Street Capitalist: Event Driven Value Investments

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.

Sir John Templeton died yesterday at the age of 95. Templeton’s ideas were a huge contribution to the world of investing, he prescribed a value-bent philosophy, but was better known as one of the first investors who advocated that we invest in foreign countries.

Today everyone seems obsessed with foreign markets, from India and China to hidden gems in the frontiers of Africa and Asia. It wasn’t always like this and we have Templeton to thank for it.

One of my most popular posts here at Street Capitalist was Learning from Eddie Lampert. I’ve always wanted to turn it into a series, and yesterday’s passing of Sir John Templeton seems like a good occasion to re-read and analyze some of his thoughts.

Templeton is famous for his maxims on investing. These basic rules or ideas that govern how you should invest in financial markets. When you read them, you’ll realize that many are timeless and should be taken to heart. They are listed below:

1. Invest for Real Returns

The idea of investing for real returns must strike people as dumb and obvious. Why else would someone invest? In reality though - many take actions when investing that actually produces negative returns.

Often, someone thinks that they are investing when they are really speculating. I characterize this as shoot for the moon investments, where you are hoping to either win big or lose your invested money. In these cases, you’re speculating or simply gambling. Then, other investors feel the need to be constantly buying and selling companies. Usually this sort of indecision leads to high commissions fees and gives your broker real returns while subjecting you to negative returns.

Investing for real returns on the other hand is an action where you not only try to preserve capital but also have that capital appreciate.

2. Keep an Open Mind

As value investors I feel that sometimes we forget to keep open minds. While we mostly spend our time investing in equities, mispricings can happen everywhere. A good example of this is with bankruptcy situations. When a company enters the bankruptcy proceedings, their equity is usually worthless and often it gets wiped out when the company emerges. However, sometimes bonds are grossly mispriced and make an optimal investing opportunity.

The same really goes for any asset class. All asset classes can become mispriced. Value investors do not simply have to look at equities, bonds or even real estate prevent opportunities as well. Seth Klarman’s Baupost Group has done over 200 real estate deals and Samuel Zell earned the nickname the “grave dancer” because of his investments in distressed properties.

I think that keeping an open mind means trying to look at all opportunities that you come across. An initial glance lets you sort them into the yes, no, and too hard buckets. This also motivates an investor to continuously learn as much as they can. You can try to learn about different industries and asset classes on a daily basis so that you can tackle a wider ranger of opportunities than most people.

3. Never Follow the Crowd

If most investors underperform the market, then generally, following the crowd should lead to under performance. I regard crowd following as detrimental because usually it showcases shoddy research on your part.

Templeton himself felt that he invested better when he moved away from New York to Nassau. It’s probably true, by being so far away he would be insulated from the manias of Wall Street and free to come up with his own more original ideas.

4. Everything Changes

Sometimes when we take positions, we become overconfident and fail to look at shifts in the environment and sectors we invest in.

Investors took positions in sub-prime mortgage companies because they felt that they were getting favorable price to book ratios. Yet they failed to take into account problems like a lock up in liquidity or the permanent impairment of sub-prime loans all together. These companies are now either bankrupt or sitting in the -90% range, neither of which is good for performance.

The key seems to be that if you have a thesis for a company, you must not only conduct thorough, but also retest it often. By doing this you can become more aware of shifts and act accordingly.

5. Avoid the Popular

The greatest inefficiencies and opportunities in the market usually come from situations that are ignored by the general population. This can be small and undiscovered areas of the market or areas in the aftermath of a panic. Think mutual thrift conversions or American Express with the salad oil crisis.

6. Learn from your Mistakes

By not learning from your mistakes, you leave yourself open to repeating them again.

“This time it is different” - No, probably not. Bubbles burst. They’ve been doing that since the 1650’s with tulips. Don’t delude yourself into thinking otherwise.

7. Buy During Times of Pessimism

The most hated and unloved areas of the market usually hold some of the best bargains. A good place to start is the 52 weeks low list.

Templeton says that we should buy on maximum pessimism and sell on maximum optimism. At the age of 26 he bought 100 shares in 104 companies that were selling at less than $1 when World War II began. In a few years, Templeton made profits on all but four of these companies which is a testament to buying on maximum pessimism.

8. Hunt for Value and Bargains

Investing in undervalued assets is difficult. Buying something that everyone is selling is incredibly difficult. Psychologically, you’re forced to question the mentality of the crowd. That’s why most investors don’t look for bargains.

However, if you accept Templeton’s idea that the crowd is usually wrong (as in 3, 5, and 7) then bargains is precisely where you need to be. How do you find bargains? Look in the red. Again, look at the 52 week low list. Also try seeing what companies are rated “sell” by analysts. Look at other asset classes that appear to be having a major sell off and apply a bottom-up analysis of them.

9. Search Worldwide

Bargain hunting is a universal concept. Go wherever you can find good accounting standards and good management. You’ll find more opportunities which can be particularly important if your own domestic market becomes overheated. By investing in multiple markets you can diversify or hedge against problems in your own nation.

Frontier markets can be an excellent place to look. They are normally less correlated with global markets and not followed by average investors. I have a feeling that we’ll see more investors stalk companies in Africa and Asia as they look for opportunities, especially if the credit crunch continues.

10. No-one Knows Everything

If we’re close-minded, we don’t learn. It inhibits learning and the finding of new investing opportunities. That’s why I think communication is important. One of the best things about blogs and investing communities is that you can bounce your ideas off of each other and hear contrary views. All of this will refine your own analysis and either make it stronger or show you the holes or failings of your investment idea.

I also use blogs/communities to find out how to invest in other assets. While I have only invested in equities so far, I’ve reached out to certain bloggers to learn more about sectors that I didn’t understand, or assets like currencies which I knew nothing about. You should try practicing this too. Continuous learning is a healthy and rewarding objective to have for yourself.

Now take a moment to follow this link to Templeton’s obituary in the New York Times. I spent most of this post discussing investing, but the article goes into some of the more important aspects about Templeton. His life, his philanthropy, and his family.

Mr. Templeton said his investment record improved after he distanced himself from Wall Street and no longer worried about the tax consequences of his decisions. He was an early investor in Japan in the 1960s and later in Russia, as well as in China and other Asian markets. He sold large holdings before the technology bubble burst in 2000, and warned several years ago that real estate prices were dangerously high.

In Nassau, his net worth swelled into the billions, but his lifestyle remained relatively modest. He drove his own car and spent his days reading, writing and managing his foundation. Visitors were given sandwiches, tea and courtly advice in the afternoon at his white-columned antebellum-style home on Lyford Cay, set on a hillside lush with citrus trees and bougainvillea, overlooking a golf course and the ocean.

John Templeton, Investor, Dies at 95 (NY Times)

Guy Spier of Aquamarine Capital Management is someone I’ve been wanting to read more about and learn from. He doesn’t appear in the news as much as other value investors, so I was really surprised to see an article written by him in Time magazine today:

Buffett has always made a point of doing business with integrity — and of working only with people who share his values. As we learned at lunch, he credits his father with teaching him early on to rely on his own sense of what’s right, rather than looking for affirmation from others. “It’s very important to live your life by an internal yardstick,” he told us, noting that one way to gauge whether or not you do so is to ask the following question: “Would you rather be considered the best lover in the world and know privately that you’re the worst — or would you prefer to know privately that you’re the best lover in the world, but be considered the worst?”
When it comes to investing, nothing is more important than the ability to think clear-headedly for oneself — and Buffett is unsurpassed on this front. In the late-90s, he was widely criticized for his refusal to invest in booming tech and Internet stocks, a decision that was richly vindicated when the bubble burst. Buffett has made a fine art of keeping this kind of distracting noise at bay: for example, he said he even limits his contact with the managers of businesses in which he invests, preferring to assess them by studying their companies’ financial records —a more neutral source of information.

My $650,100 Lunch with Warren Buffett (Time)

The whole article is worth reading and I think it shows us one of the reasons Buffett is such an interesting character to study and learn from. The fact that he takes such a hands off approach to is businesses is pretty remarkable. He really has an uncanny ability for picking CEOs to operate businesses who are truly passionate about their work which is a quality that you can’t pluck out of an MBA.

To contrast this, look at Edward Lampert of Sears. He gets a lot of comparisons to Buffett, but when it comes to attracting talent they’re worlds apart. Lampert has been unable to find the right managers to run the businesses and brands within Sears and I think it’s one of the key factors that is holding down the company’s turn around. Maybe in that situation the “people” input is simply not being given the weight it deserves.

Guy Spier’s account seems to show us that the real wisdom that can be gleaned by Warren Buffett is how to measure and judge character and people, something that is a product of decades worth of relationships and experiences. That seems to make a $650,100 lunch or even $2.11 million lunch worth the expense if you get just some of the insights of a lifetime in just a lunch at Smith and Wollensky’s!

A few hours ago, Zhao Danyang won the Glide Foundation’s auction for lunch with Warren Buffett. The lunch auction is always an interesting thing to watch because of the eclectic groups of people who bid. The 2007 lunch, which actually took place a couple days ago, was won by value investors Mohnish Pabrai (Pabrai Funds) and Guy Spier (Aquamarine Capital Management). Here is what Mohnish Pabrai had to say about his lunch:

Becky Quick:

$650,100 is what you two paid to have a 2-1/2 hour lunch with Mr. Buffett. Was it worth it?

Mohnish Pabrai: Every penny. I think we would have been willing to pay a lot more than that. Well worth it. We were here with our families and it was just fantastic.

Lunch With Warren Buffett “Worth Every Penny” at $650,100 (CNBC)

It looks like Pabrai was not the only person who seemed to think a lunch with Buffett would be worth in excess of the $650,000, since Zhao Danyang bid a record $2.11 million. So far the news on him is a little sparse, but from what I’ve been able to dig up, he sounds like a very value oriented investor from China.

According to Terrapin he began his investing career in 1996 and took the lead in promoting the philosophy of “selecting security investment from the view of an industrial investor.” To shed some more light on this philosophy I took a look at the website of his fund, the Pureheart China Growth Investment Fund:

We do not follow stock index and price-volume analysis. We rarely use individual stock charts as the basis for investment decisions. We only partly agree to fundamental analysis. By taking a long-term view, we believe that the share price of a (well managed) enterprise will undoubtedly reflect its intrinsic value over time. Our selection criteria are quite simple. We seek enterprises that can survive. These enterprises have been established usually for a decade or more and have relatively high success track records. We strongly believe that if we own part or most shares of these enterprises, our investment will grow and breed success together with the companies.

The themes described here are very inline with some of the ideas preached by Warren Buffett and Charlie Munger. Rather than simply looking for cheap companies, the fund seems very oriented towards investing in industry leaders and businesses with wide moats to give them long term competitive advantages.

The fund also aggressively utilizes a margin of safety:

Based on quantitative benchmarks, we input data into our evaluation model to calculate its intrinsic value. The market price is then compared with the intrinsic value of the companies. If the market price is traded below to the fair intrinsic values—that is half of the value or even lower—only with sufficient safety margins would we consider taking a position. We continue to monitor all businesses conditions faced by the business and adjust the parameters every quarter according to the real market environment.

We do not invest rashly. We value patience and aim for an ideal price. We would rather lose the opportunity rather than take on un-necessary risks. In the capital market, we believe that survival should always be the first consideration. Controlling risk is the key to smart investing.

This means that Zhao holds the preservation of capital at the utmost importance and I think it’s nicely reflected in this Asia Times article that discusses the liquidation of his funds.

“We would rather miss an opportunity than blindly take a reckless move under whatever [market] circumstances,” Zhao wrote in a letter to his clients before the liquidation. “To survive in each investment decision is always our priority.”

“So far, the A-share and H-share markets are beyond our understanding.” Zhao wrote in his letter, with H-shares referring to Hong Kong-listed mainland-related stocks. “The bottom and peak of the indexes are always a riddle. Now, we can’t find any proper investment targets which meet our investment criteria and have enough margin of safety as well.”

It takes a lot of courage to liquidate funds during a bull market period (the funds were liquidated on January 2, 2008). Not only do you struggle with having to dissent and break from the herd, but you also have to cope with operating in an environment with few investment opportunities while being responsible for the capital of others. The fact that Zhao did not compromise with his investing philosophy tells us a lot about his character as a fund manager and makes him someone we should keep on our radar screens.