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Great interview, especially his insider account of the crisis, helping out GE and Goldman and about cash as oxygen…
“After this, American industry literally stopped. George Bush said, “If money doesn’t loosen up, this sucker will go down” – I believe this was the greatest economic statement of all time. This is why he backed up Paulson and Bernanke. Companies were counting on the commercial paper market. In September 2008, we came right to the abyss. If Paulson and Bernanke had not intervened, in two more days it would have been all over. BRK always has $20 billion or more in cash. It sounds crazy, never need anything like it, but some day in the next 100 years when the world stops again, we will be ready. There will be some incident, it could be tomorrow. At that time, you need cash. Cash at that time is like oxygen. When you don’t need it, you don’t notice it. When you do need it, it’s the only thing you need. We operate from a level of liquidity that no one else does. We don’t want to operate on bank lines.”
According to Jean-Marie Eveillard, Senior Adviser, First Eagle Fund, after 2008 Value Investors should ask themselves if their bottom-up approach should be complemented with a top-down analysis of the macro environment.
This interview gives you a fresh insight on current macro environment and how investors should deal with it. I have made a limited (incomplete) summary of the topics he discusses.
Austrian School Best Analytical Tool to Perceive Current Environment
- For top-down analysis, according to JME, the best analytical tool is the Austrian School to see through the neo- Keynesian measures taken by governments.
- JME expects these measures to be discredited in the future
- Inflation to the Austrians is not the increase of the CPI or asset prices it is the creation of too much money and too much credit.
- Money is not supposed to be free and this situation will cause significant distortions.
Gold is the Currency of Last Reserve
- Gold is a protection against extreme outcomes. It is the currency of last resort. Warren Buffett does not seem to get this. We see it as a substitute currency to hold cash in. We don’t see any of the printed currencies as reliable.
Graham vs. Buffett
- He discusses the difference between Graham’s quantitative and Buffett’s qualitative intrinsic value measurement and describes the struggle of value investors on determining the right moment to sell their investments. At the static quantitative intrinsic value of Graham or the qualitative moat based intrinsic value of Buffett.
- He describes he was twice illuminated by Graham’s Intelligent Investor and Buffett’s Shareholder Letters
Fund Performance Management
- About his performance targets when was fund manager of first eagle funds.
- His absolute target: perform better over time than money market funds.
- In hindsight he would’ve set the absolute performance target in real terms
- His relative objective: perform better over time than an adequate benchmark.
- His absolute target: perform better over time than money market funds.
- He mentions the reasons for having so little value investors around are psychological. As Grantham recently spelled out, it is career risk. Nobody wants to diverge too much from the benchmark. Job safety is too important.
- He notices, now an advisor, value investing on personal account is much easier than doing it on behalve of clients
- Successful value investing is highly depending on the clients chosen (he mentions Klarman has chosen his clients well)
Bonds are riskier than perceived
- JME calls the run on bonds a big mistake
- People working in the bond markets under 55 have never seen a bear market, so are overconfident in safety of bonds.
- He thinks this is one of the reasons so many institutions move from equities to bonds these days.
- Europe has a real problem, the Euro is created for political reasons not for economic reasons
- Full integration of Germany into Europe requires the Euro
- National governments kept fiscal power
- The flaw became obvious from by the
- Correct the mistake and have a European government
- Giving up sovereignity is unpalatable
- Everybody is buying time
- Most European companies do business beyond Europe
- Some of these companies are worth looking at right now
- JME’s take on Japan
- JME sees parallels with investing in French undervalued Small Caps in the 80s, patience is key.
- On bicycle producer Shimano
- Cultural issues
- Accounting issues between countries – conservatism vs. aggressiveness
- Political Risk Premia
The interviewers (brothers Mihaljevic) have made a great compilation of investing wisdom and other investors in the Manual of Ideas.
Custom-made shoes to fit your feet? Live in the shop?
In this presentation Century Management’s founder Arnold van den Berg explains why 3D printing is going to lead to an improvement in productivity and how this increased productivity leads to wealth creation. But this time, I believe the consumers will benefit.
The Wealth Creation Cycle according to Century Management
Century Management’s definition of Wealth
Obsolete manufacturing facilities
The drawbacks of this coming whirlwind of change to manufacturing companies is job losses and obsolete manufacturing facilities. Even though in Europe and the US many manufacturing jobs were outsourced in the last decade, there are still many plants left, employing still significant numbers of low-skilled laborers.
For example, what will happen with a bicycle factory in France which is now protected by EU import barriers against cheap Chinese bicycles?
If it doesn’t want to lose out against competition, it will have to start buying 3D printers, hiring engineers and designers and will have to start closing factories, firing production line workers and set up 3D printing hubs in every corner of the country, perhaps in every other bicycle shop.
Competition will be higher, competitive advantages short-lived
However as 3D printers will become cheaper every year, competitors will start appearing and key competitive battlegrounds will be intellectual property, safeguarding access to the latest 3D printers, materials, retaining the best engineers and most original designers and have a fine-mazed distribution network (bicycle shops with production facility?)
This will lead to very thin profitability margins and business models being turned upside down, there’s no EU import barrier to prevent this development.
What does this mean for investors?
After the technology sector, the heavy capital intensive manufacturing sectors will have their business models constantly turned upside down.
Owning a traditional factory could very well turn into a liability as competition turns abundant and profits turn into losses.
Subsequently fixed assets will have to be impaired and the debt used to finance these assets will be uncovered, leading to restructuring and losses for equity holders.
But debt is not the only liability, think expensive pensions, severance pay for redundant employees and more. Remember what happened to US car manufacturers with uncompetitive labor costs and obsolete car models?
Who will profit from this productivity gains?
For investors, productivity is a great gain, however 3D productivity will not be limited to the company you’ve invested in. It will rather be the new normal and if your company is not flexible enough to adapt…well forget all those stable cash flows you’ve counted on.
So run this scenario when you decide paying for a company’s future cash flows. How will 3D printing affect the business model? How much is current management thinking about or already applying 3D printing techniques?
Thanks to free competition in the end most productivity gains from 3D printing will go probably to the consumer. Manufacturers should prepare for an open competitive landscape and move first to safeguard their competitive position for the years to come.
Beware Myopic Politicians
A significant unknown are protective measures by myopic politicians to avoid 3D competition from destroying jobs. Pursuing this path will lead to temporary job protection, but uncompetitiveness and a dis-incentive to innovate and forcing their citizens to pay more than their peers in other countries. Leaving less money to productively invest in the economy. But unfortunately, career risk is also a strong incentive for politicians to make bad decisions.
See for a sad example Brazil’s expensive clothing prices and inferior textile industries. Ever bought clothes in Brazil? 4 times US prices and inferior quality fabrics. Middle and upper class Brazilians travel to US to buy furniture, electronics, wedding dresses, clothes and more. Hardly a sustainable and fair situation for the country’s population.
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:
Anyone of you who is interested in the experience of the most successful value investor in Russia: Bill Browder, and how his success backfired heavily, leading to his prosecution and death of his lawyer. Take the opportunity to see his guest lecture at Columbia University with Robert Heilbrunn Professor of Finance and Asset Management, Bruce Greenwald.
I believe this scenario should be more explicit in our emerging market valuations and not be tucked away in a political risk premium in the discount rate.
Investors and valuation advisers have to consider what happens to valuations if Turkey’s government changes, what happens if Russia will re-nationalize financial institutions, what is the valuation impact of an ‘Arabic Spring’ inspired regime change in Angola, what happens when Greece exits the Euro zone and becomes the Mediterranean Argentina?
See per below a summary of the most interesting viewpoints, tips & tricks I got out of this lecture.
Getting to a proper valuation for an emerging market starts with taking a macro view, working your way down to the micro
- If the macro environment is favorable it doesn’t mean the companies on offer are great investments
- Stop thinking of getting exposure to an emerging market, that’s a sure way of losing money
- Start thinking about identifying undiscovered deep value opportunities – cheap/mispriced assets on an absolute and relative basis
- Privatization programs could offer great value opportunities, but ask yourself:
- Is there an investor friendly government?
- Why is government friendly? What is their incentive?
- Why are oligarchs friendly? What is their incentive?
- How could a change in this incentive and attitude affect your holdings?
- If not friendly? Stay out. Or realize, your market entry is a speculative bet, not an investment
- Is there an investor friendly government?
- Analyze economic fundamentals:
- Is the country a large oil producer? Timber? Diamonds?
- Are there other fundamentals supporting growth?
- Who profits from GDP growth? Don’t automatically assume GDP growth will translate in higher household consumption and revenue growth
- Be skeptical
- Look for fact based analyses to uncover lies
Note from Bruce Greenwald (the interviewer): “..keep in mind that every time you are buying and think an asset is going to perform well, somebody is selling it and one of you is always wrong. Who do you think is wrong when you‘re flying in and they are local?”
Before making any investment, conduct very thorough due diligence on the ground
- Depreciated assets often harbor hidden value, go there, determine reproduction value with you own eyes
- Being a local specialist on the ground gives you a competitive advantage in the valuation process
- Signals of conflicts of interest or worse fraud:
- Find out who owns the company
- What else do the owners do?
- How much do they own?
- How much do they own of other things?
- If you’re investing in an agricultural company and the owner also owns the fertilizer supplier, that’s not a good thing.
- A company that has switched auditors, is not a good thing
- A company where the majority shareholder is a politician
- Do a stealing analyses: Interview customers, consumers, competitors, employees etc. whether there is any stealing going on, check the facts with local registry offices (real estate, land holdings)
- Generally only companies that have stock options tend to overstate earnings, so reported earnings and assets are generally accurate. Implying they are earnings after stealing. Accounting generally counts what’s there.
Once uncovered fraud, what to do?
Fraud, can be also an opportunity: if you can stamp it out, your earnings will increase and so will the value of the companies.
- To get back leaked assets and stolen earnings: involve the press and government in your findings
- Make sure you do all this complying with local and international regulations
- As soon as you get invited for yacht-parties by your clients/investors and get awash with more cash to invest, it’s a sign you should liquidate your holdings (and those of your clients) It’s too much money chasing deals
- Think hard about what your contingency plan is, when relations with government or oligarch relations turn sour. If you see it happening: act fast!
- Think hard about what your contingency plan is, when relations with government or oligarch relations turn aggressive, towards you. If you see it happening: act fast!
Comparative attractiveness of emerging markets vs. free democracies
- Emerging market growth is all fine and nice however there’s huge economic value to fuzzy stuff like democracy and free press, so companies trading in markets without political checks and balances should be bought into against a higher discount than their comparable peers in democratic countries.
- Bill Browder: “…my single biggest lesson learned is that we undervalue what makes America and other democratic countries great, and we shouldn’t, because that plays a real role in valuation and what something’s worth..”
On country diversification:
- Country focus makes you better in knowing all that’s going on, but when political risk becomes unfavorable, that’s the only country you know
- Covering more countries costs more time and effort to figure out what’s going on locally
- However there is a 80/20 rule to this all. With 20% of the effort you can get 80% of the value reasonably estimated. As long as you buy-in cheap enough, and your downside is limited on an earnings or asset basis you can make the investment
Bill Browder on current attractiveness of emerging markets (November 2010)
Bill Browder: “…emerging markets are not attractive on a valuation basis, however they are a bubble about to be inflated due to all the completely absurd money printing that’s going on. We all know this will end in tears, but in the meanwhile there’s money to be made..” Bruce Greenwald’s warning: “…if we try to do what Bill describes it will end in tears for all of us, including Bill, the first time he invested in Russia.”
Disclaimer: this is a limited excerpt of the interview mixed with my personal notes and interpretations. This is not an exhaustive summary. Interpretation errors are mine and the quotes are not a literal transcript of the statements of the speakers. This is no investment advice.
Bill Browder has recently written down his experiences in a worthwile read: