Street Capitalist: Event Driven Value Investments

So the Treasury unrolled their plan earlier this morning. The gist:

First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

Statement by Secretary Henry M. Paulson, Jr. on Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers (US Treasury)

So far, Paulson has stated that he doesn’t know what the Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) bailout will cost US taxpayers. Part of that has to do with the fact that it’s almost wholly dependent upon the how long it takes for the housing market to stabilize. Keeping in mind this:

The GSE’s common stock and existing preferred shareholders will bear any losses ahead of the government. In exchange for entering into these agreements with the GSEs, Treasury will immediately receive the following compensation:

** $1 billion of senior preferred stock in each GSE

** Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price

It’s pretty safe to say holders of the common are in a terrible position right now. So what went wrong? Roger Lowenstein penned a really great essay this weekend about the connection between Long Term Capital Management and what’s been happening as a result of the credit crunch. He says:

More recently, housing lenders — and the rating agencies who put triple-A seals on mortgage securities — similarly misjudged the correlations. The housing market of California was said to be distinct from Florida’s; Arizona’s was not like Michigan’s. And though one subprime holder might default, the odds that three or six would default were exponentially less. Randomness ensured (or so it was believed) a diverse performance; diversity guaranteed safety…

If 100-year floods visit markets every decade or so, it is because our knowledge of the cards in history’s deck keeps expanding. When perceptions change, liquidity evaporates quickly. Indeed, the belief that one can safely get out of a “liquid” market is one of the great fallacies of investing.
This lesson went unlearned. Banks like Citigroup and Merrill Lynch felt comfortable owning mortgage securities not because they knew anything about the underlying properties, but because the market for mortgages was supposedly “liquid.” Each firm would write down the value of its mortgage investments by more than $40 billion.

Long-Term Capital: It’s a Short-Term Memory (NYTimes)

The article is a great read. At the end, Lowenstein says that “Investors, meanwhile, could help themselves by preparing for the next 100-year flood.” This made me think of Warren Buffett’s requirements when looking for a new CIO:

Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

The last line is quite prophetic. How do you avoid risks that have never been encountered? I found some good guidelines in Guy Spier of Aquamarine Capital Management’s 10 investing principles. Principle #10 is called “Prepare for Black Swans”. He states:

My goal is to invest in such a way as to minimize the impact of negative black swans, or highly unpredictable events, and to maximize the exposure to positive black swans. If black swans are, by definition impossible to forsee or predict, how is it possible in practice to guard against the bad ones and simultaneously increase the likelihood of benefiting from the good ones?

Spier breaks this down into 6 factors:

In my case, avoiding negative black swans comes down to investing in businesses that are likely to survive any social, economic, political, or natural disaster. That means investing in companies that:

1. Are run by honest management
2. Have a strong balance sheet and/or significant financial flexibility
3. Enjoy enduring assets that are exceptionally hard to impair and nearly impossible to replicate
4. Are geographically diverse
5. Have a moat that is growing wider over time
6. Make a positive contribution to our civilization

I wrote previously about using a checklist when determining what to invest in and Spier outlines a great checklist. He explains later that he specifically looks for companies that are cash-generating machines because it enables them to weather economic storms and poor market cycles. Screening for factors like high amounts of free cash flow and low debt would be a good place for investors to start.

Going through Spier’s checklist, you’ll see that most of the firms that have blown up recently fail to meet criteria #2. Investors should scrutinize this area heavily, they not only need to look at the amount of assets, but the type of assets. Part of the problem here is that the values assigned to some of these assets widely diverged from their true value. Sticking to your circles of competence is essential, so that you don’t decide to blindly throw your faith behind assets that you really don’t understand.

Right now is the time for investors to exercise patience when searching and studying potential companies. Many have been caught up in the action of it all and chose to quickly buy stakes in companies that fell substantially in a short time span. This may have forced them to relax some of their analytical standards and miss critical details. Take your time and remember this quote from the master himself:

I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.
- Warren Buffett

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.

One of the issues with Street Capitalist is that I don’t think take the time to really introduce new readers to value investing. This can be problematic with someone who is just learning about all of this and feels daunted by the task of somehow soaking it all up. I plan on doing some how-to’s in the future to help with this. For now though, I want to show you some investment cartoons I found from at Mirae Asset Financial Group.

Mirae is run by an investor named Park Hyeon Joo of Korea. I’m always fascinated at finding and learning about value investors who operate in different parts of the world - especially in Asia. Asia in particular is an interesting place for value or even long term investors. Mainly because the region as a whole has a reputation for overwhelmingly favoring short-term investing.

Here’s an excerpt from a Bloomberg article on Park:

The new firm caused a small stir in the business press because its offices didn’t include the wall-sized electronic stock ticker that graces most Korean brokerage offices. In his book, Park says his message to customers was: “Don’t sit around staring at the wall. Let professionals do your investing.” He reeled in clients by lowering the standard fee for stock purchases to 0.029 percent from 1 percent.

In a similar symbolic gesture, Park placed a clock with no hands at the entrance to Mirae Group’s Seoul headquarters — to signify to clients the importance of long-term investment.

Korea’s No. 1 Money Manager Says Genghis Khan Model for Funds (Bloomberg)

The Power of Inactivity

I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.
- Warren Buffett

Circle of Competence

We don’t handle high-tech business because we have no talent in that area.
- Charlie Munger
There are all kinds of businesses that Charlie and I don’t understand, but that doesn’t cause us to stay up at night. It just means we go on to the next one, and that’s what the individual investor should do.
- Warren Buffett

Contrarianism

Invest at the point of maximum pessimism.
-John Templeton

We invest in stocks because stocks are plunging. Since we can buy stocks at a low rate in a bull market, I am nervous in a bull market. When stock market plunges, I’m happy. Crisis is a good opportunity. I know that more opportunities happen when business is dull and disaster & revolution break out.
-Mark Mobius

The quotes may not be anything new, but it’s nice to see the visual representations of these concepts, even in cartoons. They give you a simple way of conveying some often complex and hard to understand concepts and they’re pretty fun.

News stories are already circulating about the poor performance of certain hedge funds (quite a few within the “value” group). While my portfolio is largely concentrated in Fairfax Financial (FFH), its performance has still fallen from its highs and one of my newer positions – Air Transport Services Group (ATSG) is almost 50% lower than my initial position. It is times like these that an investor’s fortitude is really tested and Jason Zweig’s latest Intelligent Investor column How to Control Your Fears In a Fearsome Market (WSJ) provides a solution for us.

Zweig points out that seeing your investments fall actually triggers a neurological response by your brain:

Merely reading the words “market crash” in this sentence can instantaneously jack up your pulse and your blood pressure, the output of your sweat glands and the tension in your muscles. Stress hormones will flood your bloodstream. Your eyes will widen and your nostrils flare, making you hypersensitive to any further danger. All this occurs automatically, involuntarily and unconsciously. You can’t be an intelligent investor if, without even knowing it, you are thinking with the panic button in your brain.

The good news is that these feelings can be controlled. Zweig outlines four steps for controlling your fears. He says first, we need to:

Reappraise. Forget what you paid for that stock or fund; instead, imagine it was a gift. Now that it is priced, say, 20% more cheaply than in December, should you want to return the gift?

I try to use the reappraisal method often. You need to really write out your thesis for investing in a company so that you can test it against any changes in the environment. It’s also pretty helpful to talk to other people about the same idea and get some contrasting opinions – this can test your thesis further.

This line of thinking is similar to what Zweig advocates next:

Step outside yourself. Imagine that someone else has suffered these losses. Think of questions you might ask to give that person advice: Other than the price, what else has changed? Is your original rationale for this investment still valid?

Then there is taking yourself away from the market:

Control your cues. Even witnessing someone else’s pain, or glancing into another person’s frightened eyes, can fire up your amygdala. Because fear is as contagious as the flu, quarantine yourself from anyone who obsesses over the momentary twitching of the Dow. Tear yourself away from the computer or television; better yet, while the market is closed, make an advance date with friends or family to get your mind off stocks during market hours.

Many of the best investors spend most of their day reading and researching. There s a definite lack of action, it is the antithesis of day trading. Some of the best investors don’t even reside in financial capitals like New York City or London. They’re often found in places that they are comfortable in. Warren Buffett has Omaha and Sir John Templeton had the Bahamas. By removing yourself from the crowd you give yourself room to think and breathe.

Finally, Zweig ends with a nod to Benjamin Graham:

Track your feelings. Fill in the blanks in this sentence: “Today the Dow closed down [or up] ___ points, and that made me feel __________.” Your emotions shouldn’t be hostage to the actions of the roughly 100 million other people who compose the collective beast that Benjamin Graham called “Mr. Market.”

The daily movements of the market are just noise; they burden us and cloud our judgment. I find that it is helpful to not really look at the movement of the market every day. One of the things I’ve noticed is that over and over, when investors like Buffett are on CNBC or Bloomberg they’re asked poor questions like “futures have moved X this morning, what are you thinking?”Often the answer is that they don’t care because it has no impact on their own investing.

Zweig’s checklist is excellent and what I like is that it is a systematic approach for re-evaluating your investments and keeping your cool under pressure. By taking this kind of approach, you distance yourself from emotions. Some of this is applicable to trading in general. A friend who recently began day trading told me that his main problem is that he’s nervous when pulling the trigger on buys and sells. I told him that his main issue is that he hasn’t really come up with a system for how he trades. Until he does, he will be at the mercy of his instincts and emotions which will prevent him from acting properly under pressure.

Zweig says that this kind of checklist will help us counteract the signals that our brain sends, so if you aren’t using one already maybe it is worth adopting. If you doubt the effectiveness of a simple checklist look at a graver scenario – being a patient in the intensive care unit at the hospital. Peter Pronovost a critical-care specialist at Johns Hopkins Hospital started employing a checklist at ICUs in 2001 with great success:

Pronovost and his colleagues monitored what happened for a year afterward. The results were so dramatic that they weren’t sure whether to believe them: the ten-day line-infection rate went from eleven per cent to zero. So they followed patients for fifteen more months. Only two line infections occurred during the entire period. They calculated that, in this one hospital, the checklist had prevented forty-three infections and eight deaths, and saved two million dollars in costs…

Within the first three months of the project, the infection rate in Michigan’s I.C.U.s decreased by sixty-six per cent. The typical I.C.U.—including the ones at Sinai-Grace Hospital—cut its quarterly infection rate to zero. Michigan’s infection rates fell so low that its average I.C.U. outperformed ninety per cent of I.C.U.s nationwide. In the Keystone Initiative’s first eighteen months, the hospitals saved an estimated hundred and seventy-five million dollars in costs and more than fifteen hundred lives. The successes have been sustained for almost four years—all because of a stupid little checklist.

The Checklist (The New Yorker)

The I.C.U. and the market have similarities. Both can be complex and terrifying, leading doctors and investors to make mistakes. Pronovost noticed that in many cases at the I.C.U. doctors would forget to take even simple precautions. In a similar sense, an investor may forget the concept of intrinsic value when watching one of their companies dive 50% in one day of trading. If you believe that in order to make out-sized market beating returns you have to take a contrarian approach, then you will have to master your fears and emotions. A checklist provides an easy way to do both.

Most readers will recognize Jason Zweig as the guy who revised The Intelligent Investor by Benjamin Graham. In the 2003 annual letter (PDF) to Berkshire Hathaway shareholders, Warren Buffett Remarked that The Intelligent Investor is his “favorite book on investing” and that Zweig did a “first-class job in revising” it.

This was actually one of the first investing books that I read. What I liked most was Zweig’s own remarks after every chapter. Zweig was able to take a book written a long time ago and make it easy to digest and show how Benjamin Graham’s concepts parallel what is going on in modern financial markets. The commentary he added was helpful because even if some of the material was hard to understand, I was able to come back to it after reading the commentary.

So today I was pleased to see that Zweig would be penning a new column at the WSJ. Zweig says:

In the last long bear market, 1969 to 1982, stocks returned just 5.6% annually; after inflation, investors lost more than 2% a year. That mauling by the bear made stocks so inexpensive that over the ensuing 18 years they went up 18.5% a year, enough to turn $10,000 into more than $200,000.

The people who so far this year have yanked $39 billion out of U.S. stock funds, and $6 billion out of exchange-traded stock funds, do not understand this. But if you are still in your saving and investing years, a bear market is a gift from the financial gods — and the longer it lasts, the better off you will be. Instead of running from the bear, you should embrace him.

This new column takes its name from the classic book by Benjamin Graham, who wrote that “the investor’s chief problem — and even his worst enemy — is likely to be himself.” I hope to help you understand the chaotic markets around you, and the even more treacherous enemy within. For, as Mr. Buffett has also pointed out, investing is much like dieting: It is simple, but not easy. Everyone knows what it takes to lose weight. (Eat less, exercise more.) Nothing could be simpler, but few things are harder in a world full of chocolate cake and Cheetos.

Stop Worrying, and Learn to Love the Bear (WSJ)

With many investors hurting right now, a Graham themed column might be just what they need. It would prevent them from pulling out of the markets all together and instead expose them to concepts like Mr. Market and the need for a margin of safety when you invest in companies. Those two ideas will be essential for surviving and thriving in the negative market we seem to be in.

It looks like the WSJ has not set up an RSS feed yet for Zweig’s column, but since I’m really looking forward to them I’ll be linking and posting excerpts whenever I see them.