far too clever to do that. Instead, for less than two years, we received some extra dividend income (the difference between the preferred’s yield and that of the common), at which point the company - quite properly - called the issue, moving to do that as quickly as was possible. If I had negotiated for common rather than preferred, we would have been better off at year end 1995 by $625 million, minus the “excess” dividends of about $70 million.

Berkshire Hathaway Letter to Shareholders (1995)

This is one of the best characteristics of Buffett, he’s able to scrutinize even some of his greatest successes and learn from them. It’s something that all of us as investors should do, sometimes we spend too much time trying to learn from our failures that we forget to closely examine our successes.

The Wall Street Journal has a story on where “smart money” investors are going as stocks continue to fall. I was happy to see Jean-Marie Eveillard of the First Eagle Global Fund on the list. Here’s what he had to say:

Mr. Eveillard has been running money for nearly 50 years, and now at age 68, he plans to retire in March from managing First Eagle Global, which has logged an annualized 11.6% over the past 10 years. Drawing on his experience, he’s asking his analysts to consider that, in a damaged economy, operating profits might fall 30% to 40%. And if so, he’s asking, “Are the stocks we like still reasonably priced?”

That’s certainly the case in Japan, Mr. Eveillard finds. His fund now has about 30% of its equity positions in Japan, because Japan has gone through what the U.S. is now dealing with, and many Japanese companies are stronger for it. In the U.S. he has been buying American Express Co. (NYSE:AXP), “though we were too soon” as the stock has been dropping.

One thing I like about Eveillard is that he distinguishes himself from other value investors by sometimes taking positions that are influenced by macro-economic condition, for example - he’s a big proponent of gold. At this price, American Express certainly looks interesting and it’s on a shortlist of companies that I’ve been researching.

The rest of the value managers listed in the article read as a Who’s Who of Vale Investing for mutual funds. There’s Robert Rodriguez, Wally Weitz, David Winters, Bill Freiss, and Tom Marisco. To be honest, I wasn’t very familiar with the last two investors, but their long term annualized performance is strong and they are worth looking into.

A unifying theme that I saw was constant with these investors was the acquisition of companies that have tons of cash.

From Robert Rodriguez:

Yet amid this month’s violent moves, he began buying again for the first time in nearly a year. He wants market leaders with pristine balance sheets. Example: oil-field services firm Ensco (NYSE:ESV)International Inc., which has more cash than debt. Stocks he likes, Mr. Rodriguez says, “will make it through to the other side of this crisis.”

And Wally Weitz:

Instead, his Weitz Value is opting for Microsoft (NYSE:MSFT), whose once-lofty stock has tumbled. Now, it sports a thrifty price-earning s multiple of less than 12. “It’s safe and has a fortress balance sheet,” Mr. Weitz says.

As we look for companies holding large cash hordes, you’re going to want to look at the management behind the company and ask “Are they good allocators of capital?” If they’re not, that cash could be wasted, try using a discount rate when you see cash.

I’m also pretty astounded by how bad performance has been YTD with all of these funds. However, most of the managers on the list would probably identify themselves as value investors, which can produce some lumpy results. With stocks at a multi-year low though, their bargain hunting prowess should be well rewarded in the years to come — meaning it might be a good time for mutual fund investors.

This week’s column by Jason Zweig (Take a Deep Breath, Turn Off the TV, Calm Yourself) comes at a good time. The markets are experiencing a level of volatility that they haven’t been through in a long time. Such wild swings in stock prices have the ability to induce fear in investors, causing them to make gaffes like selling companies too early or racking up high commission fees by engaging in frequent trades.

According to Zweig, fear is contagious:

You can catch other people’s emotions as easily as you can catch a cold. In an experiment by neuroscientist Elizabeth Phelps at New York University, people either watched someone else get a mildly painful electric shock or suffered the shock themselves. Their brain responses and their dread before the shock were highly similar in both cases, suggesting that seeing another person’s fear is all it takes to make us afraid. Even encountering the circumstances under which the other person was shocked is enough to trigger your own fear.

When you cave to fear, you cease being a rational investor. You stop looking at the fundamentals and instead submit to your emotions. Often, it’s this sort of investing that ruins your portfolio.

To master fear, Zweig outlines four rules:

Break the circle. Instead of socializing with other investors nursing their losses, hang out with folks who do not obsess over the market. You are less likely to be spooked by dilated pupils, grim faces and quavering voices.

The idea of breaking your circle is one which I believe is practiced by a number of prominent value investors. They may talk about the market with their teams and associates, but they tend to reside away from Wall Street where they would be incessantly affected by the buzz of brokers and investors on Wall Street. Being away from the commotion of the markets can allow an investor to have the peace of mind needed to buck the trend or chaos that might ensue when the markets panic.

Value investors operate out of many places besides Wall Street: Warren Buffett in Omaha, Seth Klarman (of the Baupost Group) in Massachusetts, Mason Hawkins (of Longleaf Funds) in Memphis, Mohnish Pabrai in Irvine, and Bruce Berkowitz (of the Fairholme Fund) in Florida. All of these investors have had good long term track records while residing away from Wall Street.

Turn off the tube. The sight and sound of screaming traders with fear in their eyes are enough to fill you with fright, whether you are conscious of it or not. If hitting the mute button won’t suffice to calm you down, turn off the TV.

Here, I’d also recommend to be cautious of the internet as well. Many investors also like to visit message boards like on Yahoo for the specific companies they own. Many of these message boards can be cesspools of rumors and lies. During a time when the market is being excessively volatile, you risk letting your guard down and listening to these deceiving liars.

It’s important that you keep up to date with news on your companies, but you should do so by utilizing more official means of information. Instead of looking at the prices of diving charts that they show on CNBC, you should take the time to see if what’s going on in the market can actually affect the businesses you own. With Warren Buffett now buying stocks personally, it’s easy to see that he believes some businesses have been oversold. That does not mean that all are oversold, some sectors will probably be in for tough times. Anything with excessive leverage could be at the mercy of their spooked creditors.

Think positive. When Warren Buffett feels his blood pressure rising or his nerves on edge, he calms himself down by gazing at snapshots of his family or playing a game of bridge with his friends.

In The Snowball, Alice Schroeder described how Warren Buffett was excellent at compartmentalizing his emotions. This is probably a pretty hard thing for investors to do on their own, but maybe there are some other methods for staying positive. I think that having a system in place for investing or trading helps. By taking a systemic approach, you work to divorce emotions from your investing and really make it a dry activity. Benjamin Graham is said to have had simple forms for security analysts to fill out when investing a particular company - they filled the forms and then checked them against their particular system. If the company appeared cheap enough it was bought.

One idea I’ve heard that sounds interesting is to spend time studying famous leaders through history. We know that Buffett reads a tremendous amount and when he was younger he spent a lot of time reading biographies about famous business leaders (think Carnegie, Rockefeller). Investors could also read about leaders who faced periods of crisis (Churchill for example), the lessons they glean from such experiences could be used to create a powerful latticework of mental models for protecting them against Mr. Market’s swings.

The other factor is to just know yourself and how you react to stressful situations. For Warren Buffett he may like bridge, but perhaps what works for you is a jog or listening to some music. If you understand yourself and your emotions, you should be able to keep positive as the market dives.

Finally Zweig says:

Stick to it. Set yourself the simple, stark goal of investing more money in something you don’t want to own. You may need help fighting your fears, so visit www.stickk.com and make a public commitment to your future action. Buying a stock fund next week is mentally easier than buying it today — especially if you recruit some friends to cheer you on.

Chances are, we’ll be in for more market volatility than what we saw last week. If that’s the case, it’s going to be important for you to learn how to keep your emotions in check and keep your investing method in tact. If you do this, I believe that you’ll be able to take advantage of the market and find some good buys. They probably wont talk about this on CNBC or in the rest of the mainstream media, but when you’re looking at risk. Instead of gauging it by the market’s prices, try the following:

In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful.The primary factors bearing upon this evaluation
are:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

These factors will probably strike many analysts as unbearably fuzzy, since they cannot be extracted from a data base of any kind. But the difficulty of precisely quantifying these matters does not negate their importance nor is it insuperable. Just as Justice Stewart found it impossible to formulate a test for obscenity but nevertheless asserted, “I know it when I see it,” so also can investors - in an inexact but useful way - “see” the risks inherent in certain investments without reference to complex equations or price histories.

Warren Buffett - Letter to Shareholders (1993)

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?

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.