Street Capitalist: Event Driven Value Investments

Today’s New York Times features an awesome article: “Challenging the Crowd in Whispers, Not Shouts” by Robert J. Shiller.

Shiller discusses why the housing bubble was ignored by colleagues. At heart here is the issue of when to be a contrarian. This is a subject I’ve posted about a lot since the start of the blog. As value investors we almost always have to act as contrarians by nature.

The thing I liked about the article is that it discusses a reason for not being a contrarian that I hadn’t have thought of:

The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group…

In addition, it seems that concerns about professional stature may blind us to the possibility that we are witnessing a market bubble. We all want to associate ourselves with dignified people and dignified ideas. Speculative bubbles, and those who study them, have been deemed undignified.

I’ve never thought of contrarianism in these terms — where being a contrarian can affect how your colleagues perceive you and whether or not your professional opportunities are limited by bucking the trend.

When I think of contrarianism, it’s really from a more individualistic perspective. Many investment fund managers are able to achieve a good sense of individuality, managers in the value sector are actually afforded the luxury of being contrarian - it’s part of the job. In other professions, that isn’t the case.

Shiller describes economists working for the federal reserve, but I can think of other places affected by the same problem. A number of people working in the mortgage industry raised questions about the sub-prime loans being made, but were basically told to get back in line. Similarly, recent testimony from the ratings agencies revealed documents detailing questions that were raised regarding certain CDOs.

With economic research councils, like Shiller cites - perhaps something can be done to promote more diverse areas and contrary opinions. I know that some organizations utilize a technique where when someone proposes a plan another employee is given the task of playing devil’s advocate and arguing why the plan should be rejected.

In the other examples, the mortgage lending industry and ratings agencies the problem was a bit different. It was an agency issue. These folks were generally paid based on quantity of work, not quality. That kind of thinking creates a culture of greed and we know how that ends. Tackling that problem is more difficult. You need to adjust the psychological mindset of the people working there. The easiest way would be to alter how compensation works at those firms - so that they have an economic interest in their work, rather than being able to pass the risk off to the next person down the line.

How do you fix something like this, or prevent this kind of thinking?

You need a diverse group of mental models.

Why do professional economists always seem to find that concerns with bubbles are overblown or unsubstantiated? I have wondered about this for years, and still do not quite have an answer. It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing.

Shiller highlights one of the greatest issues with economics, the lack of interdisciplinary thinking. He’s not the first person to bring this up. Warren Buffett’s famous business partner, Charlie Munger has been a huge proponent of interdisciplinary thinking .

From his speech - Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs (PDF)

I think there’s a modern name for this approach that Whitehead didn’t like, and that name is bonkers. This is a perfectly crazy way to behave. Yet economics, like much else in academia, is too insular. The nature of this failure is that it creates what I always call, “man with a hammer syndrome.” And that’s taken from the folk saying: To the man with only a hammer, every problem looks pretty much like a nail. And that works marvelously to gum up all professions, and all departments of academia, and indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man with a hammer syndrome is to have a full kit of tools. You don’t have just a hammer. You’ve got all the tools. And you’ve got to have one more trick. You’ve got to use those tools checklist-style, because you’ll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. But if you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of answers that you won’t
find any other way.

Maybe Shiller will find Munger’s speech. I think he’s enjoy it.

Having these mental models can improve your judgment by getting you to look at problems from non-traditional perspectives. It will get you to question the crowd and might give you the oomph you need to yell instead of whisper amongst your colleagues.

I came across a great interview with Nate Silver of Five Thirty Eight. What I liked most was that Silver highlights how the media is changing for electoral campaigns:

The rise of blogs at the expense of talk-radio could have some interesting financial implications. Media companies are transporters of content. They get paid by putting up advertisements. Think of ads in newspapers and the internet or commercials on the radio and television.

Silver’s proposal is that we’re seeing a coming of age for the internet as a content transporter and that blogs are becoming the new source of viral media. If you think about it, it makes sense. It’s easy now to transport viral media, you can quickly send out youtube videos that link people to videos of events and have millions of views in a few hours. I think that this is a big difference from the last time we saw a lot of internet hype - back in 2000.

Now, internet speeds for the average user are faster. According to the Pew Internet & American Life Project, broadband internet usage is about 57% for American adults. As a result, video content is much more easily accessible than it was in 2000. Video will always be more accessible and in turn more viral than a simple article and sites like YouTube make the transmission of such content extremely easy.

But how does this affect you as an investor? A few ways.

One of the companies I’ve spend a bit of time looking at is CBS (NYSE:CBS) — well really, the media sector all together. We know that traditional forms of media are on the decline, namely radio, TV, and newspapers.

CBS is really a play on radio and TV stations. A decline in usage will hurt their ad revenues, especially in an already distressed economic environment.

For a company like News Corp. (NYSE:NWS), the situation is different. There, investments have been made to keep the company quite competitive as we shift to a more internet heavy world.

Myspace alone averaged 67.7 billion page views for June of 2007. Conversely, collective properties owned by CBS only averaged about 7.3 billion page views in the entire year of 2007, or 10% of the monthly page views for MySpace. As one medium gains momentum, it usually eats away at the other. In this case, the internet versus TV and radio. This hurts CBS more than it does News Corp.

I saw that News Corp was trading at 4.75 EV/EBIT, with cash on hand (great for this environment) but using multiples doesn’t work as well when everything else in the sector is depressed. As a result, valuing media companies becomes tricky, but more exciting too. You have to normalize earnings from from different revenue streams - where some are trending down while others are trending up. It’s the main reason I’ve held off on investing in either of these companies so far, I’m having trouble figuring out how to peg their earnings for the next few years– but maybe one of you out there can give some input.

Meryl Witmer is a value investor who regularly participates in Barron’s roundtables. Today, I came across a video interview with her and thought it would be worth sharing:

If you’re too lazy to watch the video, brief notes are below:

-a whole lot of things that are cheap now, it’s a “new world” for value investors.

-Remember a line from Warren Buffett: You should detach from the market emotionally, but pay attention to opportunities as they arise. That’s what you should try to do now.

-Proposes the following investment idea: Kaiser Alumnium Corporation (NASDAQ:KALU)

-Originally purchased Kaiser at $35/$36 a share. Sold in the $70s. Now the company is back to $25. They make the aluminum sheet metal that goes into industrial products, airplanes.

-Kaiser’s book value, hard book is $50 per share. $10 per share is NOL carry forward (loss). Stock is $25 with $50 book. Replacement cost for their rolling mill would cost $1.5 billion dollars to replace + $200 million value of NOL. Might be worth $1.7 billion.

-No debt, no legacy costs due to bankrutpcy. Market cap is about $500 million.

-Should earn 3.50 to 4.00 a share in an OK environment. If Boeing gets going and planes sell, it should make $5 per share. Worst Case $2.50 per share of fully taxed earnings + $10-12 per share of NOL value..

-Minimum trading price at $35 vs $25 with upside to the $70s

-Why has it traded down? Forced liquidiations by hedge funds. No good fundamental reason.

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.