Value Investing Congress Blog

Scott Bommer at the 3rd Annual New York Value Investing Congress reported by Marcelo Lima.

Scott Bommer of SAB Capital spoke about finding the asymmetric risk/reward scenario. He’s looking for situations where the money you win outweighs the money you can lose by 3:1, 4:1, or more.

Scott presented three detailed long ideas. The first one was Endeavor Acquisition (EDA, with the ticker recently changed to APP), which is a SPAC that recently announced the purchase of American Apparel. Scott thinks they paid an attractive multiple and that AA has an outstanding opportunity to open new international stores, which are outperforming their US counterparts. The deal closes on Dec 15 so there’s a real opportunity to make money now. (Note: Since Scott spoke, the deal actually closed ahead of schedule.)

One thing that Scott didn’t mention is the colorful background of both the CEO of American Apparel, and the President of Endeavor. A friend wrote to provide some interesting tidbits on the latter:

“Dov Charney, the CEO of American Apparel, is an interesting character, what with the sexual harassment lawsuits and all, and certainly has a unique management style, but I don’t really know him at all. John Ledecky though, is a guy I know well.

In 1998 I was reading an S-1 that caught my attention. A guy that did one leveraged buyout (office products company), using his credit card for the equity piece, was now raising $500mm in a blind pool for a roll up (blank check, they called it then). I found the S-1 fascinating because the guy did one deal, and was now raising a substantial amount without so much as disclosing the industry to the prospective investors (IPO ticker was cryptically “BUYR”). I was a fresh analyst then and I went to the road show not because I wanted to buy the stock – I couldn’t believe anyone would be so gullible – but because I wanted to see how people try to pull off that kind of magic.

The guy was John Ledecky, and he was a master salesman: sleek, polished, charismatic, and knew how to generate buzz. It was ten years ago, but I still remember somebody asked him how he was finding prospective acquisitions if he spends all his time on the road raising money. He said no problem, my brother is analyzing buyouts, and he is the brain in the family. Everyone was charmed.

I left the lunch incredulous, but started to follow his career – I am a fan of anyone who can pull off such tricks. He was able to raise the money, and shortly thereafter they announced an acquisition of a building maintenance company, changed the symbol to BOSS, and soon the stock got cut by half. They brought in new management, Ledecky announced BOSS is now under “adult supervision” (but sold $25mm worth of his stock), and the next year they accepted a takeunder from a private equity firm. By that time his original company, US Office Products, has also gone under.

Ledecky was unphased though, and he proceeded to do more deals. The modus operandi was always the same: he goes on the road to sell a roll up deal on a blind pool basis, puts up zero capital of his own and gets a big cut of the equity (hedge fund style compensation), quickly takes most of his stake off the table (great return on (no) investment), the excrement hits the fan and the company runs to the ground through a combo of sloppy management and heavy debt load, and nothing is left but the immolated skins of the shareholders.

In that exact manner he did US Floral in late ‘98 (Ch. 11 in ‘01, too bad because they had a great ticker, ROSE), UniCapital around the end of ‘99 (roll up of leasing businesses, chapter 11 by late 2000), E2net.com (also in 1999, you can imagine how that one ended), ISP roll up whose name I forgot (stock collapsed to pennies per share), and this stuff is just what I remember off the top of my head.

In a short while Ledecky amassed such string of BK’s that he was considered toxic on Wall Street. He couldn’t raise any more money, but by then he was worth at least several units (Texan for $100mm), so he bought a stake in a basketball team (partner with Michel Jordan) and enjoyed life for a while. He knew that people have short memories and indeed, he is now back (other than Endeavor, he is also in two other SPAC’s: Victory Acquisition and I think Triple Crown). Hope springs eternal in the hearts of men (albeit not in their brains).

I should emphasize that I don’t know anything about EDA. I did not even attempt to analyze or understand it. I am confident it will work great for Ledecky (like I said, I am a big fan). It is certainly possible this will also work well for shareholders. My point is, Ledecky is one of the greatest promoters I have ever seen. He can make P.T. Barnum blush. More importantly, he has a public track record. Almost all his roll ups ended up as blow ups. To invest alongside this guy you would need to be a religious man and believe in redemption.”

For one interesting article on Ledecky, here’s a link from Forbes:
http://www.forbes.com/forbes/1998/1005/6207141a.html

Scott’s next idea was Willbros Corp (WG), a leading international pipeline construction company whose project economics work at much lower energy prices. Scott thinks the numbers are much better than they appear on a looking-forward basis and that this is one idea where you can get the CFO and the customers on the phone and easily see how much cheaper it is than it looks. Despite this assertion, he did mention it’s a relative value play where you can short comps or oil.

American Standard Companies (now called Trane, ticker TT) is a conglomerate that was broken up in February 2007. They are market leaders for industrial HVAC units. Scott acknowledged that this is a 2009 story; the company is pursuing a 15% stock buyback and their parts and services business has been very stable through the last economic slowdown. The company is highly likely to pursue a strategic alternative, because it has a very attractive franchise that would be of interest to companies such as LG or Siemens and because the CEO has a large portion of his net worth in the company and would probably pursue a sale before retiring.

During the Q&A, Scott mentioned he’s short on retailers because he sees a dicey next 12 months for the consumer.

Marcelo Lima is a securities analyst for the Flexor Fund, at Miami-based Horn Eichenwald Investments. He focuses on running a concentrated value-oriented portfolio.

Atticus Lowe & Lance Helfert at the 3rd Annual New York Value Investing Congress reported by Marcelo Lima.

Atticus Lowe & Lance Helfert of West Coast Asset Management began their talk with a list of 10 signs of a strong company:

1. A simple business model – Dell vs. Wrigley
• Understandable, focused
2. A wide-moat competitive advantage – Cisco Systems vs. Microsoft
• Barriers to entry, pricing & buying power, sustainability
3. Recurring revenue – ADP vs. Toll Brothers
• Long-term contracts, repeat clients (razor blades)
4. Low inventory risk – Starbucks vs. Circuit City
• Don’t get stuck with inventory – quick turnover
5. Alignment of interest – National Home Health Care vs. ATP Oil & Gas
• Ownership, motivations, per share value, compensation
6. A healthy culture – General Electric vs. Johnson & Johnson
• Ruthless vs. selfless, ethical, lead by example
7. A flat organizational structure – Kodak vs. Contango Oil
• Fewer layers better, lean environment, close to customer
8. Low reinvention risk – Apple vs. Tootsie Roll
• Product life cycle, predictable, hit or miss, uncertainty
9. Low capital requirements – General Motors vs. Google
• Flexibility, resilience, generate cash vs. consume
10. Favorable demographics – Tribune vs. Angiotech
• Population characteristics – digital, baby boomers

They presented Noven Pharmaceuticals, of which they own 14%. Noven has a patented drug patch – a proven concept – which is much smaller than previous patches, and can administer a huge variety of drugs in a less intrusive way.

The company’s enterprise value is $270m, which is particularly attractive given that aside from their product portfolio and pipeline, there’s a JV with Novartis which alone is valued by WCAM at approximately $350m.

Overall, they believe a base case for the stock is $21.60 per share with potential to reach $30.80.

Marcelo Lima is a securities analyst for the Flexor Fund, at Miami-based Horn Eichenwald Investments. He focuses on running a concentrated value-oriented portfolio.

David Einhorn at the 3rd Annual New York Value Investing Congress reported by Marcelo Lima

David Einhorn of Greenlight Capital gave a great talk on the Lehman Brothers black box, which was essentially his short thesis on the stock. His talk began with the Value at Risk formula, and proceeded to show how it’s essentially useless when it comes to capturing the risk actually taken by market participants.

The major banks have been reporting about 40 basis points of value at risk across their asset portfolios, so on the face of it, they’re not exposed to much risk. David’s next presentation slide showed the actual losses which, of course, were orders of magnitude greater than the amount estimated by the VaR formula and disclosed in the companies’ financial statements.

The root of the problem has to do with the fact that a normal or lognormal distribution doesn’t capture what, in reality, is a fat tail phenomenon: that events at the tail ends of these distributions (the so-called 5 or 6-sigma events) really happen a lot more often than one would expect, implying that these aren’t really the appropriate distributions to use in the first place.

Interestingly, David seems to have become interested in this because his reinsurance business (publicly traded Greenlight Re) also used a measure similar to value at risk. He and the board decided to scrap it because they considered it the “FMOW” or “Failed Measure of Whatever.”

David then spoke about FAS 159 (The Fair Value Option for Financial Assets and Financial Liabilities), a new accounting standard, which he called “Profiting from your own demise.”

This new standard allows companies to update the fair value of both their assets and liabilities. Previously, if interest rates moved, only the assets were revalued, so companies would report a gain or a loss based on that move. If your assets are properly funded by matching liabilities, however, both should move in lockstep and offset each other, so this new standard makes sense.

However, suppose a company’s debt is being severely downgraded. Suppose further that the market hasn’t changed, so the value of the assets remain the same. Now the company will record a gain and increase its apparent book value, or equity, when in fact it is in recognizably worse financial shape due to the downgrade. It is an entirely absurd outcome.

According to David, the investment banks have been early adopters of this standard and this has had the absurd effect that the worse their credit, the more money they’re making (because of the gain in book value that goes through the income statement). The logical extreme of this is that the most lucrative day in the history of your company will be the day you go bankrupt.

Bear Stearns, in its conference call, has defended these gains as real. Sell-side analysts have followed suit.

FAS 159 underpins David’s short thesis on Lehman. He goes on to show that he believes the majority of Lehman’s earnings in 2007 have been derived from credit spreads widening and the effects of FAS 159. One perverse aspect of this is that as your company’s credit deteriorates, compensation bonus pools tied to earnings become fatter and you are essentially incented to report these fictitious earnings.

Furthermore, in 1998 Lehman marked their portfolio to model and when the market recovered, they emerged unscathed. The difference is that this isn’t a liquidity problem that we’re facing today: it’s a credit problem. You can’t just sweep these mark-to-market losses under the rug because there are real defaults happening within these credit structures. Lehman refuses to disclose what David thinks are hidden losses.

Lehman has said that their portfolio is hedged, but these hedges are completely black box. Nobody understands how they work, not even the ratings agencies, according to conversations with them.

According to Lehman, its main objective is to underwrite CDOs to move, not to own them. But in reality, a lot of this toxic junk is getting stuck on the balance sheet because the company can’t sell it. Its exposures are increasing each quarter as leverage also ratchets up. Finally, there’s significant impairment being done to Lehman’s franchise value, since it’s made so much money recently from acting as a manufacturer of so much of the toxic junk that is now moving against it.

David’s long idea was Criteria Caixacorp, a Spanish investment company. It is trading at a 26% discount to ascertainable net asset value. The company is today a collection of shareholdings in listed companies, for the most part, and a few unlisted businesses. Expenses are being held at under 10 bps of assets under management. The parent is a very large, well managed and conservative Spanish bank. David believes that over time these holdings will be sold and the company will be converted from a holding company to an operating business in the financial services sector.

Larry Robbins at the 3rd Annual New York Value Investing Congress reported by Marcelo Lima 

Larry Robbins of Glenview Capital gave a humorous and information-packed presentation. He said that there are two ways to make money: earnings growth or multiples growth. He said that for the first time he’s backing down from his usual aggressive style and cautioning investors not to bet on earnings growth.

Early in his talk he made a very good point: if Merrill Lynch, which has perfect information of its own balance sheet, swings by about 100% within a few weeks on its estimate of how many billions of write-downs it will have to make, there’s no hope for him, or anybody in the audience, of estimating what any of these banks will have to write-down on their balance sheets.

Last year Larry was able to pitch ideas that were reasonably priced, growing dramatically, and had no economic sensitivity. He said that this year he can’t find similar ideas, and that he’s going to have to be patient. “If there’s one lesson we can give you today, it’s that in this environment we encourage patience. And frankly patience isn’t something Glenview has been known for in our history and so this is a meaningful departure from our normal aggressive style.”

Before I continue with Larry, one note on the overall macro scenario: it’s not pretty. If you’re Warren Buffett and you’re buying stocks to hold them “forever” in an investment vehicle like Berkshire Hathaway, perhaps you can afford to ignore the cycle and buy cheap stocks regardless of what the economy is doing. But in fact there’s a thin line between being early and being wrong (to paraphrase Bill Miller). In this context, Whitney Tilson made a very interesting comment following an audience member’s question on Delta Financial:

“I just wanted to make one comment on what the lesson may be for Delta Financial or for value investors. We’ve had similar suffering in our portfolio on the retail side.

One of the dangers or traps value investors fall into plenty of times is we tend to be bottoms-up, company specific analysts. When we get killed it’s often because there are big macro factors affecting an entire industry. It doesn’t matter if you’re right on the company if the big macro factor – which is very hard to predict – Warren Buffett and Peter Lynch say “I spend 5 minutes a year thinking of macro factors” – well, if those macro factors turn south, it doesn’t matter if Delta Financial didn’t participate in any of the stupidity in the subprime area, they’ll still get massacred.

It doesn’t matter that Target, our largest holding, is one of the best managed retailers in the country, with embedded value in their credit card and real estate portfolios and a great catalyst in Bill Ackman working hard on it.

You can ride those coattails, but the stock is still down a bunch since we bought it because the consumer is crapping out and people are worried about what consumer spending will be next year.

Good lesson, and I’m not sure I have any easy answers for you except that sometimes you better think about those big macro factors even if they’re hard to predict because they might destroy all the micro-level company work you’ve done.”

With this advice – which Whitney gave us the following day, after Larry’s presentation – it’s easier to appreciate that Larry’s long ideas were among the best at the Congress because they don’t depend necessarily on US consumer spending.

His first ideas were United Health Care (UNH) and Wellpoint (WLP). They each have their unique sets of scandals. The CEO of UNH walked away with hundreds of millions of dollars after backdating numerous stock options (he was since refunded a whopping $600m back to the company).

Wellpoint had a CFO who was dating eleven women at the same time on Match.com and using the corporate “summer house” to meet them. He was forced to resign for violating corporate ethics policies which, as Larry joked, “Was limited to dating only six at the same time. Talk about multi-tasking.”

Larry likes the HMOs because there are only four players. The cost line goes up every year but because they don’t want to lose margin, they price accordingly, and membership usually tends to go up. Of course, if there’s a recession, that would imply job losses and fewer members, but Larry still thinks revenues can grow 7-9% next year. Because of operating leverage, they can grow EBIT at a faster clip. They’re both overcapitalized, cheap (circa 13x ’08 EPS), and buying back stock at a rate of 3% per quarter. So over three years, Larry sees overall 15-17% EPS growth.

The prevailing wisdom is that you don’t want to touch these stocks during an election year, but Larry thinks that regardless of who wins, the managed care organizations will benefit from the fact that healthcare is the #1 domestic issue being talked about by all candidates.

Onto UK pubs. Larry mentioned three companies: Enterprise Inns (ETI LN), Punch Taverns (PUB LN) and Mitchells & Butlers (MAB LN).

The last one gets the most press because of an activist investor, Robert Tchenguiz, who’s taking a large stake, but Larry thinks the other two are far more interesting. (Since Larry spoke, Mitchells & Butlers was downgraded by Lehman and taken off the FTSE 100 index, and the stock is off over 20%.)

ETI trades at 12.3x ’08 EPS and PUB at 9.5x ’08 EPS, but Larry prefaced his thesis by saying that at Glenview they’ve made the most money on simple analogies. And the simple analogy for these UK pubs is that they are cell-phone tower-like. Not quite as good as cell phone towers, but they’re cheap enough and enjoy secular growth.

The reason is that the tenanted model of operation – whereby the company owns the real estate and leases it out to the pub operator – allows for yearly rent increases, much like the cell phone towers. It also allows for a cut of revenues. This is a stable and growing annuity, which allows the company to employ high leverage. Larry loves this model – by keeping high constant leverage, the company can use its free cash flow plus 7x income into EBITDA for new pubs, dividends and share repurchases.

These pub companies are under pressure to split into operating and real estate businesses, which on a blended multiple basis provides a lot of upside (based on where they historically trade). Larry doesn’t think this is likely in the next year or so but believes this opportunity will come back once the credit markets stabilize.

The most important catalyst is conversion to REIT status. Only in January of this (2007) year has the UK enacted REIT laws and Larry thinks that the chance of these companies converting in the next two years is about 75%. Naturally, when companies retain more money instead of paying it to the government, the enterprise increases dramatically in value, especially if it’s levered like these are. Upside is anywhere from 30-100% depending on whether conversion to REIT status happens or not.

His last idea was Burberry, the UK upscale retailer. It’s cheap because “nobody wants to own a good house in a bad neighborhood.” Peers such as Nordstrom and Coach have come down a lot because of profit warnings and slowing top-line growth, respectively.

Burberry is currently undergoing an SAP installation which is depressing the numbers. But they’re moving to higher margin items – Larry used $1,000 handbags as an example – and so Burberry is essentially following the script that allowed Coach to reap much higher margins and a headier valuation.

Two other key points are that Burberry has 40 stores in the US and Coach has 272. He doesn’t think Burberry will get up there, but doesn’t think it’ll stay at 40, either. Furthermore, the new CEO has reversed the idea that it’s not good for Burberry to set up inside other larger department stores, saying that this is just lost revenue.

The thesis follows:
1. SAP installation ends and expenses fall out
2. Move to higher margin items
3. Expansion in the US (which is only 29% of revenues today) causes operating leverage to kick in
4. Multiple expansion from 12x ’09 EPS to match other luxury retailers, closer to 20x

 Mark Sellers at the 3rd Annual New York Value Investing Congress by Marcelo Lima 

Mark Sellers of Sellers Capital spoke at length about the Kelly Criterion (you can read all about it in the book Fortune’s Formula). It’s essentially a betting system that guarantees that (1) you never go broke and (2) you compound your bankroll at the fastest, most optimal rate possible.

Of course, because it’s a formula that requires you to handicap odds and payoffs, it’s subject to the to the garbage in / garbage out pitfall of any model, and can give seemingly ridiculous results – like “bet 500% of your bankroll on this stock” – if you make incorrect assumptions about the likelihood and magnitude of winning or losing on a stock investment. It could also mean that betting 500% of your bankroll is the optimal thing to do. The strength of your assumptions really matter.

To mitigate the risk of making mistakes in handicapping the odds and payoffs, Mark limits his purchases to situations where the expected return of a stock exceeds 20%, the upside is 3x greater than the downside, and the Kelly Formula tells him that he should bet.

Mark still likes Contango (MCF), quite a bit actually, since he’s put 50% of his fund’s NAV in the stock. He considers Ken Peak, the CEO of MCF, the “Warren Buffett of the natural gas industry.” My favorite part of the story is that Ken owns 25% of the company, has never sold a share, and his ex-wife gets his salary. He’s about $10m in debt – he borrows money to live – but since his stake is worth close to $200m, he’s not so worried.

Mike’s made quite some money on Contango, but with the stock at $47, he thinks that $42 is the worst case, $57.50 the base case, and $70 the best case. The company has recently hired Merrill Lynch to explore alternatives.

Mark’s second idea, which is “only” 25% of his fund’s NAV, is Lowe’s (LOW). Mark believes that the odds of LOW trading forever at a forward P/E of 11 are essentially nil. Over time, one gets earnings growth plus multiple expansion. In his estimation, the base case for LOW is a value of $30 per share, with $20 being the worst case and $42 the best case. The probabilities for these scenarios are 35%, 50%, and 15% respectively.