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At Georgia Tech professor Mulford has made available some great resources.
The spreadsheets with trailing data for various industries can help you back-up your valuation assumptions or provide benchmarking data.
Why do industry averages matter?
The pervasive effect of reversion to the (industry) mean is stronger than many good competitive positions as barriers to entry tend to get broken down. On the positive side, terrible businesses generally get a break when better management comes in. Terrible industries profit when raw materials become cheaper or technology makes capex less burdensome. As a result both negative and positive ROIC’s tend towards their cost of capital.
Extrapolating a firm’s current margins and asset turnover is a capital mistake.
Change in Median ROIC by Quintile (2000 to 2010)
What can you find?
Per industry data on:
- Operating cash margins
- Free cash margins
- Net margins
- Cash as % of revenue
- SGA as % of revenue
- Cash cycles
- Receivable cycles
Follow the link, use and enjoy!
Not so long ago I mentioned we should probably pay much more attention to short sellers.
Besides Chanos vs. HP there is another interesting battle unfolding: Ackman vs. Herbalife. Ackman stated he has over a billion USD invested in this short position and he said he’s donating his personal profits to charity.
At first glance, Herbalife never looked healthier, with Gross Margins around 80%! And Returns on Assets and Equity well into the double digits for years.
Ackman and his team at Pershing Square however have analyzed the company for two years and don’t think the financials add up. Watch and download their analysis here: http://factsaboutherbalife.com/
See also Ackman interviewed on CNBC: http://video.cnbc.com/gallery/?video=3000136735
And Ackman interviewed on Bloomberg: http://tinyurl.com/d4p3os2
Some critics of Ackman say: Herbalife runs a sustainable pyramid scheme.
“Here is where I believe Ackman may have made a strategic error. Short of an external force like the FTC or the SEC, there is nothing that stops Herbalife from profitably operating a pyramid scheme. The people targeted by Herbalife certainly do not read the financial press or read 343 slide presentations. There will always be a supply of uninformed victims for the Herbalife sustainable pyramid scheme. Herbalife is certainly not going to collapse under its own weight, given that it controls its diet of victims rigorously.”
Check the arguments here. http://tinyurl.com/dxpbh6r
Herbalife reacted as follows: “Today’s presentation was a malicious attack on Herbalife’s business model based largely on outdated, distorted and inaccurate information. Herbalife operates with the highest ethical and quality standards, and our management and our board are constantly reviewing our business practices and products. Herbalife also hires independent, outside experts to ensure our operations are in full compliance with laws and regulations. Herbalife is not an illegal pyramid scheme.”
Now is Herbalife cooking the books or have Ackman and his team got it wrong this time? Judge for yourself.
Full Disclosure: I have no position in Herbalife
Generally short sellers are viewed as a force of evil, speculators, increasing the cost of government debt and endangering the confidence in listed financial institutions, hence causing systemic risk.
But Short Sellers Are Often Right!
Look for example at the developing story around Hewlett Packard (HP). Jim Chanos mentioned HP as a short candidate in June 2012. And now HP is in the midst of an accounting scandal. Who are the bad guys here? And how did he do it?
How did Chanos identify HP?
Chanos typically searches for problems instead of growth stories. He sees short candidates in roughly 4 areas of opportunity:
- Debt-financed booms that go bust
- Companies that are becoming technically obsolete, through creative destruction
- Bad accounting: from earnings overstatement to outright fraud
- Would be customer fads: extrapolation of one time success.
Chanos identified HP as a short candidate when they acquired Autonomy for a significant premium (see chart below). The acquisition and the price raised a red flag to Chanos. Chanos was short Autonomy at that time because of reason 3: bad accounting. We see now, for good reasons.
Autonomy was to Chanos another confirmation of HP’s dismal M&A track-record. Chanos, June 2012: “..Compaq impairment, EDS restructurings, Palm write-off, Autonomy revenue implosion…”
“HP has been hiding the true costs of its R&D through acquisitions. Once the costs of these acquisitions are taken into account, revenues and cash flow at the company are “basically flat,” Chanos said.
To make things worse, Chanos also detected the computing market is in decline (E.g. Computers with hard drives vs. Tablets and Cloud Computing) and HP had no strategy to move to new profitable high-grounds. It was just waiting for accidents to happen.
So HP dealt with problem number 2 and acquired problem number 3 through Autonomy. Definitely a short candidate!
What if more investors had made this analysis? Should we listen more often to short sellers? What can we learn from short sellers like Jim Chanos? How do short sellers perform their analysis?
First, Some History on Short Sellers
Short sellers are with us since financial markets exist. Jenny Anderson of the New York Times notes in 2008:
“…In the days when square-rigged galleons plied the spice route to the East, the Dutch outlawed a band of rebels that they feared might plunder their new-found riches. The troublemakers were neither Barbary pirates nor Spanish spies—they were certain traders on the stock exchange in Amsterdam. Their offence: shorting the shares of the Dutch East India Company, purportedly the first company in the world to issue stock.
Short sellers, who sell assets like stocks in the hope that the price will fall, have been reviled ever since. England banned them for much of the 18th and 19th centuries. Napoleon deemed them enemies of the state. And Germany’s last Kaiser enlisted them to attack American markets (or so some Americans feared)…”
Enemies of the State or an Accounting Police?
Contrary to the general public and policymakers view, the investment world respects short sellers and views them as the most fundamental analysts, the smarter, more independent thinkers outside the herd. James Montier, a famous investment strategist at GMO classifies short sellers as follows:
“…the short sellers I have met are among the most fundamental-oriented analysts I have come across. These guys, by and large, really take their analysis seriously (and so they should since their downside is effectively unlimited). So the continued backlash against short sellers as rumour mongers and conspirators simply leaves me shaking my head in bewilderment.
I can only assume that the people making these claims are either policy-makers pandering to shorted companies, or shorted companies themselves. Rather than being seen as some malignant force within the markets, in my experience short sellers are closer to accounting police – a job that the SEC at one time considered its remit…”
Ok, ok: from Napoleon’s enemies of the state to the accounting police, now some facts please!
Yes, Short Sellers Identify Overpriced Companies…
Owen Lamont (2012) recently updated his 2003 study. He studied battles between short sellers and firms from 1977 to 2002.
He finds the following: firms that started fighting short sellers show a monthly underperformance of 2% (!), for the 12 months after a firm started the battle.
Lamont finds a 1 year cumulative return of – 24% and a 3 year cumulative return of – 42%. Pretty serious negative returns.
…and Short Sellers Detect Fraud, Insider Trading and Earnings Manipulation
And believe me it gets worse. The sample studied by Lamont showed that the majority of the firms undertaking actions against short sellers are subsequently revealed to be fraudulent.
Karpoff and Lou (2010) find short sellers anticipate revelations of misrepresentations of financial statements, which are material events (average 1 day share price declines of 18%!).
They also see the amount of short selling increases with the severity of the misrepresentation indicating short sellers sniff-out fraud, insider trading and earnings manipulation rather systematically.
Again some convincing evidence short sellers speed up the time-to-discovery and help deflate overpriced shared due to misstated earnings.
Does this sound familiar? At least in this case the company (HP) has picked another scapegoat for the fraud: Autonomy’s former management. The short seller (Chanos) escapes a court case, for now. The pattern however is clear: the financials were materially misstated and a short seller pointed it out and now management is playing the blame game.
So Who Are These People?
So shouldn’t we study more carefully what short sellers say, rather than disqualifying them as malignant? Shouldn’t we watch their presentations and think about what their analysis implies for our investments? If we want to listen tot them we at least have to know who they are!
Let’s look at what Jim Chanos had to say recently:
- See his presentation on Value Traps: this is where he identified HP as short candidate!
- Interview with Chanos in Graham & Doddsville 2012
We haven´t discussed him yet, but another famous short seller is David Einhorn. Yes, the short seller Dick Fuld (Lehman) wanted to crush. Luckily, gravity did its work and we can still enjoy Einhorn’s analyses:
- Recently Einhorn was at the Buttonwood conference and discussed the Fed. Europeans, think about what this says about Draghi, the ECB and the eurozone.
- For some background see this interview with Einhorn in Value Investor’s Insight
Other short sellers are Gerorge Soros, John Paulson, Steve Eisman, Michael Burry, Jamie Mai etc.
So How Do Short Sellers Analyze Companies?
Of course there is more on Chanos and Einhorn and other short sellers. However I’ll leave that for later posts or your own research. I think it’s time to take a class on what short sellers’ generally look for in company financials.
As we’ve seen, it is a useful training for any investor.
European distressed debt for sale
Baupost of value investor Seth Klarman, together with Centerbridge, Kennedy Wilson and DE Shaw & Co. is in the running for problematic consumer loans of Spanish and Irish banks, het Financieele Dagblad, a Dutch financial newspaper reported early August.
A KPMG report, on which the article is based, mentions:
- these US investors have recently transacted for the first time in Spain and Ireland;
- deal values are within a EUR 400 mln. and EUR 600 mln. range with outliers around EUR 1.5 bn;
- Spanish banks are expected to shed problematic loans of around EUR 10-15 bn. in the upcoming 12 months alone;
- There’s still EUR 1.5 trillion of non-performing loans on European bank balance sheets and KPMG expects these amounts to be offloaded under pressure of Basel III regulations;
- A peak for debt sales is expected around 2014-2015;
According to Reuters, there is a ‘huge’ interest with private equity and hedge funds to buy-up loan portfolios. PWC estimates there’s EUR 65 bn. in capital waiting to be deployed.
Thanks to their continued access to cheap funding (ECB) and hostage to their low capital buffers, European continental banks, until now, have held on to their assets, to avoid the one-off losses selling debt below par.
Baupost and distressed debt experience
So why is this environment interesting to a value investor like Klarman? Aren’t value investors, like Buffett generally interested in low priced stocks to buy and hold?
Well, Seth Klarman is known for his creative approach to value investing and applying its principles in finding any mispriced asset as compared to its intrinsic value. Today Baupost has built up a track-record investing in distressed debt, providing CIT a rescue loan, investing in Lehman’s debt after they filed for bankruptcy and Enron’s bonds after the firm had collapsed. All with extraordinary returns (e.g. Enron: 5 times investment)
Still the news triggered my curiosity as I am relatively unfamiliar with distressed debt markets and Baupost:
- How would Klarman’s team source these more obscure deep value opportunities?
- How would Baupost evaluate this as a deep value opportunity?
- How would Baupost consider the risks and expected returns of this kind of opportunity?
Please note: I am not active in the distressed debt market, nor do I know anyone at Baupost. I did study Klarman’s writings, speeches and interviews, detailing his approach.
How to source these deep value opportunities?
In a 2006 guest lecture at Columbia University Klarman explains how Baupost search strategy is set-up differently than other investment firms. For example Baupost has no telecom or utilities analysts, but has a distressed debt analyst or a post-bankruptcy analyst which evaluate any situation that they come across.
Klarman says, often for distressed debt, Baupost receives calls from Wall street. In 2011 Baupost set-up shop in London to be closer to distressed debt opportunities, however debt sales have failed to materialize, until now.
But is this enough as a search strategy? If the seller hires experienced advisers it is hard to avoid an auction process. Klarman’s ‘Margin of Safety’ philosophy fits better with negotiated sales, so my guessing is, the analysts do not sit around and wait Canary Wharf or ‘The Street’ to call.
How would Baupost evaluate this as a deep value opportunity?
Klarman: “We focus on a bottom-up approach. Finding specific one-off situations that are undervalued. Undervalued because of a specific reason and there’s a catalyst often enough in place for realizing that value.”
Now looking at the opportunities in Spain or Ireland, they are quite clear and fit very well into Baupost’s strategy:
- It’s a one-off situation: quite uniquely banks are shedding valuable assets beyond rational prices. An example: certain banks are canceling service-fee generating, non-drawn credit lines of triple A multinationals. It sounds irrational and it is, hence a great environment for undervalued opportunities.
- The main reasons: an imbalance in supply and demand of capital and liquidity – high demand for capital and liquidity due to Basel III vs. a lack of investor confidence in banks and limited asset sale opportunities.
- Especially problematic credit has become a burden on banks’ balance sheets, because the risk weighting of these assets under the Basel accords will increase and the loss given default (LGD) is uncertain, making regulators jumpy.
- The catalyst for the loans is straightforward. It is the expiration date or redemption of the loans.
What are the key risks and expected returns of this kind of opportunity?
One of Baupost’s key principles is consider the risk first and then the return. Rule #1: don’t lose money. Rule #2: Never forget rule #1. As a follower of Benjamin Graham’s school and as intelligent investors Klarman’s team probably considers three key risks:
- Valuation Risk: an inadequate projection of future earnings
- Business/Earnings Risk: the danger of a loss of quality and earnings power through economic changes or deterioration in management
- Balance sheet/Financial Risk: financial weakness that may detract from the investment merit.
In his seminal work, Margin of Safety, Klarman writes: “There are three principal alternatives for an issuer of debt securities that encounters financial distress: continue to pay principal and interest when due, offer to exchange new securities for securities currently outstanding, or default and file for bankruptcy.”
So the key questions perceiving the risks and grasping potential returns are:
- how to understand and mitigate valuation/earnings/financial risk sufficiently?
- what is the price we can buy this for?;
- what percentage of the debt holders would default or need to be made a restructuring offer?;
- and what % of loans could be recovered in such case?
Of course, this is not easy to determine for me as an outsider, however even being part of Klarman’s due diligence team there probably is sufficient uncertainty about the outcomes.
As Klarman’s says: “Risk simply cannot be described by a single number”, and uncertainty is not risk. Therefore I will make an attempt to qualitatively understand risk and return potential of doing a distressed debt deal.
Clearly a price of 2%-20% of nominal loan value is a significant discount. How much of a discount? That depends on ultimate payoff. Putting in 20 cents on the euro and receiving 30 eurocents still provides a 50% return (assuming no interest payments). However the further away the redemption, the less valuable this transaction becomes.
Valuation risk is also a function of buyers and sellers. As there are still some EUR 1.5 trillion of non-performing assets for sale and little deal appetite at strategic investors, the demand and supply side will be unbalanced for a while. Or?
There are some worrying signals suggesting otherwise:
- KKR (a private equity house): “An insane amount of capital has been chasing the big portfolio sales and the prospective returns will likely be low,”
- When big deals have executed, huge investor interest has, in some cases, forced the prices higher, eating into returns.
- A recent rally in prices is also forcing funds to turn to leveraging to earn the double-digit gains investors expect.
- Even hedge funds not traditionally associated with distressed-debt trading are getting in on the act.
- KPMG indicates that Spain’s market is hottest of all debt sales markets.
Still there is a fundamental an imbalance in demand and supply between EUR 1.5 trillion of assets vs. EUR 65 bn. in capital implying valuations will be favorable eventually, assuming non-performing loans in majority cannot be bought with debt financing.
The loss of earnings power is a clear and present danger in Spain and Ireland, with unemployment at record levels. Due diligence will somewhat clarify whether borrowers have reliable income streams. Naturally not all loan files will be in order and some borrowers will look unreliable on paper, but in fact aren’t. These are the loans with high uncertainty and where Baupost could have the significant edge over the competition.
Baupost could work with local experts for a debt recovery strategy. One of the strategies could be offering an advanced repayment discount to the most problematic cases, hence creating a self-induced catalyst and moving the repayment date forward increasing the IRR and reducing uncertainty.
Moving fast, will mitigate the risks of currency devaluation in real terms or through Eurozone departure, so the majority of cash flows is in Euros not Pesetas.
As per Q2 2012 Baupost has hedged it’s Eurozone exposure several blogs report
Due to the abundance of credit many households and companies in Spain have their debt at unsustainable levels (McKinsey reports: 216% of GDP excl. financial institutions), with all increased risks of default and restructuring.
Again, stimulating firms and households to redeem debts to Baupost first and fast, could mitigate the risk and advance cash flows.
Prices, Returns and Safety Margins
Generally a value investors doesn’t go to work for margins of safety less than 30%. Including the price range (2%-20% of nominal) mentioned in het Financieele Dagblad, this implies recovery rates should be minimally at 30% if investors are to pay 20 cents on the euro. SM: 33% = 1-20%/30%
If Baupost would like to make similar returns as on their Enron investment the average recovery should be around 5x above prices paid, implying realized recoveries of 10 cents for the 2 cent deals. Increasing the recoverability of these loans will have major impact on returns. Vice versa, just as much.
The local experts can detail expected recovery best of course, based on their local data on debt repayments. Of course these databases are based on historical data and correlations change through spillover effects, however it could give a range of probable payoffs.
Time to maturity
If a debt portfolio consists of debt maturing on average between now and 2.5 yrs, the target 5x return would be around 200% p.a. excluding interest payments. However would the payment be moved forward, the IRR (internal rate of return) will increase substantially.
Baupost could even offer debtors restructuring at a higher discount to nominal the faster they respond, taking into account the time value of cash flows and the higher riskiness and uncertainty of cash flows further in the future.
Note the importance of a low price and a rapid and high debt recovery as both risk mitigators, return optimizers and uncertainty reducers.
The current European distressed debt sales indeed offer a good fit with Baupost’s investment strategy. In the competitive European environment sourcing strategy and patience is key to avoid valuation risk.
The EUR 1.5 trillion of assets vs. EUR 65 bn. in capital imply an imbalance in demand and supply, so it still looks like an attractive market in less popular debt segments, leaving room for price negotiations.
The inherent earnings and financial risks can be mitigated by moving fast in restructuring and hiring local recovery experts. Making the eventual returns higher en less risky.
For the interested reader, many great blogs are available on Baupost’s and Klarman’s investments and strategy, a selection:
A summary of Klarman’s guest lecture is available at: http://seekingalpha.com/article/81024-seth-klarman-comments-on-money-management-and-baupost-s-approach
A great blog (unfortunately only in Dutch) on Basel III and risk management is available at:
If you care to buy Klarman’s book. Take a look at: