On Saturday, Warren Buffett released his annual letter to shareholders. The major theme for the letter might be, "we are turning the corner."
Performance & results
Mr. Buffett would like investors to look at the per-share intrinsic value to determine the performance of the firm against the performance of the S&P 500 including dividends.
The three key components of Berkshire intrinsic value incloudes the value of investments, value of earnings from other than investments or insurance underwriting, and the value of how retained earnings will be deployed back into the business. The first two of these pillars of these are easy to calculate, while the final pillar is hard to calculate. Regarding deploying capital:
This "what-will-they-do-with-the-money" factor must be always evaluated along with the "what-do-we-have-now" calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value...If a CEO can be expected to do his job well, the reinvestment prospects add to the company's current value; if the CEO talents or motives are suspect, today's value must be discounted. The difference in outcome can be huge...
Mr. Buffett alluded to the fact that in the early days of his control of Berkshire, there was much more emphasis put on the investment side versus the development of earnings from non-insurance businesses. This practice will most likely continue as Berkshire continues to grow in size, and amount of cash to invest continues to grow due to earnings from the portfolio of businesses, income from investments, and insurance float. Furthermore, the size of Berkshire will reduce the ability to generate the large outperformance it did in the earlier years. Regarding size:
...shows our 46-year against the S&P, a performance quited good in the earlier years and now only satisfactory. The bountiful years, we want to emphasize, will never return. The huge sums of capital we currently manage eliminate any chance of exceptional performance. We will strive, however, for better-than-average results and feel it for you to hold us to that standard.
As Mr. Buffett alludes to in the letter, Berkshire's best days ended in the early 1980's. In the market's golden period in the next seventeen years, Berkshire's absolute advantage narrowed. In recent years, Berkshire's negative outperformance or lower outperformance came in years where the market did not properly reward the businesses Berkshire invests in. Berkshire's outperformance comes in the years where the market is terrfied about market events and moves towards a "flight for safety." In 2008 market turmoil, the per-share-book value of Berkshire went down -9.6% versus the -37.0% for the S&P 500 including dividends, or 27.4% of outperformance. In 2009, when the equity started in recovery, the per-share-book value of Berkshire went up only 19.8% versus the 26.5% for the S&P 500 including dividends, or -6.7% of underperformance. These results largely include the large, quality businesses that Berkshire invests in that have strong cash flow and balance sheets.
Because of the size, Berkshire is looking to another big target like the acquisition of BNSF. Regarding a big acquisition:
Charlie and I hope that the per-share earnings of our non-insurance businesses contines to increase at a decent rate. But the job gets tougher as the numbers get larger. We will need both good performance from our current businesses and more major acquisitions. We're peprared. Our elephant gun has been reloaded, and my trigger finger is itchy.
Corporate culture
Rather than get into an explanation about Berkshire's culture, I think the quotes below best illustrate Berkshire's culture:
Our trust is in people rather than process. A "hire well, manage little" code suits both them and me.
Berkshire's CEOs come in many forms. Some have MBAs; others never finished college. Some use budgets and are by-the-book types; others operate by the seat of their pants. Our team resembles a baseball squad composed of all-stars having vastly different batting styles. Changes in our line-up are seldom required.
Cultures self-propagate...bureaucratic procedures beget more bureacracy, and imperial corporate palaces induce imperious behavior...at Berkshire's "World Headquarters" our annual rent is $270,212. Moreover, the home-office investment in furniture, art, Coke dispenser, lunch room, high-tech equipment - you name it - totals $303,363.
Successors
With the recent retirment of Lou Simpson, the next generation of leaders at Berkshire still remains in question. It appears the next Berkshire CEO will have "x" amount of money to manage, and the firm may hire additional portfolio managers. Mr. Buffett, along with Charlie Munger, intend to do the primary investing at Berkshire until neither one of them are in the role. Regarding the criteria for successors:
...But past results, though important, do not suffice when prospective performance is being judged. How the record has been acheived is crucial, as is the manager's understanding of - and sensitivity to - risk (which is no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed. Finally, we wanted someone who would regard working for Berkshire as far more than a job.
Todd Combs was chosen as one of those successors. Previously, Mr. Combs ran a hedge fund. Regarding hedge funds:
...The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich...investors who put money with such managers should be labeled patsies, not partners.
Most investment professionals have some sort of style that is theirs. Regarding that style:
...fund consultants like to require style boxes such as "long-short", "macro," "international equities." At Berskhire, our only style box is "smart."
Leverage
Mr. Buffett speaks about how much he does not like Berkshire to use leverage. To illustrate his point, Mr. Buffett includes a letter from his grandpa to his Uncle Fred. The point of the letter was that there is peace of mind when people have cash they can put their hands on, it is important not to spend all a person makes, and do not sacrifice your business because of some one-time event. Thus, "...liquidity is a condition for assured survival." Furthemore:
At Berkshire, we have taken his $1,000 solution a bit further and will hold at least $10 billion of cash, excluding that held at our regulated utility and railroad businesses. Because of that commitment, we customarily keep at least $20 billion on hand so that we can both withstand unprecedented insurance losses...and quickly seize acquisition or investment opportunities even during times of financial turmoil.
Mr. Buffett maintains a relatively riskless strategy for investing short-term cash. To his point:
We keep our cash largely in U.S. Treasury bills and avoid other short-term securities yielding a few mere basis points, a policy we adhered to long before the frailties of the commercial paper and money market funds became apparent in September 2008...At Berkshire, we don't rely on bank lines, and we don't enter into contracts that could require postings of collateral except for amounts that are tiny in relation to total liquid assets.
By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well...we will be equipped both financially and emotionally to play offense while others scramble for survival.
On America
The most important them from the letter I think the biggest them that permeates Mr. Buffett's letter is his bullish attitude for the United States. Now, a person in Mr. Buffett's position is in a different situation than an unemployed construction worker, but he is putting his money where his mouth is.
Mr. Buffett believes there is plent of of opporunity in the United States. Regarding that opportunity:
Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk about "great uncertainty." But think back, for example, December 6, 1941, October 18, 1987 September 10, 2011. No matter how serene today may be, tomorrow will always be uncertain.
Don't let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential - a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War - remains alive and effective....America's best days lie ahead.
The biggest news in 2010 for BNSF was the acquisition of BNSF railway. Mr. Buffett is extremely optimistic about the acquisition and the earnings power of the business. As a result, Berkshire is increasing CAPEX spending in BNSF railway, but most CAPEX spending for the portfolio of businesses will be in the United States.
Both of us are enthusiastic about BNSF's future because railroads have major cost and environmental advantages over trucking, their main competitor...When traffic travels by rail, society benefits.
Over time, the movement of goods in the United States will increase, and BNSF should get its full share of the gain. The railroad will need to invest massively to bring about this growth, but no one is better situated than Berkshire to supply the funds required. However slow our economy, or chaotic the markets, our checks will clear.
...we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion - or 90% of the total - was spent in the United States. Certainly our businsses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending - $8 billion - and speand all of the $2 billion increase in the United States.
What does all of this mean?
There are several themes in this letter that relate to the average retail investor. First, I would not bet against America. Nor would I make a pure play on America. Instead, I would continue to look at large U.S. based companies that have a good portion of their revenues generated outside of the United States and have sustainable dividend yields. By looking at these companies with this type of sales mix, you will be exposed to an ever growing stream of non-US revenues, while seeing a recovery in sales from the United States. Regarding the dividend point, we will be seeing some sort of inflation in the coming years. These firms will be able to increase dividends the easiest, allowing investors to hedge inflation. I would still look at select small-cap companies in areas that will benefit from a U.S. recovery. Some sectors include rail, housing, and consumer discretionary.
Second, do not buy into trends. It is important to develop your own style of investing, which may include investing in all different asset classes. Rather than pack a particular asset class, develop an approach that is uniform to all asset classes. Most people would associate Mr. Buffett as an equity investor. In this year's letter, he speaks about bets he made using derivatives. He used his approach to these instruments as well.
Third, be liquid and do not overly rely on leverage. This can be applied several different ways to investing. One way to interpret this is to invest in liquid companies meaning invest in companies that have strong cash flow and balance sheets. As a result, these companies can internally provide the cash for operations, capital improvements, or be able to return cash to shareholders. Another way to interpret this is it is ok to have cash drag on your portfolio. I look at the cash allocation or cash drag problem like a football game. As a value investor, it is important to follow a list of companies, determine their appropriate valuation, and when the time comes, buy the company. Often times, these companies hit their appropriate valuation when a crisis hits.
Warren Buffett's Annual Letter (click here)
Sunday, February 27, 2011
Tuesday, February 15, 2011
Liquidity Induced Bubbles
Contrary to Chairman Ben Bernanke's recent comments, investors are beginning to feel the inflation threat is real. Unlike Mr. Bernanke and the Federal Reserve, the market looks at different factors. What does the Federal Reserve use to sniff out inflation? The Federal Reserve looks at core inflation excluding food and energy. In addition, the Federal Reserve looks at the output gap (i.e. actual output versus potential output). In the Federal Reserve's mind, as the economy is bumping along at the current rate, there will be a large output gap (and high unemployment) minimizing the perceived inflation rate.
So, what does the market use to sniff out inflation? The market actually uses market factors like commodity prices and interest rates. Recent movements in these markets all indicate investors feel the inflation threat is real. Let's first look at Treasury bonds. At December 31, 2010, the 10-yr Treasury closed at 3.31%. On February 15, the 10-yr Treasury closed at 3.62%. On December 31, 2010, the 30-yr Treasury closed at 4.36%. On February 15, the 30-yr Treasury closed 4.66%. These movements indicate traders are realizing the inflation risk and moving out of Treasuries, and into commodities.
In my opinion, a recent CNBC article summed up the movement in the bond market:
While inflation today looks pretty benign, what bond investors don't like right now is the uncertainty factor around the future inflation picture.
These factors will not inhibit the Fed to continue to pursue the policies it has been pursuing. First, the Fed has to maintain stable prices. As long as core CPI is under two percent, the Federal Reserve is going to maintain the current interest rate policy. Second, the Fed has the mandate to maintain prices. As long as unemployment is high, the Fed will continue to puruse quantitative easing and zero interest rates to increase growth and lower unemployment. The end game for the Federal Reserve is to create a wealth effect. The idea is that asset prices will go up, which will encourage investors to spend and firms to be more ambitious about expansion plans.
Good questions to ask right now include: 1) are commodities and equities going up because an underlying bubble is being formed?; 2) how should policymakers respond?; and 3) how is an investor able to protect themself in either high inflation or asset bubble?
Pedro de Noronha, Noster Capital, believes the market is currently in a bubble. According to him, the valuations do not support 2012 and 2013 earnings. So, as a value investor, it is important to let the market indicate the firm's intrinsic value. Until it does, it is important to get paid through dividends. Also, it is important to note Mr. de Noronha's point:
If we are indeed witnessing the third liquidity-induced bubble in a little over ten years (this time fuelled by public, not private sector debt), we are fearful that there could be severe consequences for the market over the medium term...We won't hesitate forsaking some upside for the fund in order to ensure that we will be in good standing to take advantage of very compelling opportunities that will arise should such a financial event occur
So, if there is an asset bubble being created, what are the mechanics of one? In my senior year of college, I wrote a paper about inflation targeting. I wrote how Mr. Bernanke does not believe central banks can prevent one from forming, in addition to the behavior of their creation and aftermath:
Inflation Threat: Investors Starting to Show Inflation Threat Is Real (click here)
Liquidity Induced Bubble Could Burst: Fund Manager (click here)
So, what does the market use to sniff out inflation? The market actually uses market factors like commodity prices and interest rates. Recent movements in these markets all indicate investors feel the inflation threat is real. Let's first look at Treasury bonds. At December 31, 2010, the 10-yr Treasury closed at 3.31%. On February 15, the 10-yr Treasury closed at 3.62%. On December 31, 2010, the 30-yr Treasury closed at 4.36%. On February 15, the 30-yr Treasury closed 4.66%. These movements indicate traders are realizing the inflation risk and moving out of Treasuries, and into commodities.
In my opinion, a recent CNBC article summed up the movement in the bond market:
While inflation today looks pretty benign, what bond investors don't like right now is the uncertainty factor around the future inflation picture.
These factors will not inhibit the Fed to continue to pursue the policies it has been pursuing. First, the Fed has to maintain stable prices. As long as core CPI is under two percent, the Federal Reserve is going to maintain the current interest rate policy. Second, the Fed has the mandate to maintain prices. As long as unemployment is high, the Fed will continue to puruse quantitative easing and zero interest rates to increase growth and lower unemployment. The end game for the Federal Reserve is to create a wealth effect. The idea is that asset prices will go up, which will encourage investors to spend and firms to be more ambitious about expansion plans.
Good questions to ask right now include: 1) are commodities and equities going up because an underlying bubble is being formed?; 2) how should policymakers respond?; and 3) how is an investor able to protect themself in either high inflation or asset bubble?
Pedro de Noronha, Noster Capital, believes the market is currently in a bubble. According to him, the valuations do not support 2012 and 2013 earnings. So, as a value investor, it is important to let the market indicate the firm's intrinsic value. Until it does, it is important to get paid through dividends. Also, it is important to note Mr. de Noronha's point:
If we are indeed witnessing the third liquidity-induced bubble in a little over ten years (this time fuelled by public, not private sector debt), we are fearful that there could be severe consequences for the market over the medium term...We won't hesitate forsaking some upside for the fund in order to ensure that we will be in good standing to take advantage of very compelling opportunities that will arise should such a financial event occur
So, if there is an asset bubble being created, what are the mechanics of one? In my senior year of college, I wrote a paper about inflation targeting. I wrote how Mr. Bernanke does not believe central banks can prevent one from forming, in addition to the behavior of their creation and aftermath:
A debate exists among central bankers who believe asset prices should play a role in creating an inflation forecast. Ben Bernanke, Federal Reserve Chairman and a leading proponent of inflation targeting, has argued against a central bank’s focusing on asset prices, “…only to the extent they affect a central bank’s forecast for inflation.” Bernanke argues a central bank does not know the level of price increases in volatile assets that constitute an asset bubble or when the bubble will burst. Claudio Borio and Philip Lowe argue that a central bank should not “target” asset prices such as stocks or real estate, but instead focus on their changes.
A central bank should take asset prices into consideration for specific reasons. First, asset price bubbles have occurred when credit increased at a greater rate than inflation. Since the central bank can control inflationary expectations, firms and households feel optimistic when high GDP growth can be accompanied by low inflation; this causes firms to increase investment. Due to the influx of credit, lenders, firms and households begin to make poor decisions by overvaluing assets and not assessing risk.
Second, the supply side of the economy improves because of low inflation. One impact is workers and firms are more willing to enter into contracts when current inflation is low. Because the nominal price inputs like labor are held constant or grow at a specific rate, corporate profitability increases. Increased profitability makes investment in stocks more attractive to the public. Capital gains from the stock and bond markets become “self-reinforcing” and feed into each other. Also, it is more attractive for firms to increase their investment in assets such as land and equipment. Because of their increased profitability, firms predict overall demand will continue to increase and may borrow funds to purchase these investments.
Third, when an asset bubble bursts, deflation usually occurs, which creates various problems. To fund expansion, many firms may finance part of the expansion with debt. Because inflation improved their outlook for the future, it may have caused a misallocation of assets. Furthermore, lenders make the decision to lend to firms and households based on increases in nominal income. The end result is more debt than before the bubble and deflation causes the real value of the debt to increase. As the value of debt increased, firms and households cannot afford to make regular interest payments. The end result is deflation, an increase in defaults and tightened lending standards.
These three arguments make a case that asset prices should play a role in creating inflation forecasts and determining monetary policy. Since asset prices play a major role in daily decisions that affect firms and households, an asset bubble created by inflation is not good for the economy in the long run. As the prospect of deflation increases, the central bank will have to reverse the trend it created. As Cecchetti and others argued, the central bank should not target asset prices, but only take them into consideration when determining monetary policy. If equities, real estate or any other volatile assets are increasing at a rate higher than historical levels, the central bank should raise interest rates. If any of these assets are increasing at a rate lower than historical levels, the central bank should lower interest rates.
Inflation Threat: Investors Starting to Show Inflation Threat Is Real (click here)
Liquidity Induced Bubble Could Burst: Fund Manager (click here)
Monday, February 14, 2011
Q4 2010 Form 13F Filings
One way for an average investor to be successful is to look at professional investors that have an investment philosophy/strategy that most mimmicks theirs. Most average people who want to get involved in investing do not know large investors have to disclose their stakes to the SEC each quarter through a Form 13F.
According to Investopedia, a Form 13F is:
An SEC reporting form filed by institutional investment managers in accordance with the provisions of section 13(f) of the Securities and Exchange Act of 1934, which states that all institutional investment managers who are managing over $100 million on the last trading day of any month of the calendar year must disclose their holdings on a quarterly basis.
Due to their value tilt, I have highlighted changes in Warren Buffett's, John Paulson's, and Bill Ackman's holdings below.
Warren Buffett
There were no key additions to Berkshire Hathaway portfolio of publicly traded companies during Q4 2010. Instead, most of the major changes came from the elimination of core holdings in the portfolio. Key eliminations included the entire share of Bank of America, Comcast, Loews Companies, Nalco Holdings, Nestle and Nike. Other positions that were reduced some include Bank of New York Mellon.
Most of the positions that were eliminated were in the $200-$300 million range. These are the typical size of the stakes managed by Lou Simpson, the former GEICO stockpicker. Some of these holdings included Bank of America, Comcast, and Nike. Essentially, as some analysts have pointed out, Buffett is simply eliminating the positions he is not comfortable with as other portfolio managers will begin to take over the Berkshire portfolio.
The largest stake that was eliminated included Bank of America, which was purchased in 2007. Mr. Buffett did not approve of the "crazy price" Bank of America paid for Merrill Lynch. As Buffett said, "He could have bought them the next day for nothing because Merrill was going to go when Lehman went."
Buffett Closes Out His Bank of America Stake (click here)
Berkshire Hathaway Form 13-F (click here)
John Paulson
In an earlier post, I commented on the annual letter sent to investors in the Paulson & Co funds. Several of the additions and reductions in positions represent the themes that were stated in the letter.
Merger arbitrage positions - Mr. Paulson stated he expected M&A activity to be high in 2011, thus creating a strong environment for merger arbitrage. Two key merger arbitrage trades by the fund right now include J. Crew Group and Del Monte foods.
Distressed situations - As borrowing costs continue to decrease for lower rated companies, these firms valuations continue to look more attractive; this creates a lower cost of capital and higher firm value. In addition, Mr. Paulson stated companies that were formerly in distressed situations have repaired their balance sheets, so the upside risk is much larger than the downside risk. One position that illustrates this point is the addition of Alcoa Inc. bonds into the portfolio. Leading up to the financial crisis, Alcoa management engaged in a significant stock repurchase program using leverage to do so. When the economy went into a recession, the demand for aluminum fell and the company experienced losses. Because of the increased leverage and decreased equity, the rating agencies downgraded Alcoa many levels. The weakened credit picture forced Alcoa to have problems accessing the short-term debt markets (i.e. commercial paper). As a result of all these factors, Alcoa's credit spreads have widened greatly creating value in their bonds. Finally, the extension of the Bush-era tax cuts, Mr. Paulson is more bullish in the U.S. economy. Thus, if the economy improves, Alcoa's future improves and the company credit spreads should decrease causing the bond's value to increase. This is a pure play of an improving economy helping poor credits improve
Other examples of these type of positions include Lear Corporation (i.e. the auto industry) and International Paper.
Financials - Key reductions include reducing the common stock position in Bank of America and Citigroup. Mr. Paulson increased his position in Wells Fargo and Capital One, while adding a position in Royal Bank of Scotland. Key positions that were maintained included JPMorgan Chase, Northern Trust, and State Street.
In my opinion, Mr. Paulson saw the earnings powers of these banks diminish and had some "profit-taking" over the past quarter. JPMorgan Chase is a solid franchise that is just as strong or stronger than before the crisis. In addition, Northern Trust, State Street, and Wells Fargo are well positioned if inflationary pressures cause a large increase in interest rates; this should increase the net interest margin, thus profitability.
Inflation trade - Mr. Paulson's portfolios are positioned for the inflation trade. For example, key trades in Gold Fields Ltd, IAMGOLD, and the SPDR Gold Trust were all maintained.
John Paulson Trims Citigroup and BofA Stakes (click here)
Paulson & Co. Form 13F (click here)
Bill Ackman
Bill Ackman's Pershing Square portfolio saw a good amount of change. Positions in Automatic Data Processing (ADP), Citigroup, Kraft Foods, and Target Corp were all down. Positions in Fortune Brands and JCPenney were up.
Fortune Brands - Recently, Fortune Brands announced in its Q4 2010 earnings release that it would split itself into three brands: the spirits group that owns Jim Beam whiskey; the golf equipment unit that owns Titleist; and the home products operations that own the likes of Moen faucets.
Regarding the golf equipment part of the business, the company is seeking out large bidders (i.e. Nike) or private equity firms. If the company cannot get the right price for the golf part of the business, the firm intends for an IPO. Regarding the home products part of the business, the firm intends an IPO by late 2011. The intent is that increasing home starts will lead to an increase in demand for home products, thus creating the most value of shareholders. So, what is left of the spirits business? If firms like Diageo can overcome antitrust issues, the spirits business will be a likely target.
Fortune Brands on Track For Breakup (click here)
Video: Fortune Brands Big Breakup (click here)
Pershing Square Adds GM, Almost Triples General Growth Holding (click here)
Pershing Square Form 13F (click here)
What does this mean?
Overall, I think the investment community is very bullish on financials going forward. These three investors all reduced their positions in financials that faced the brunt of the crisis (i.e. Citi and Bank of America). If positions were added or maintained, they were to more traditional lenders (i.e. Wells Fargo) or service providers (i.e. Northern Trust or State Street) with earnings that are levered to higher interest rates and increase mortgage origination. These stocks have not performed well against the general market. To position a portfolio, I think these are great names. Other names include Bank of Hawaii (BOH) or Hudson City Bancorp (HCBK). Finally, JPMorgan should continue to deserve a look.
Overall, these investors are very bullish on the U.S. economy. One such area is in housing. For example, Mr. Paulson holds a large position on Beazer Homes. Mr. Ackman is the major driver of the Fortune Brands break-up, including pushing for an IPO for the home security business predicated on an increase in new home starts. Thus, another area to look to value right now is housing.
An area of concern I have is in the area of M&A. Although the economic picture is looking brighter for the U.S., large multinationals are going to struggle for organic growth. Instead, they will need to look at acquisitions to have earnings growth, particularly in emerging market economies. To help get a foot in these markets, buyers will often overpay for companies and may never receive the benefits. While this is good from a merger arbitrage perspective, it is bad from a value investor's perspective that looks at companies to either grow organically or allocate capital efficiently.
According to Investopedia, a Form 13F is:
An SEC reporting form filed by institutional investment managers in accordance with the provisions of section 13(f) of the Securities and Exchange Act of 1934, which states that all institutional investment managers who are managing over $100 million on the last trading day of any month of the calendar year must disclose their holdings on a quarterly basis.
Due to their value tilt, I have highlighted changes in Warren Buffett's, John Paulson's, and Bill Ackman's holdings below.
Warren Buffett
There were no key additions to Berkshire Hathaway portfolio of publicly traded companies during Q4 2010. Instead, most of the major changes came from the elimination of core holdings in the portfolio. Key eliminations included the entire share of Bank of America, Comcast, Loews Companies, Nalco Holdings, Nestle and Nike. Other positions that were reduced some include Bank of New York Mellon.
Most of the positions that were eliminated were in the $200-$300 million range. These are the typical size of the stakes managed by Lou Simpson, the former GEICO stockpicker. Some of these holdings included Bank of America, Comcast, and Nike. Essentially, as some analysts have pointed out, Buffett is simply eliminating the positions he is not comfortable with as other portfolio managers will begin to take over the Berkshire portfolio.
The largest stake that was eliminated included Bank of America, which was purchased in 2007. Mr. Buffett did not approve of the "crazy price" Bank of America paid for Merrill Lynch. As Buffett said, "He could have bought them the next day for nothing because Merrill was going to go when Lehman went."
Buffett Closes Out His Bank of America Stake (click here)
Berkshire Hathaway Form 13-F (click here)
John Paulson
In an earlier post, I commented on the annual letter sent to investors in the Paulson & Co funds. Several of the additions and reductions in positions represent the themes that were stated in the letter.
Merger arbitrage positions - Mr. Paulson stated he expected M&A activity to be high in 2011, thus creating a strong environment for merger arbitrage. Two key merger arbitrage trades by the fund right now include J. Crew Group and Del Monte foods.
Distressed situations - As borrowing costs continue to decrease for lower rated companies, these firms valuations continue to look more attractive; this creates a lower cost of capital and higher firm value. In addition, Mr. Paulson stated companies that were formerly in distressed situations have repaired their balance sheets, so the upside risk is much larger than the downside risk. One position that illustrates this point is the addition of Alcoa Inc. bonds into the portfolio. Leading up to the financial crisis, Alcoa management engaged in a significant stock repurchase program using leverage to do so. When the economy went into a recession, the demand for aluminum fell and the company experienced losses. Because of the increased leverage and decreased equity, the rating agencies downgraded Alcoa many levels. The weakened credit picture forced Alcoa to have problems accessing the short-term debt markets (i.e. commercial paper). As a result of all these factors, Alcoa's credit spreads have widened greatly creating value in their bonds. Finally, the extension of the Bush-era tax cuts, Mr. Paulson is more bullish in the U.S. economy. Thus, if the economy improves, Alcoa's future improves and the company credit spreads should decrease causing the bond's value to increase. This is a pure play of an improving economy helping poor credits improve
Other examples of these type of positions include Lear Corporation (i.e. the auto industry) and International Paper.
Financials - Key reductions include reducing the common stock position in Bank of America and Citigroup. Mr. Paulson increased his position in Wells Fargo and Capital One, while adding a position in Royal Bank of Scotland. Key positions that were maintained included JPMorgan Chase, Northern Trust, and State Street.
In my opinion, Mr. Paulson saw the earnings powers of these banks diminish and had some "profit-taking" over the past quarter. JPMorgan Chase is a solid franchise that is just as strong or stronger than before the crisis. In addition, Northern Trust, State Street, and Wells Fargo are well positioned if inflationary pressures cause a large increase in interest rates; this should increase the net interest margin, thus profitability.
Inflation trade - Mr. Paulson's portfolios are positioned for the inflation trade. For example, key trades in Gold Fields Ltd, IAMGOLD, and the SPDR Gold Trust were all maintained.
John Paulson Trims Citigroup and BofA Stakes (click here)
Paulson & Co. Form 13F (click here)
Bill Ackman
Bill Ackman's Pershing Square portfolio saw a good amount of change. Positions in Automatic Data Processing (ADP), Citigroup, Kraft Foods, and Target Corp were all down. Positions in Fortune Brands and JCPenney were up.
Fortune Brands - Recently, Fortune Brands announced in its Q4 2010 earnings release that it would split itself into three brands: the spirits group that owns Jim Beam whiskey; the golf equipment unit that owns Titleist; and the home products operations that own the likes of Moen faucets.
Regarding the golf equipment part of the business, the company is seeking out large bidders (i.e. Nike) or private equity firms. If the company cannot get the right price for the golf part of the business, the firm intends for an IPO. Regarding the home products part of the business, the firm intends an IPO by late 2011. The intent is that increasing home starts will lead to an increase in demand for home products, thus creating the most value of shareholders. So, what is left of the spirits business? If firms like Diageo can overcome antitrust issues, the spirits business will be a likely target.
Fortune Brands on Track For Breakup (click here)
Video: Fortune Brands Big Breakup (click here)
Pershing Square Adds GM, Almost Triples General Growth Holding (click here)
Pershing Square Form 13F (click here)
What does this mean?
Overall, I think the investment community is very bullish on financials going forward. These three investors all reduced their positions in financials that faced the brunt of the crisis (i.e. Citi and Bank of America). If positions were added or maintained, they were to more traditional lenders (i.e. Wells Fargo) or service providers (i.e. Northern Trust or State Street) with earnings that are levered to higher interest rates and increase mortgage origination. These stocks have not performed well against the general market. To position a portfolio, I think these are great names. Other names include Bank of Hawaii (BOH) or Hudson City Bancorp (HCBK). Finally, JPMorgan should continue to deserve a look.
Overall, these investors are very bullish on the U.S. economy. One such area is in housing. For example, Mr. Paulson holds a large position on Beazer Homes. Mr. Ackman is the major driver of the Fortune Brands break-up, including pushing for an IPO for the home security business predicated on an increase in new home starts. Thus, another area to look to value right now is housing.
An area of concern I have is in the area of M&A. Although the economic picture is looking brighter for the U.S., large multinationals are going to struggle for organic growth. Instead, they will need to look at acquisitions to have earnings growth, particularly in emerging market economies. To help get a foot in these markets, buyers will often overpay for companies and may never receive the benefits. While this is good from a merger arbitrage perspective, it is bad from a value investor's perspective that looks at companies to either grow organically or allocate capital efficiently.
This information is for educational purposes only, and the opinions expressed do not constitute a recommendation to buy or sell. Author may have a position in the companies discussed, subject to change at any time. Information on this website obtained from reliable sources, but there is no guarantee of accuracy. Please consult your financial advisor before making investment decisions. Past performance is not indicative of future success.
I am long JPM.
Wednesday, February 9, 2011
Fly like a cheesehead...
I am a Packers fan, btw. I have not had any posts considering their Super Bowl victory, so I thought it would be cool to share some cool stuff I have read about the Packers since they won the Super Bowl.
Fly like a cheesehead...
A group of students at the University of Wisconsin came up with a parody to the song, "Like a G6." Instead of going like, "...like a G6," the song goes, "...like a cheesehead." Being a Packer fan, I remember the Packarena from the 1990's. It is interesting to note that without the internet or sites like YouTube, things like this would not be possible. As we all know, the internet creates a venue and mass marketing opportunity for anybody out there.
http://www.youtube.com/watch?v=Y3pFD-xdPRE
Owning the Packers
The Green Bay Packers are a team that is owned by the public. The article explains, I think in a great way, the tangible and intangible benefits of owning a business:
Sometimes, though, the sentiment may be what you're most interested in. Witness all the online services that will sell you a single framed stock certificate of the company of your choice. You'll probably never get rich off that sole share, but at least you can proudly say you own a small piece of your favorite company.
Btw - I would love to own a piece of the Packers!
The Packers and Pride of Ownership (click here)
A Packer Fan on Wall St.
Aaron Nagler works at Blackstone and runs cheeseheadtv.com, which is the largest Packer fan website. Because of working at Blackstone, Mr. Nagler lives in NY. Besides not having the money to go to the game, I really liked the reason of why he stayed in New York to watch the Packers win the Super Bowl:
To put it as simply as possible — I want to watch the Packers win the Super Bowl with my family...call me foolish, tell me I’m angering the football Gods — I don’t care. I like our chances. The Packers are ready to start winning championships. Plural. And I want to watch the first one with my girls.”
Checking in with Wall Street's Cheesehead (click here)
Fly like a cheesehead...
A group of students at the University of Wisconsin came up with a parody to the song, "Like a G6." Instead of going like, "...like a G6," the song goes, "...like a cheesehead." Being a Packer fan, I remember the Packarena from the 1990's. It is interesting to note that without the internet or sites like YouTube, things like this would not be possible. As we all know, the internet creates a venue and mass marketing opportunity for anybody out there.
http://www.youtube.com/watch?v=Y3pFD-xdPRE
Owning the Packers
The Green Bay Packers are a team that is owned by the public. The article explains, I think in a great way, the tangible and intangible benefits of owning a business:
Sometimes, though, the sentiment may be what you're most interested in. Witness all the online services that will sell you a single framed stock certificate of the company of your choice. You'll probably never get rich off that sole share, but at least you can proudly say you own a small piece of your favorite company.
Btw - I would love to own a piece of the Packers!
The Packers and Pride of Ownership (click here)
A Packer Fan on Wall St.
Aaron Nagler works at Blackstone and runs cheeseheadtv.com, which is the largest Packer fan website. Because of working at Blackstone, Mr. Nagler lives in NY. Besides not having the money to go to the game, I really liked the reason of why he stayed in New York to watch the Packers win the Super Bowl:
To put it as simply as possible — I want to watch the Packers win the Super Bowl with my family...call me foolish, tell me I’m angering the football Gods — I don’t care. I like our chances. The Packers are ready to start winning championships. Plural. And I want to watch the first one with my girls.”
Checking in with Wall Street's Cheesehead (click here)
Reading List - January 8, 2010
Bill Ackman, Michael Porter & efficient markets
Below is a link to a video from "Squawk Box" on CNBC with Michael Porter and Bill Ackman. For those of you who don't know who Michael Porter is, Michael Porter is a professor at Harvard Business School and today's leading expert on competitive strategy. Bill Ackman was mentioned in an earlier post because of buying a large portion in JCPenney and gaining a few seats on JCPenney's board. The video centers around are capital markets efficient and are useful for businesses to raise capital today. Interesting points from the article include:
Private equity: stage left?
The article highlights a company's management teaming with private equity plaers for a private equity buyout. The issue has come to forefront as Kinder Morgan and HCA, both part of management led buyouts, will be seeking to tap the IPO market.
The risk to a management led buyout is often management is friends with the directors. This creates a problemdddd as management might try to force a low bid. If the directors refuse the deal, they may in effect be firing key managers. There is another additional agency cost. Often times, management will steer directors to accepting a deal from private equity versus a strategic buyer because private equity will retain that management.
So, can management led buyouts create value? According to the article:
Yet management-led buyouts can be economically beneficial, others argue. The primary justification is that a private company can be more efficient than a public one because of the capacity for an increased debt load, lower regulatory costs and diminished public scrutiny. And management is best positioned to reap these gains. After all, this is what private equity is about — creating benefits by taking companies private.
In Kinder Morgan and HCA IPO's, a Cautionary Tale (click here)
A Drilling Boom
Ensco will buy rival Pride International for $7.3 billion. The future for offshore drilling looks bright as we are building up offshore rigs at a level last seen in 2007.
The Beginning of a Deepwater Drilling Boom (click here)
Goldman to Playboy
On a lighter note, just read it.
Goldman Intern Turns Playboy Bunny (click here)
Below is a link to a video from "Squawk Box" on CNBC with Michael Porter and Bill Ackman. For those of you who don't know who Michael Porter is, Michael Porter is a professor at Harvard Business School and today's leading expert on competitive strategy. Bill Ackman was mentioned in an earlier post because of buying a large portion in JCPenney and gaining a few seats on JCPenney's board. The video centers around are capital markets efficient and are useful for businesses to raise capital today. Interesting points from the article include:
- Bill Ackman had Michael Porter as a professor at Harvard while earning his MBA. What struck me is how much Ackman said Porter was influential on him. Ackman said Porter's strategy emphasis really made him look at the business (or franchise) he was investing in. To take that a step further, it is just as important to understand the industry your investing in and the external forces that impact that industry.
- The point was brought up about the increased frequency in trading that occurs in today's markets, essentially separating short-term traders and long-term investors. Ackman said this dualism in the markets in the market is actually a good thing by creating arbitrage opportunities. Because so many traders and short-term investors are focused on quarterly earnings, the stock is sold off and does not reflect the intrinsic value of the business. Long-term investors can purchase the business at these depressed valuations and drive the price towards the intrinsic value.
- The whole notion of guidance is a bad idea and investors should do their own homework. Also, by setting quarterly earnings targets, a firm often deserves the type of investors it gets. By setting quarterly earnings targets, it may force management to make the wrong decisions to essentially game the share price. You have to think, "If I were running this business privately, what would I do?"
- Ackman goes against the Benjamin Graham notion of intrinsic value and realization of value. Instead, Ackman believes you purchase an undervalued company at the current moment, but do not sell the company when the company reaches the intrinsic value at which you bought. Businesses are not static. Instead, it is important to find businesses that will continually create value and re-assess the intrinsic value on an ongoing basis.
Private equity: stage left?
The article highlights a company's management teaming with private equity plaers for a private equity buyout. The issue has come to forefront as Kinder Morgan and HCA, both part of management led buyouts, will be seeking to tap the IPO market.
The risk to a management led buyout is often management is friends with the directors. This creates a problemdddd as management might try to force a low bid. If the directors refuse the deal, they may in effect be firing key managers. There is another additional agency cost. Often times, management will steer directors to accepting a deal from private equity versus a strategic buyer because private equity will retain that management.
So, can management led buyouts create value? According to the article:
Yet management-led buyouts can be economically beneficial, others argue. The primary justification is that a private company can be more efficient than a public one because of the capacity for an increased debt load, lower regulatory costs and diminished public scrutiny. And management is best positioned to reap these gains. After all, this is what private equity is about — creating benefits by taking companies private.
In Kinder Morgan and HCA IPO's, a Cautionary Tale (click here)
A Drilling Boom
Ensco will buy rival Pride International for $7.3 billion. The future for offshore drilling looks bright as we are building up offshore rigs at a level last seen in 2007.
The Beginning of a Deepwater Drilling Boom (click here)
Goldman to Playboy
On a lighter note, just read it.
Goldman Intern Turns Playboy Bunny (click here)
Sunday, February 6, 2011
The Fed's Third Mandate?
So far on this blog, I have not posted a lot of articles or written about macroeconomic policy, particularly Federal Reserve policy. Today will be the start, as I intend to post more about Fed policy, inflation, and how inflation can impact an investor's decisions.
When I was an economics major in college, I learned all about the Federal Reserve's mandate and the Humphrey-Hawkins Act. The Humphrey-Hawkins charges the Fed with two major policy mandates. The first mandate is a stable price level. The second mandate is full employment, or a low unemployment rate that does not cause inflation. Recently, with quantitative easing, creating a wealth effect appears to be a new mandate.
Most of you have probably heard of quantitative easing (QE), but what exactly is QE? QE is the Federal Reserve purchasing medium- to long-term Treasury bonds with the goal that interest rates will remain low. The goal of QE is to create a wealth effect in riskier assets (i.e. equities, real estate, etc.) The wealth effect will be a positive for the investor class, which should then lead to broader economy. The problem the Federal Reserve now faces is long-term interest rates have risen, and commodity prices have risen. The side effects of QE have created a wealth effect for upper income earners and investors, while creating a poverty effect for lower income earners because of rising commodity prices. So, does the emperor have any clothes? The emperor might still have clothes, but he is getting caught with his pants down!
A CNBC blog, NetNet, had an interesting article titled, "Is the Fed's Real Target 1,755 for the S&P?" The article highlights the corner the Federal Reserve has backed itself into points that the only way to get out is higher asset prices. It tries to answer the question: do rising stocks lead to lower unemployment, or does lower unemployment lead to rising stocks? Although the correlation is not strong (somewhere in the 28% range), the correlation points to higher stock prices leading to lower unemployment. Considering the Federal Reserve has expanded its balance sheet by $2 trillion and unemployment has actually gone up, what are implications for QE3, QE4 or QE5? As the article points out:
....If the economy does get to Fed Chairman Ben Bernanke’s target of 8 percent unemployment by 2012, that would mean the Standard & Poor’s 500 would have to rise to 1,755—a stunning 35 percent gain from current levels and beyond even the already-bullish prognostications for this year.
The problem for investors is there is no real way to determine the true effects of QE. One indicator is to look at the US Treasury market, and the twos-tens spread. The twos-tens spread is the difference in yield between a ten-year Treasury and two-year Treasury. Because the Federal Reserve is buying so much debt around the ten-year space of the yield curve, it creates a ceiling of how much rates can actually rise. The market will only truly understand when QE2 is stopped in mid-year 2011.
Dick Fisher, president of the Dallas Federal Reserve and an inflation hawk, has stated he would no longer support QE after QE2 ends. He compared the program to a fait accompli. In addition, he stated he would not support it considering the improvement in the overall economy:
You can never say never, but I cannot imagine a convincing argument for further quantitative easing after this round, given what is developing now in the economy...
Stay posted!
Is the Fed's Real Target 1,755 for the S&P? (click here)
Dallas Fed's Fisher Says He Won't Support Further Asset Buying After June (click here)
When I was an economics major in college, I learned all about the Federal Reserve's mandate and the Humphrey-Hawkins Act. The Humphrey-Hawkins charges the Fed with two major policy mandates. The first mandate is a stable price level. The second mandate is full employment, or a low unemployment rate that does not cause inflation. Recently, with quantitative easing, creating a wealth effect appears to be a new mandate.
Most of you have probably heard of quantitative easing (QE), but what exactly is QE? QE is the Federal Reserve purchasing medium- to long-term Treasury bonds with the goal that interest rates will remain low. The goal of QE is to create a wealth effect in riskier assets (i.e. equities, real estate, etc.) The wealth effect will be a positive for the investor class, which should then lead to broader economy. The problem the Federal Reserve now faces is long-term interest rates have risen, and commodity prices have risen. The side effects of QE have created a wealth effect for upper income earners and investors, while creating a poverty effect for lower income earners because of rising commodity prices. So, does the emperor have any clothes? The emperor might still have clothes, but he is getting caught with his pants down!
A CNBC blog, NetNet, had an interesting article titled, "Is the Fed's Real Target 1,755 for the S&P?" The article highlights the corner the Federal Reserve has backed itself into points that the only way to get out is higher asset prices. It tries to answer the question: do rising stocks lead to lower unemployment, or does lower unemployment lead to rising stocks? Although the correlation is not strong (somewhere in the 28% range), the correlation points to higher stock prices leading to lower unemployment. Considering the Federal Reserve has expanded its balance sheet by $2 trillion and unemployment has actually gone up, what are implications for QE3, QE4 or QE5? As the article points out:
....If the economy does get to Fed Chairman Ben Bernanke’s target of 8 percent unemployment by 2012, that would mean the Standard & Poor’s 500 would have to rise to 1,755—a stunning 35 percent gain from current levels and beyond even the already-bullish prognostications for this year.
The problem for investors is there is no real way to determine the true effects of QE. One indicator is to look at the US Treasury market, and the twos-tens spread. The twos-tens spread is the difference in yield between a ten-year Treasury and two-year Treasury. Because the Federal Reserve is buying so much debt around the ten-year space of the yield curve, it creates a ceiling of how much rates can actually rise. The market will only truly understand when QE2 is stopped in mid-year 2011.
Dick Fisher, president of the Dallas Federal Reserve and an inflation hawk, has stated he would no longer support QE after QE2 ends. He compared the program to a fait accompli. In addition, he stated he would not support it considering the improvement in the overall economy:
You can never say never, but I cannot imagine a convincing argument for further quantitative easing after this round, given what is developing now in the economy...
Stay posted!
Is the Fed's Real Target 1,755 for the S&P? (click here)
Dallas Fed's Fisher Says He Won't Support Further Asset Buying After June (click here)
Saturday, February 5, 2011
Reading List - February 5, 2011
Merger Update
In Bloomberg Brief: Mergers, Howard Lanser of Robert Bard & Co. gives thoughts on the middle-market deal pipeline:
On the deal pipline: In typical M&A recoveries, there are a lot of $10 billion plus deals (i.e. mega deals). Instead, around 60 percent of the deals have been middle market deals under $1 billion. There is still reluctance for large companies to do large deals, as most are looking for strategic deals that will be accretive in a low-growth environment.
On financial sponsors: The economic environment of 2009 and 1H 2010 was not favorable to sell a business. The economic data and earnings in 2H 2010 create a lot more favorable conditions, and will even be more favorable in 2011. Many business owners are beginning to ask how long are the ideal financing conditions going to last, which could limit the ability for buyers.
On Asian deals: The Japanese prefer local deals, and will go after deals they only want. The Chinese view this space differently. As we all know, China is a low-cost producer. China wants to have technologies and processes that will help move them up the value chain.
Private equity IPO's
Recent developments in the private equity markets have shown how much the industry shape has improved from the depths of the recession. Over the past week, Kinder Morgan and Neiman Marcus announced plans for IPO, in addition to Blackstone posting strong quarterly earnings. Although some of the deals that were completed at the peak in 2007 will never be profitable, favorable financing conditions have allowed these companies to refinance and extend debt maturities at lower rates.
Equity Deals Rebounding with IPOs (click here)
Kinder Morgan to Go Public (click here)
Blackstone Posts 56% Rise in Quarterly Profit (click here)
Reverse takeovers
Reverse takeovers are something that are gaining more and more prominence in U.S. capital markets. Primarily, reverse takeovers have been used by Chinese companies and some Israeli tech companies. Since the majority of these reverse takeovers are Chinese companies, there have been more and more people telling investors to be alert for these takeovers.
A reverse takeover (RTO) is:
...accomplished when a privately-held operating company acquires a publicly-traded entity. The idea is that the latter not be a legitimate business but, essentially, a corporate shell. These aren’t hard to find. If you remove all liquidity filters from your own screens, you may find many penny stocks that are little, if any, more than shells. After the takeover is completed, the managers of the acquiring firm take control over the newly merged entity and usually change its name to match that of the privately-held business. Voila! A privately held business is now associated with trade-able U.S. stock. If the stock already has a NASDAQ listing, so much the better. When the RTO is completed, listing applications are filed for those that aren’t yet listed.
The article goes into the pros and cons for reverse takeovers. Pros include a fast and inexpensive way for a company to gain access to capital markets, less time than an IPO, and brings more companies into securities markets. The one I found most interesting is its a fast and easy way for a company to gain access to capital markets. The story highlighted the struggles that companies like Apple had when going public because regulators were scared that normal retail investors did not possess the knowledge to fully understand their investments. Between the fraud of the tech bubble and recent Wall St. bailouts, no wonder why RTO's have come under increased scrutiny. But, what is important is that growing companies need access to capital markets. If the RTO is the way for them to do so, then great!
The long-and-short of it is investing in companies that go through an RTO are risky, and investing in those that do not is is risky. But, buyer beware because these companies often are in the corners of the market most unfamiliar to regular investors.
Reverse Takeovers: The Poor Man's IPO Deserves Some Respect (click here)
Government IPO's
Ally Financial (the former GMAC) has chosen the lead banks for its IPO. The banks that will complete the Ally IPO, in addition to the other IPO's for the bailed out companies, will only receive a fraction of the fees if they were private businesses. Banking chiefs actually consider this an honor as they feel they will help taxpayers earn a profit on these deals.
The Bailout Stock Sale Action (click here)
Treasury Warrior at the Negotiating Table (click here)
John Paulson's January
I have recently has a few posts on John Paulson highlighting strong performance for 2010. The new year has not been so kind to Mr. Paulson, as his funds showed negative returns for January. The declines are primarily due to the decrease in gold prices over the month of January.
January Not Golden for Paulson (click here)
In Bloomberg Brief: Mergers, Howard Lanser of Robert Bard & Co. gives thoughts on the middle-market deal pipeline:
On the deal pipline: In typical M&A recoveries, there are a lot of $10 billion plus deals (i.e. mega deals). Instead, around 60 percent of the deals have been middle market deals under $1 billion. There is still reluctance for large companies to do large deals, as most are looking for strategic deals that will be accretive in a low-growth environment.
On financial sponsors: The economic environment of 2009 and 1H 2010 was not favorable to sell a business. The economic data and earnings in 2H 2010 create a lot more favorable conditions, and will even be more favorable in 2011. Many business owners are beginning to ask how long are the ideal financing conditions going to last, which could limit the ability for buyers.
On Asian deals: The Japanese prefer local deals, and will go after deals they only want. The Chinese view this space differently. As we all know, China is a low-cost producer. China wants to have technologies and processes that will help move them up the value chain.
Private equity IPO's
Recent developments in the private equity markets have shown how much the industry shape has improved from the depths of the recession. Over the past week, Kinder Morgan and Neiman Marcus announced plans for IPO, in addition to Blackstone posting strong quarterly earnings. Although some of the deals that were completed at the peak in 2007 will never be profitable, favorable financing conditions have allowed these companies to refinance and extend debt maturities at lower rates.
Equity Deals Rebounding with IPOs (click here)
Kinder Morgan to Go Public (click here)
Blackstone Posts 56% Rise in Quarterly Profit (click here)
Reverse takeovers
Reverse takeovers are something that are gaining more and more prominence in U.S. capital markets. Primarily, reverse takeovers have been used by Chinese companies and some Israeli tech companies. Since the majority of these reverse takeovers are Chinese companies, there have been more and more people telling investors to be alert for these takeovers.
A reverse takeover (RTO) is:
...accomplished when a privately-held operating company acquires a publicly-traded entity. The idea is that the latter not be a legitimate business but, essentially, a corporate shell. These aren’t hard to find. If you remove all liquidity filters from your own screens, you may find many penny stocks that are little, if any, more than shells. After the takeover is completed, the managers of the acquiring firm take control over the newly merged entity and usually change its name to match that of the privately-held business. Voila! A privately held business is now associated with trade-able U.S. stock. If the stock already has a NASDAQ listing, so much the better. When the RTO is completed, listing applications are filed for those that aren’t yet listed.
The article goes into the pros and cons for reverse takeovers. Pros include a fast and inexpensive way for a company to gain access to capital markets, less time than an IPO, and brings more companies into securities markets. The one I found most interesting is its a fast and easy way for a company to gain access to capital markets. The story highlighted the struggles that companies like Apple had when going public because regulators were scared that normal retail investors did not possess the knowledge to fully understand their investments. Between the fraud of the tech bubble and recent Wall St. bailouts, no wonder why RTO's have come under increased scrutiny. But, what is important is that growing companies need access to capital markets. If the RTO is the way for them to do so, then great!
The long-and-short of it is investing in companies that go through an RTO are risky, and investing in those that do not is is risky. But, buyer beware because these companies often are in the corners of the market most unfamiliar to regular investors.
Reverse Takeovers: The Poor Man's IPO Deserves Some Respect (click here)
Government IPO's
Ally Financial (the former GMAC) has chosen the lead banks for its IPO. The banks that will complete the Ally IPO, in addition to the other IPO's for the bailed out companies, will only receive a fraction of the fees if they were private businesses. Banking chiefs actually consider this an honor as they feel they will help taxpayers earn a profit on these deals.
The Bailout Stock Sale Action (click here)
Treasury Warrior at the Negotiating Table (click here)
John Paulson's January
I have recently has a few posts on John Paulson highlighting strong performance for 2010. The new year has not been so kind to Mr. Paulson, as his funds showed negative returns for January. The declines are primarily due to the decrease in gold prices over the month of January.
January Not Golden for Paulson (click here)
What is Merger Arbitrage?
What is arbitrage?
In its simplest form, arbitrage is the purchase of a security in one market and sale of the same security in a different market.
For example, Special Microbrew Co. makes a large array of microbrews. Management decides to list the company in both New York and Paris. At one point in time, Special trades at $5.00 per share in New York. At that same point in time, Special trades at $5.01 in Paris. An arbitrageur would purchase the shares in New York at $5.00 and sell them in Paris at $5.01, netting a $0.01 profit.
Obviously, a penny profit per share is not a large amount. Arbitrageurs of this sort need large amounts of capital to make real money. There are other forms of arbitrage.
What are the different types of arbitrage?
Different types of arbitrage including pure arbitrage, pairs trading, liquidation arbitrage and merger (or risk) arbitrage. This post will focus on merger arbitrage.
What is merger arbitrage?
Merger arbitrage is the trading of companies involved in mergers and acquisitions. For retail investors, it is the simplest form of arbitrage. It essentially involves one company that another company decides to acquire, because the company could be undervalued. The acquiring company announces the deal and the price of the company being acquired should increase to the intrinsic value.
A simple example: Special Microbrew Co. is trading at $5.00 per share. Big Brewery Co. decides it would like to expand in microbrew business and wants to acquire a microbrewery. Big Brewery’s investment team looks at potential targets and decides Special is the appropriate target. Big Brewery’s investment team and a selected team of banks decide what Special’s intrinsic value is, and decide Special’s value is $7.50 per share. Big Brewery announces the deal that it will acquire Special for $7.50 per share in cash in three months.
Early traders, primarily hedge funds, try to take advantage of their first mover advantage and connection to instant information and bid up the price to $6.50 per share. Currently, there is a $1.00 difference between the market price and target price, thus creating an opportunity for arbitrage. A retail investor can purchase the shares of Special shares for $6.50 and receive $7.50 in cash in three months. This would work to over a 15% return, or over 60% when annualized.
Details of the deal
The example given above only explains the situation if there is a cash deal. Different types of deal structures are:
- All cash deal
- All stock deal
- Combination of cash and stock
All cash deal
An all cash deal is where the buyer offers the investors in the company being acquired all cash for the shares. The example above is the simplest form of an all cash deal.
All stock deal
An all stock deal is where the buyer offers the investors in the company being acquired some fraction of shares in the buyer’s company. For example, in the above example, Special Microbrew is trading at $5.00 per share. Big Brewery is trading at $75.00 per share. Keeping consistent with the idea that Special is worth $7.50 per share, Big Brewery offers Special’s investors 0.10 shares of Big Brewery ($75.00/$7.50 = 0.10).
These deals are more complex than an all cash deal. In an all stock deal, an investor is betting on the stock price of the acquirer. In these events, the share price of the company being acquired often increases and the share price of the buyer often decreases. Thus, investors frequently purchase (or are long) the company being acquired and be short the buyer. Shorting the buyer protects against changes in the buyer’s stock price, which will ultimately impact the final price of the deal.
In the all stock example above, Big Brewery is trading at near $75.00 per share and will offer Special’s shareholders 0.10 shares. For example, a retail investor has $650 to invest. He would purchase 100 shares of Special and short 0.10 shares (100 * 0.10 = 10) of Big Brewery. After the deal is announced, Big Brewery falls in price from $75.00 to $65.00. Thus, Special’s investors only would receive $6.50 per share versus the $7.50 at the time of announcement. By shorting Big Brewery, the retail investor is protected. See below the comparison of the mechanics of the all cash deal and all stock deal.
| # of shares | Price | Total | |
| All cash deal | |||
| Special at time of completion | 100 | $7.50 | $750.00 |
| Total received at closing | $750.00 | ||
| All stock deal | |||
| Special at time of announcment | 100 | $6.50 | $650.00 |
| If investor shorts Big Brewery | |||
| Big Brewery at time of announcement | 10 | $75.00 | $750.00 |
| Big Brewery at time of completion | 10 | $65.00 | $650.00 |
| Profit for shorting Big Brewery | $100.00 | ||
| Investor receives 0.10 shares of Big Brewery | 10 | $65.00 | $650.00 |
| Total received at closing | $750.00 | ||
Combination of stock and cash
A combination of stock and cash is the most complex. It is where the buyer offers some stock and cash to the investors of the company being acquired. Instead of offering 0.10 shares of Big Brewery, Big Brewery’s management could offer 0.05 shares ($75.00 * 0.05 = $3.75) and $3.75 in cash per share. Thus, the investor is still receiving $7.50 per share. In addition, as in the all stock deal above, an investor would have to short the buyer’s share by the appropriate amount.
What are the risks involved in merger arbitrage?
The primary risk in merger arbitrage is the deal not being completed causing prices of both the company being purchased and buyer to move in unknown directions. Thus, there are risks for large losses.
For example, assume the purchase of Special by Big Brewery will be an all stock deal. The arbitrageur is long Special and short Big Brewery. Assume the deal falls through due to the rating agencies believing Special could pose a credit risk to Big Brewery. Big Brewery’s credit rating is too important and management decides to withdraw the purchase. In this case, the share price of Special could decrease from the $6.50 to $5.00 or where it was trading before the deal was announced. The share price of Big Brewery could increase from $75.00 to $80.00 because investors were worried that Big Brewery has less credit risk. Thus, there are large losses on both sides of the trade.
Another risk for merger arbitrage is the “realization of value” problem. The “realization of value” problem, according to Benjamin Graham, is investors place a value on a security at sometime in the future. If the security does not reach the estimated value at that time, the annualized return will continue to fall. For example, in the Special example above, the deal will be completed in three months and net approximately a 60% gain. If the deal takes six months instead, the annualized return falls to 30%.
Key reasons deals may fall through or be delayed include ability of the buyer to obtain financing, issues that surface during the due diligence phase, regulatory problems, or competing offers.
Why should an investor consider merger arbitrage?
With all the risks associated with merger arbitrage, why should an investor consider it? Well, most investors would like to commit their capital to the long-term. The market may create conditions where investors cannot allocate capital to enough attractive long-term commitments.
The market conditions that many find advantageous for merger arbitrage include when equity markets are going down. Down equity markets typically include a rally in risk-free bonds (i.e. US Treasuries), thus increasing the price of Treasuries and reducing the yield. In addition, management of companies may be concerned with the decreasing share price and could consider selling portions of the business or acquisition offers.
Warren Buffett sometimes engages in arbitrage situations. According the book, “The Essays of Warren Buffett,” in his 1988 and 1989 letter to shareholders, he outlines the reasons for arbitrage:
Our insurance subsidiaries sometimes engage in arbitrage as an alternative to hold short-term cash equivalents. We prefer, of course, to make long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills, and equally important, cools any temptation we may have to relax our standards of long-term investments…
(after discussing the RJR Nabisco arbitrage) considering Berkshire’s good results in 1988, you might expect us to pile into arbitrage during 1989. Instead, we expect to be on the sidelines.
One pleasant reason is that our cash holdings are down – because our position in equities that we expect to hold for a very long time is substantially up. As regular readers of this report know, our new commitments are not based on a judgment about short-term prospects for the stock market. Rather, they reflect an opinion about long-term business prospects for specific companies…
Even if we had a lot of cash we probably would do little arbitrage in 1989. Some extraordinary excesses have developed in the takeover field…
We have no idea how long the excesses will last…But we do know that the less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled – and, in our view, often unwarranted – optimism of both buyers and lenders…
How is return in merger arbitrage situations calculated?
The most straightforward way to calculate the return in arbitrage situations is the formula provided by Benjamin Graham. It is simply:
G = expected gain if deal is completed
L = expected loss if deal is not completed
C = expected chance deal is completed
Y = expected time when value will be realized
P = current price per share
Annual return = (CG – L(100%-C)) / YP
In the above example, the return would be expressed as the following:
G = $1.00, expected gain if deal is completed
L = $1.50, expected loss if deal is not completed
C = 95%, expected chance of success
Y = 0.25 year, expected time when value will be realized
P = $6.50, current share price
Annual return = ((95% * $1.00) - $1.50(100%-95%)) / (0.25 * $6.50)
Annual return = ($0.95 - $0.075) / ($1.625)
Annual return = 53.85%
Based on the risk characteristics of the trade, the investor could expect an annual rate of return of approximately 54% if the purchase of Special by Big Brewery is completed on schedule.
Conclusion
There is a reason merger arbitrage is called risk arbitrage – there is a large amount of inherent risk. But, if done correctly, merger arbitrage can provide solid returns over the long-term.
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